With the Eid Al Adha holidays, we are close to turning the page on the first-half of the year. So far, 2023 has been great for investors, with all major asset classes in the green.
Stocks have led the charge, up 14 per cent in developed markets and 7 per cent in emerging ones as we write. It isn't just a handful of AI-related shares boosting Nasdaq. It is broader: Japan, Europe, Latin America, and notably the Dubai DFM are all printing double-digit returns.
And it's not only equities; gold gains 6 per cent, followed by corporate bonds, then money market funds, govies, real estate, and hedge funds. None are in the red. What's not to love?
Well, interestingly, many market participants don’t like this rally, particularly for risk assets. The consensus at 2023’s dawn was for a challenging year. To take an example among many, the usually constructive Goldman Sachs predicted in their yearly outlook that US stocks would, at best, stagnate.
Surely, 2023 hasn’t been a smooth ride for markets. But resilience has been the recurring theme. The global economy has defied forecast; the decline in Western manufacturing was more than compensated by robust services, generating jobs, and bolstering demand.
The Q1 corporate profits exceeded (low) expectations. Stress in the banking sector was controlled, triggering a welcomed flexibility from central banks. AI took the world by storm, hinting at new tech disruption possibilities. Lastly, investors' positioning wasn't ready for good news; flows turned from risk-aversion to the fear of missing out.
As we wrote last month, we have gradually started to take the opposite direction. The backdrop is clear. Western economies are decelerating rather than collapsing, but core inflation is still there.
The latest core CPI for the UK was shocking at 7.1 per cent year-on-year. Western central banks will have to increase their policy rates a bit more, and crucially maintain them at elevated level until inflation convincingly abates closer to their targets.
When's recession showing up?
Consequently, while recession risk seems low in the coming months, it’s likely just a delay. The risk for 2024 is mounting, precisely because economic stagnation is the way to lower inflation. Western stock markets are priced for the current ‘Goldilocks interlude’ (resilient growth, plateauing monetary tightening), but their multiples leave scant room for disappointment.
By contrast, money market funds offer robust risk-free returns, and safe bonds of longer duration add the possibility of capital appreciation if, or when, recession fears come back. Fundamentally, we thus favor safe sources of income from developed markets over their stocks, on which we are now underweight.
Turning to the rest of the world with the same growth/valuation lens, our positive stance on the UAE remains firm – our overweight call started around two years ago and is still on. India's solid growth justifies its elevated valuation among emerging markets.
Awaiting more stimulus cues in China
Japan is our sole overweight within developed markets. However, China’s recovery is fading, with a prolonged real estate situation and rising youth unemployment, compounded by decreased global goods demand.
With no inflation problem there and clear economic ambitions from the country’s leadership, authorities will undoubtedly intervene. It has begun, and we're reasonably optimistic about their GDP trajectory. But convincing markets will take time.
The short-term is unpredictable, and one cardinal rule of investment is to never go ‘all in’, in one direction or another. We anticipate more volatility, but also note that the summer could keep the Goldilocks scenario alive, with resilient activity and only marginally tighter monetary conditions. If markets continue to brush-off inflation and growth concerns for the medium-term, we firmly believe that upside potential for risk-assets is anyway higher in emerging than in developed markets.
Hence our preference for emerging markets. Should more doubts appear, as we anticipate, we should be happy with our strong exposure to safe income sources, as well as with the tactical flexibility provided by liquid money markets.
So far, so good: our strategies are firmly positive in absolute and well placed compared to our global competitors. A gradual and measured level of de-risking makes sense.