After closing out a year in which the S&P 500 dropped nearly 20 per cent, Wall Street extended its gloomy demeanour into the start of 2023, with stocks edging lower to start the year amid retreats in some high-profile names. Volatility is likely to remain a big theme for markets this year as economic uncertainty lingers and each data point becomes an opportunity for a clearer picture. Although the pace of rate hikes slowed to 50 basis points in December, the Federal Reserve minutes sent a hawkish signal that they were expected to raise interest rates more times and remain higher for some time until there was enough data to prove that inflation had cooled.

The one sentence from the just-released Fed minutes that captures well the delicate balance that the world’s most influential central bank is seeking to strike: “Participants emphasised that it was important to make it clear that the slowdown in the pace of rate hikes did not signal a weakening of the Committee’s resolve to achieve its price stability goals, or a judgment that inflation has persisted on a downward path.“  It seems the Fed is trying its best to avoid cutting interest rates prematurely, which is not in line with market expectations of a rate cut at the end of this year. Once again, here to remind Investors don’t go against the Fed. Judging from bond market pricing, it’s yet to convince investors and traders and that matters. The market in our view has underestimated its determination to fight inflation.

Investors should be cautious and conservative on investment in 2023. Despite signs that inflation has peaked, prices remain stubbornly high and falling very slowly. Interest rates are climbing, and Fed officials have pledged to keep them steady for some time. The result could be a recession, which seems to be the base case for all in 2023.  It’s been a tough ride, but that doesn’t mean investors can’t find stocks that can weather the triple whammy of macro complications. Investment needs to focus on companies with low debt ratios, strong profitability, and stable growth.

There will be a roller coaster in the current decade, which is a good opportunity for investors who adopt proactive strategies and those who can seize the timing of cyclical fluctuations. But it could be disadvantageous for passive investors in 60/40 share/debt portfolios. If you don’t want your returns to be too low, you must grasp the cycle.

What to predict this year?

There have been too many black swan events in 2022. High inflation has led to a radical tightening of the central government, geo-conflicts have triggered energy crises in many countries, and crypto market shocks have reshaped the investment philosophy of a generation. In 2023, what shall we predict?

The Fed will not withdraw interest rate hikes to boost stocks because it is likely to lead to stagflation, in which case inflation expectations will become entrenched. This could lead to the triple impact of high unemployment, low growth rate and high prices, which is more severe than the recession. They are likely to carry out the tightening to the end. Trillions of dollars have evaporated from the cryptocurrency market and Tesla, Inc.’s valuation has fallen by US$700 billion, a sign that retail investors are panicking.

The threat of a strike: Labour disputes between workers and employers will continue in 2023. If the rise in social wages can be realised, it will mean the occurrence of stagflation, which will have a negative impact on both the bond and stock markets. Investors preparing for a rise in risky assets this year may have underestimated the threat posed to markets by millions of workers around the world protesting higher wages. While signs of inflation peaking have fuelled bets on a weaker dollar and a rebound in global stock markets in 2023, rising labour costs will curb the economic recovery. The flip side of the threat of workers’ strikes and high inflation is rising treasury yields, a recovery in the dollar and changing demand for physical goods and value stocks.

Let’s take a look at the big picture. The globalisation period of the past 30 years is over. The efficiency of a de-globalised world will decline and inflation will increase. A secure supply chain will become more important than a cheap supply chain. The growth rate of the total money supply in the US or around the world is declining sharply. Among them, M2 in the US experienced the worst decline since World War II. So if the Fed does not change its policy stance, monetary tightening will continue, eventually hurting the economy.

Also it is expected that margins will get squeezed in the first half by slowing revenues (a flip side of lower inflation), higher wages and higher interest rates. Small businesses which account for all net new hiring in the past 3 years are especially exposed, given their high labour intensity, and high floating rate exposure. We expect businesses to respond to margin pressures with cost cuts and layoffs, which will likely kick off a recession around Q3.

Companies in Asia, Europe and North America currently have low inventories relative to sales. However, if sales slow in the first half of the year, then companies will reduce inventories and they will have to cut prices. This puts pressure on profit margins and sharply lowers earnings expectations. This is usually when stock prices fall again.

The good news is that inflation is expected to fall in 2023, export prices will fall and oil prices will fall due to exchange rates and other factors. Lower inflation and rising unemployment will prompt the Fed to pivot. Futures markets widely expect major central banks in Europe and the US to slow the pace of interest rate increases, raising hopes that they will eventually be suspended, but continued rate increases will raise the risk of recession, traders are betting the Fed will be forced to cut interest rates with rates peaking in May.

