Gauging the inflections

Markets are off to a solid start in 2023 as falling inflation, r elatively robust economic data, and China’s COVID policy change drive investor h opes of a “soft landing” for the global economy.

The big question now is whether the latest activity readings and China’s reopening mean the current rally will prove durable, or if we face more volatility and uncertainty ahead.

In our Year Ahead report, we said that 2023 would be a “Year of Inflections,” with the timing and magnitude of turning points in inflation, interest rates, and growth shaping the outlook for markets. In this letter, we assess the progress of the key inflection points and the implications for positioning.

In short, the backdrop remains one of high inflation, rising rates, and slowing growth. But at the same time, labor market and inflation data in r ecent weeks has been encouraging, and we recognize that some parts of the market will reach inflection points before others, meaning dispersion between different geographical markets and sectors is likely to be elevated. We therefore think selectivity will be rewarded, and our positioning reflects that.

For example, we think China’s reopening should allow for a faster turning point in global growth and prove supportive of emerging market equities and commodities. We have added a preference for both asset classes this month. Lower gas prices should reduce recession risks in Europe, and we have moved to a neutral view on the euro from least preferred. We have also added a preference for emerging market bonds relative to high grade bonds, given cooling US inflation and China’s policy shift.

By contrast, still-tight labor markets in the US mean that investor and central bank concerns about inflation are likely to persist despite recent declines in price readings. In addition, we do not believe that US valuations fully reflect the earnings contraction we expect this year. The risk-reward trade-off therefore remains unfavorable for broad US indexes, in our view, and we retain a least preferred stance on US equities and the technology sector.

Elsewhere, within equities, we continue to favor healthcare, consumer staples, and energy. In fixed income, we prefer higher-quality bonds, including high grade and investment grade, relative to high yield credit. In currencies, we have moved the Swiss franc down to neutral, have a most preferred view on the Australian dollar, and retain a least preferred view on the British pound.