2022 was a tough year for all investors. The Financial Times reported last week that the average 60/40 investment portfolio* lost -17% in 2022. We don’t exactly run portfolios on this basis, but the outcome for most customers was similar. Both bonds, equities, and property fell last year, making it especially challenging.
What of the economy in 2023?
The main debate in investment circles at present revolves around how much damage to corporate profitability will be inflicted by central banks’ desire to control inflation and bring it back to target levels. Clearly, with inflation running at 10% there’s a lot of work to do.
So far, central banks have increased interest rates to around 3% or 4% with more increases to come. The maximum level of rates is forecast to be around 5% in the US and maybe a little lower in the UK and Europe. Commentators are relatively confident in their forecasts and also expect inflation to roll over and drop fairly quickly to low single digits, if not exactly to the target range (which is typically 2% to 3%).
There is good evidence for this positive inflationary outlook.
The price of oil has dropped back below where it stood when Russia invaded Ukraine and has come down from a peak of over $120 a barrel to around $80 a barrel today.
The price of gas has also fallen significantly due to Europe enjoying a mild winter (although it doesn’t feel like this to me at the moment!) and this is now under $3 a Metric Million British thermal unit (MMBtu) from a peak of over $9 an MMBtu. The current level is also lower than at the outbreak of war in Ukraine.
Additional evidence is that the price of shipping containers (say from China to Europe) has plunged to the level that existed before Covid and anecdotally, many supply chain issues are now being, or have been, resolved. An additional help when it comes to bottlenecks is the change of stance exhibited by the Chinese authorities whose Covid “lockdowns” have ceased, with the result that factory production is reverting to normal.
Concerns about corporate profitability remain
So, if one takes the view that inflation will normalise, and interest rates then come down, why the concerns around corporate profitability?
The reason is that historically central banks have had to create a recession to control inflation. Currently, especially in the US and to a lesser extent in the UK and Europe, labour markets are strong and business conditions remain good. Many think this situation will continue and thus markets can move ahead as corporate profits continue to grow.
I don’t share this view and unfortunately think that equity markets are likely to be in for another setback as it dawns on investors that there really will be a global recession, or at least a significant slow-down. Evidence for this comes from the “yield curve**” which is a very accurate predictor of recessions. Indeed, in the past, it has predicted recessions with almost 100% accuracy.
Where to invest in 2023?
We are currently increasing our allocations to bonds. These often perform well in recessions, especially once interest rates start to fall (as the value of bonds then starts to rise). Many bonds are not sensitive to the state of the economy.
I started by stating that this could be a year of two halves. My view is that as we move into an economic slowdown, and market values have fallen, we will then be nicely positioned for the recovery. Inflation will be beaten, interest rates will fall, and the economy will start to recover.
Before this recovery has commenced, markets will start to move ahead in anticipation of better times ahead, and the prospect of higher corporate profits.
Sadly, I have no crystal ball and no market stopwatch. My advice is to simply remain invested and watch events unfold. In short, I expect things to get worse before they get better, but to get better they will, to the benefit of all investors.
*A 60/40 portfolio has 60% exposure to equities (shares) and 40% exposure to bonds (fixed-interest securities). The bond component for a UK investor would traditionally be government-issued gilts.
**The yield curve measures the difference in yields of government bonds over different durations or different terms to maturity. It’s a technical bond market measure of considerable significance.
