The time will come for risk assets

By Dr. Frank Engels, 

member of the Board of Managing Directors of Union Investment responsible for securities portfolio management

From a purely economic perspective, 2023 will be a challenging year. Western countries are unlikely to be able to avoid a recession. The underlying reasons vary, however. Whereas US growth is likely to diminish due to the rapid pace at which monetary policy has been tightened, the downturn in Europe is attributable to the energy crisis and high inflation. These two western economic heavyweights will see a contraction of growth: by 0.2 per cent in the US and by a more substantial 1.0 per cent in the eurozone.

Germany is being hit particularly hard. The German economy is in the eye of the storm. High energy costs are taking their toll on manufacturers, while consumers are tending to hold back in view of stubbornly high inflation and growing uncertainty about job security. Foreign trade is another factor. The US is not the only country with growth problems. In China too, economic growth is very weak due to the zero-COVID strategy. This will not be enough to push Germany’s growth rate above zero, even though fiscal policy is providing some support. We anticipate that German GDP will decrease by 1.4 per cent overall.

It is important for the capital markets that the recession is not expected to be severe. These fairly positive prospects should have an increasing influence on investor sentiment over the course of next year, which means we should see optimism about economic growth and inflation. Inflation will remain structurally high compared with the levels we have become accustomed to in the past ten years. However, it will drop from its current elevated level during 2023 due to the slowing economy, the damping effects of tightening monetary policy worldwide and the fact that prices for base products and intermediates have come down again thanks to more stable supply chains. Energy prices are also expected to settle down. According to our forecasts, inflation will be 4.1 per cent in the US and 6.4 per cent in both the eurozone and Germany next year.

Falling inflation will make life easier for the central banks. Their focus is currently trained firmly on curbing inflation. However, the slower that prices continue to rise, the sooner that central banks will be able to rein in or even stop the tightening of monetary policy. We will see the European Central Bank (ECB) raising interest rates by another 75 basis points this year, followed by further rises of 50 basis points in the first quarter of 2023 – but that should be all.

Central banks will then turn their attention to trimming down their balance sheets, with the ECB likely to make a start on this in 2023. We therefore expect the central banks to reduce the overall level of liquidity next year. This will also be the case for the US Federal Reserve (Fed), which we believe is already approaching the end of its cycle of interest-rate increases. We expect a further rise of 50 basis points at the Fed’s meeting in December 2022. The US central bank may possibly raise interest rates again next year, but not by much.

Opportunities are available, particularly from certain fixed-income investments. Bonds are increasingly regaining their appeal after a long lean spell. The interest-rate market has now largely absorbed the changes in the key economic parameters growth, inflation and monetary policy. Peak inflation and the turning point for monetary policy are likely to be reached soon, so the potential for further yield rises is limited. But at the same time, yields are back at a level that, unlike in recent years, make safe-haven bonds appealing to investors.

Selective exposure to corporate bonds and structured bonds – especially those from issuers with a relatively good credit standing (investment grade) – over the course of the year is likely to be particularly attractive. The headwinds created by rising yields on safe-haven bonds should die down. Furthermore, the fundamental risks presented by investment-grade borrowers are limited, even in a recessionary environment. There is also a cyclical argument to be made: When conditions turn gloomy, corporate bonds are typically among the first asset classes to deteriorate. But they are also one of the first to benefit when the situation improves again.

Particularly careful security selection is therefore advisable, especially when it comes to high-yield paper. These include some interesting issuers and attractive yields, but many of these companies are hit the hardest in an economic downturn. In the emerging markets, there is a definite split in the investment universe between winners and losers. This is due to rising commodity prices on the one hand and rising interest rates in industrialised countries on the other. It is also important to be very discerning about bonds from eurozone periphery countries. Italy is currently faced with significant political uncertainty, making rising risk premiums likely. By contrast, other countries have put their houses in order, are relatively stable in political terms and will probably get through the still difficult capital market environment without too much problem.

Following a lacklustre performance in 2023, we believe that the equity markets are about to rebound slightly. Again, this rebound will probably not materialise until the second half of the year. Although the recession will cause corporate profits to fall by around 10 per cent globally, pressure on valuations will ease markedly because significant interest-rate rises are no longer on the cards.

In the same way as for corporate bonds, the recommendation is to be careful about the equities selected and wary about past trends. For many years, growth stocks have outperformed the broader market. And why? Because there was little growth and interest rates were at historically low levels. This is now changing, so this style’s dominance will diminish. Top-quality and value stocks will therefore become more appealing from a structural perspective. There are also signs of a turnaround for equities with strong sustainability credentials, which took a tumble in 2022. Not all of the adverse effects weighing on shares in the ESG segment will simply disappear in 2023. However, such shares will be supported by the accelerating transition to a greener economy, not least in the US.

By contrast, more caution is required when it comes to equities from the emerging markets (EM), especially given the huge significance of Chinese shares. China accounts for around 40 per cent of EM equities, which creates difficulties not only due to concentration risks but also in light of the increasing politicisation of the Chinese financial markets. These factors become all the more important when you consider that the rivalry between China and the West is only likely to intensify in the medium term. EM shares are therefore currently viewed as relatively unattractive in terms of risk-adjusted expected returns, even though valuations are comparatively favourable.

In our opinion, the opportunities for commodities, which acted as an anchor of stability for portfolios in the first half of 2022, will be scarce in 2023. The main reason for this will be the economic situation. The slowdown in growth will also impact on commodities. Energy commodities are a case in point, with a surplus of crude oil predicted. Our forecast for a barrel of Brent crude in twelve months’ time is US$ 80, i.e. much lower than the current price. The upside potential for precious metals such as gold and silver is also limited owing to the increased appeal of low-risk alternatives like US government bonds. By contrast, we believe the prospects for industrial metals are good. Industrial metal prices have undergone a substantial correction, and demand is receiving a boost from the expansion of renewable energies.

With regard to the approaching new year, investors should not be put off by bad news in the months ahead. Patience will be rewarded. The expected gradual improvements in the key parameters of economic growth, inflation and monetary policy will help to bring about a turnaround in 2023 and the important thing for investors is to be on board when it happens.

As at 16 November 2022.