As we navigate through uncertain times, one phrase that has stood the test of time is "never fight the Fed". This adage is a reminder that the Federal Reserve holds significant power over the direction of the economy and the markets. Its decisions can have a ripple effect across industries, asset classes, and global markets. Understanding the Fed's role and its impact on the economy and markets is crucial for investors and traders alike. Nevertheless, it seems like in 2023 investors have completely thrown this saying out the window. Investors have been optimistic this year despite the Federal Reserve's decision to raise interest rates, believing that the rate-raising cycle may be over and we’re in for a soft-landing. The Nasdaq stock market is up nearly 15% this year, after posting its best January since 2001. While some believe that this is the beginning of a new bull market, we are of the opinion that this is just another bear market rally and that we will continue to experience ongoing market volatility for the time being.
The Fed keeps reassuring investors that it's not done hiking, and that interest rates will continue to rise. We believe that the current target range of 4.5-4.75 percent likely is to rise to around 5-5.25 percent, with the potential to even go up to 5.5 percent. This will push borrowing costs even higher, which is what the Fed wants to see, and which will have a significant impact on stock markets. From a historical perspective, it would be completely unprecedented to achieve a soft landing considering the economic market reality.
The severely increased financing costs will have a significant impact on financial markets. While the unemployment rate in the States is extremely low, the labor market may be distorted by special effects. There were severe layoffs in the U.S. tech sector, but most other industries are reluctant to lay-off people because they are worried, they will not be able to re-hire them during economic upswing due to the labor shortage.
Source: Visual Capitalist
The U.S. economy currently being overestimated, can cause the Fed to pump the breaks for even longer. On top of that we expect corporate profits to decline sharply.
WE EXPECT CORPORATE PROFITS TO DECLINE SHARPLY
While the strong job market and slowing inflation are likely to provide some cushioning to the growth of stock prices, the Fed's policy of raising rates will continue to cause volatility in the markets. Especially with the consensus of a soft landing, we are confident that once investors realize they have been too optimistic the reaction becomes even more severe.
One final development that confirms our stance on an economic downturn is the current consumer confidence respectively lack thereof. Consumer confidence is a measure of how optimistic or pessimistic people are about their financial situation and the economy's prospects. It reflects people's willingness to spend money on goods and services, which drives economic growth. A sharp decline in consumer confidence indicates that people are becoming less optimistic about the future and are more likely to curtail their spending. This drop in consumer spending has a significant impact on the overall economy, as consumer spending makes up a large part of the GDP. Gilbert Fontana's illustration, based on OECD data from 2019 to 2022, outlines the fluctuation of consumer confidence in nine different economies.
Source: Visual Capitalist
Consequently, to all the above reasonings, we see a recession to be imminent in 2023, though the severity of it remains uncertain. With inflation still high, it makes it difficult to predict the length of the recession. The World Bank predicted a global recession for 2023, with an anticipated GDP growth of 1.7%, the slowest pace since the 2009 recession. While our crystal ball is no clearer than anyone else’s we feel it is important to be prepared for any economic downturn.
Unlocking Asia's Investment Potential: China Reopens and Japan's Central Bank Gets a Facelift
Before we dive deeper into our different asset classes and how they will be affected by the economic developments, let’s first quickly turn our attention to Asia.
We currently see two major developments that affect our investment strategy. First, China re-opened its economy after being closed off due to covid for years and secondly, Japan electing a new president to its central bank.
Since China removed some of its strictest Covid measures, the Chinese yuan has strengthened by more than 6% against the U.S. dollar since the end of November:
The re-opening of China is generally expected to positively influence the economies around the world. Nevertheless, we expect growth will remain weak by historical standards, as the fight against inflation and Russia's war on Ukraine weigh on global economic activity.
At the World Economic Forum, business leaders and policymakers discussed the implications of the Chinese re-opening. There are concerns about inflation and the cost of living, but overall, the business community is excited about making new deals with the world's second-largest economy. Satish Shankar, managing partner for APAC at consultancy Bain & Company, said that "Chinese demand is going to be the biggest driver of global growth". Due to the geopolitical risks, we remain hesitant on increasing our exposure to Asia in the short-run but see China’s opening as a positive sign that Asia might become more attractive again in the midterm.
At the same time Japanese Prime Minister Fumio Kishida's government has nominated Kazuo Ueda as the new head of the Bank of Japan (BoJ). Ueda, a 71-year-old former BOJ policy board member, is set to succeed incumbent Haruhiko Kuroda, whose second, five-year term, ends on April 8th. His appointment marks a historical end to Kuroda's decade-long policy experiment, and he faces the delicate task of normalizing its policy. His predecessor has led the central bank's ultra-dovish monetary policy, including maintaining a negative interest rate since 2016. Bank of America Global Research expects gradual policy normalization under the central bank's new leadership instead of an abrupt change. The team said in a report that completely removing the central bank's yield curve control won't happen any time soon.