Commodities review and outlook — turbulent 2022, uncertain 2023

2022 was volatile for commodity markets. Behind this, factors such as the geopolitical situation, the energy crisis, the hawkish stance of the Fed and fears of a recession are the main drivers. Entering into 2023, commodity markets still face a lot of uncertainty. Investors should consider these factors: How will the situation in Russia and Ukraine develop? Will inflation fall as desired? Can there be a shift in Fed policy? What is the severity of the recession? Many of these problems will have an impact on how commodities develop in 2023.

On the positive side, commodities could once again be the best-performing asset class in 2023, driven by underinvestment in new capacity, the recovery in global growth on the back of China reopening and the slowdown in Fed interest rate increases. However, the severity of the global recession on the other hand is also the key factor that influenced commodity prices. The underlying global recession, energy shocks in Europe and other factors such as weak demand for crude oil, coupled with higher-than-expected supply in Russia and OPEC+, these factors put pressure on oil prices. OPEC+ production cuts and US actions to replenish strategic oil reserves could provide a soft bottom of US$70 a barrel.

Dollar Trend

The dollar and global liquidity: weakening is the consensus. Recessionary pressure in the US and the slowdown in the Fed’s interest rate increases are the main reasons why the market consensus expects the dollar to weaken. Our view is slightly different and believes the recent weakness of the dollar has been somewhat “preemptive” and has deviated from our indicators of dollar liquidity, while the dollar has rarely weakened significantly under recessionary pressures.  Monetary policy is not the determining variable to judge the strength of the exchange rate, growth is, and the recessionary pressure in the eurozone is greater, so the driving force that determines the reversal of the dollar trend comes from Chinese growth. Judging from the current recovery of Chinese growth and the expected pace of the Fed, the opportunity to judge a complete weakening in the second half of the year could not be ruled out.

China: Post-epidemic era

As China continues to optimise its epidemic policy, the market consensus expects the impact of the epidemic to gradually fade out, thus promoting demand side to restore and supply shocks to subside. The global impact of China’s epidemic policy optimisation may be reflected in the following four aspects: demand is greater than supply; domestic demand is greater than foreign demand; around Asia demand is larger than Europe and the US; service demand is greater than commodity demand. The risk would be if there is further large-scale spread and impact of the epidemic, such as Omicron (XBB and BQ.1), which has recently become a major strain in Europe and the US. 

As demand slows in Europe and the US, markets are generally bearish on emerging market assets and exchange rates that are sensitive to global trade demand and exposure to external demand. In this context, domestic demand is the key, and China is the key to global growth. The market consensus on the restoration of China’s growth under the new reopening policies and epidemic disturbance is basically in line but the difference is only to what extent. 

Multiple positive catalyses, the dawn of Hong Kong stocks has emerged

There are favourable policies released recently, the Sino-US cooperation agreement on audit supervision has been successfully signed, and the risk of delisting of US-listed Chinese stocks has been alleviated. The SFC and Hong Kong’s monetary authorities expand practical cooperation between the capital markets of the two places. The liquidity of Hong Kong stocks will be further enhanced. The Chinese government pays close attention to the development process of digital platform economy and gradually relaxed by policy adjustments.  With the intensive introduction of relevant policies such as the new “10 measures” for epidemic prevention, consumer industries such as catering and tourism will fully benefit from the policy adjustments. 

According to the statistics of the Hong Kong Immigration Department, in 2019 before the epidemic, the total number of inbound and outbound passengers in Hong Kong was about 301 million. The number of tourists visiting Hong Kong was 55.91 million, of which 43.61 million were from the Mainland, accounting for about 78v per cent, becoming the largest source of tourists and income for Hong Kong’s tourism industry. In 2021, there were only about two million visitors, a dramatic drop of nearly 92 per cent.  Obviously, from the most challenging and lowest point, visitor numbers will only balloon from here. 

Hong Kong stocks are still in the early stages of a bull-bear reversal. We expect the negative factors in the past that suppressed the performance of the index will be restored in stages and enter an upward recovery trajectory. That is Stage One: boosting risk appetite when uncertainties eliminating, stocks changed from a valuation trap to a valuation depression, and investors have regained the courage to enter the market. Stage Two: FOMO (fear of missing out) overseas liquidity to enter the market to drive Hong Kong stocks to further repair its valuations. Stage Three: there will be a profit-driven market rally.

This article was written by Inez Chow, Chief Strategist & Co-Head of EAM, VSFG External Asset Management. For more information, click here.

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