Stocks: Staying Cautious while Navigating Market Volatility and Preparing for Future Opportunities
Due to the current market volatility and expected recession we remain cautious in our approach when it comes to stock selection. We do believe, however, that during the year there will be more opportunities presenting itself. We consider this year as crucial to position your portfolio for the next five to ten years. Typically, stock markets are about six months ahead of economic developments. This means that once we hit a recession this presents the turning point at markets and indicate the beginning of a long-term recovery. For the time being we are staying the course with a focus on Swiss investments as well as industries that are not cyclical and have a strong price setting power.
Revisiting Bonds: A more Optimistic Outlook
We remember that 2022 was a historically bad year for bonds. However, we still believe that bonds serve a valuable role in portfolios and that this role will become bigger again this year once interest rates come to a halt.
In the past, when investors have moved their focus from inflation to economic health, the outlook for bonds have often become more positive. That’s why investors may be relatively well served by favoring bonds over stocks in 2023.
We are looking forward to an environment that makes bonds an attractive part of a portfolio again. However, for the time being we focus more on short- and intermediate-term bonds. Reason is the ongoing inflation pressure that looms over the economies. As we could see in the U.S., inflation in January slowed to 6.4% from 6.5% in December. That is 0.3% above what experts were forecasting. We believe that the expectation about disinflation is too optimistic. Accordingly, the Fed might raise interest rates even above the expected 5% – 5.25% range mentioned above and more importantly, will refuse to lower them anytime soon. Also, the inflation in the European Union stays high with 8.5% (vs. 9.2% in December ’22). As long as interest rates are rising, bonds bear the risk of suffering. However, once we have confidence that interest levels are close to their peak, bonds will get back into favor. However, always remember our guiding principle: “quality beats profitability.”
Currency Clues: The Short-Term Strength and Long-Term Uncertainty of the U.S. Dollar
The U.S. dollar is expected to remain reasonably strong in the short-term due to its reliability as a safe-haven currency and the Federal Reserve's rate hikes. Despite this, there is still limited room for further dollar gains based on monetary policy. Speculative traders have shifted to a net short position in the dollar for the first time in 16 months, indicating that they are somewhat concerned about the currency's future. As we have mentioned in previous publications, we do not see the U.S. dollar remaining strong in the long-term. Amongst other reasons we see the huge amount of government debt as a strong factor weighing against continued strength of the currency.
Once the world find itself in a broadly accepted and confirmed recession, we believe that investors will aim for international diversification, leading to increasing capital outflow from the U.S. dollar into foreign currencies. Among others we believe that emerging markets have the potential to be favored in such an environment since they are still attractively priced and have the potential to pick up in their development in another upwards cycle.
One currency you do not want to miss in your portfolio is still the Swiss Franc. Although, the USD/CHF exchange rate was somewhat on a roller-coaster last year, the Swiss Franc proved once again to have the strength to be on a par with the U.S. dollar. We see the main difference in the set-up Switzerland finds itself in. With an inflation of about 3.3% (vs. 2.8% in December ’22), the price level stays considerably stable.
Golden Opportunities: Precious Metals Poised for a Strong Year
For 2023, we expect precious metals prices, especially gold and silver to stay strong. A combination of a sticky high inflation, high interest rates, decreasing corporate profits, and eventually an expected recession are the drivers for precious metals prices. It is our understanding, that the Fed and other central banks will start to ease once they see clear signs of inflation converging to their target of 2%. Due to fact that central banks representatives do also focus on lagging indicators as for example the unemployment rate tells us that they will not stop until a recession is clearly visible.
On top of that, we are still confronted not only with the war in Ukraine but also different other geopolitical hotspots. The latest saber-rattling between the U.S. and China regarding the shootdown of the Chinese balloon increased the tensions between the two superpowers. On top of that four-star general, head of the US Air Mobility Command (AMC), Gen Mike Minihan, recently stated that he expects the U.S. being in war with China by 2025. The risk of an attack from China on Taiwan with an involvement of the U.S. must not be underestimated.
Therefore, we stay our ground on having part of your clients’ portfolios invested in precious metals for the time being. Nevertheless, we consider another spike in precious metals prices, as we saw last year or in 2020, as an opportunity to realize gains and reduce our exposure toward precious metals to generate liquidity to diversify into other investments. Accordingly, the current overweight in precious metals and related investments can be understood as a strategic allocation rather than a long-term strategy.