Outlook 2023

As I look forward to the year ahead, if there is one piece of advice I can give, it is this: beware of the recency bias – placing too much emphasis on the freshest experiences… Public markets have gone on sale, and for yield-seeking investors, there is a significant opportunity in high-quality bonds.

Playing it SAFE

• In 2023, we expect recessions in the US and Europe, a recovery in China, a slowdown in global inflation, and a pause in Fed rates in H1 23, followed by cuts in H2 23. In this fast-changing environment, sequencing asset class preferences is likely to be key.

• We believe it will pay to be SAFE: (i) Secure your yield via income strategies, (ii) Allocate to Asian assets offering long-term value, (iii) Fortify against surprises via defensive assets, and (iv) Expand beyond the traditional via alternative strategies.

• We see opportunities in consumer-focused equity sectors in China as the economy reopens. In FX, we are bullish on the EUR and JPY over a 12-month horizon.

A SAFE approach to foundation portfolios

Financial markets in 2022 left investors with unusually few places to hide, with stocks and bonds both down for only the fourth time in the last 150 years. The experience raises the risk of investors falling prey to the recency bias and extrapolating recent trends into the future. However, history suggests that an unusually bad year for investors is rarely, if ever, followed by yet another poor year. Thus, we believe a fresh perspective based on current market conditions will best serve investors from here.

We expect the economic growth backdrop to remain challenging in 2023. One of the fastest Fed interest rate hiking cycles on record makes a US economic recession very likely. We also expect a recession in Europe due to the energy price shock. An economic slowdown should help inflation cool significantly, but not all the way back to 2%. We expect growth in China to be the exception as a gradual removal of mobility restrictions and a policy focus on growth stabilisation improve consumer and business sentiments.

This backdrop is useful for investors because the historical behaviour of major asset classes through a recession can offer a guide to asset class performance. On average, high-quality bonds bottom first, usually not far from the last Fed rate hike in a cycle. Equities usually bottom later – but typically well before an economic recession ends – once the ensuing rate cutting cycle improves the growth outlook.

Against this backdrop, we see a SAFE strategy as a prudent way to build Foundation allocations in 2023 by: Securing your yield, Allocating to Asian assets offering long-term value, Fortifying against further surprises and Expanding beyond the traditional.

Fig.1 Bond returns have historically been very positive in the years after very negative returns

Calendar year US bond returns distribution over 150 years

Secure your yield

We see today’s bond yields as one of the best opportunities of 2023. We are Overweight bonds – including government and high-quality corporate – relative to equities and cash.

Corporate Investment Grade (IG) bond yields are not far from peaks last achieved in the cycle prior to 2008. We also expect the Fed to reach the peak of its current hiking cycle in H1 2023. In our view, this has created an attractive opportunity to lock in an attractive long-term yield.

We also see a growing possibility of capital gains. Historically, US government bond yields tend to peak around the last rise of a Fed hiking cycle, with bond yields subsequently falling (bond prices rising) as markets start to worry about slower growth and the likelihood of eventual rate cuts. Therefore, we would move to lock in the current yield levels soon, particularly on any spikes in the 10-year US government bond yield to or above 3.75%. We would also lengthen maturity profiles to take advantage of an eventual turn in bond yields. This will help mitigate reinvestment risk if yields move lower by end-2023, as we expect.

High-quality IG bonds, both government and corporate, are one route to earn income. High dividend equities are another, given their history of outperforming mainstream equity indices in current environments. Our multi-asset income strategy seeks to bring these asset classes together to offer an attractive income.

Allocate to long-term value

While today’s higher yields offer a more immediate income opportunity, we also believe this should be balanced by exposure to assets offering longer-term value. We currently see attractive value in Asia ex-Japan equities and bonds.

Given likely recessions in the US and Europe, history suggests their equity markets have not yet bottomed. Asia ex-Japan, though, is likely the key exception and we believe the region’s equities now offer value. This is best exemplified by P/E valuations on Chinese equities that are not far from the previous crisis lows. Chinese policy has already pivoted

Fig.2 High-quality bonds offer the best chance of positive returns 12m after the last Fed rate hike

Range of asset class returns after last hike of a Fed cycle

towards stabilising growth, but the ongoing gradual easing of extreme mobility restrictions is likely to allow these measures to start having a positive impact. More broadly, a turn in the USD should ultimately be supportive for EM assets, including Asian equities.

Within Asia ex-Japan, we are Overweight Chinese equities as we expect them to outperform the region given their inexpensive valuations and positive catalysts (we, however, expect temporary setbacks, given the reopening experience of other major markets).

Indian equities could struggle to replicate their spectacular regional outperformance in 2022 given elevated valuations, but still-robust earnings growth and the return of foreign investment flows mean we expect them to perform in line with the region and outperform global equities. In India, we are Overweight large-cap equities.

We also see long-term value in Asia USD bonds. While pockets of High Yield bonds could remain under some stress, we believe c.6.5% yield is an attractive value for an asset class where 85% of bonds are Investment Grade-rated.

Fortify against further surprises

While yield and long-term value offer room for optimism in 2023, we believe a US recession outlook means investors should be prepared for downside surprises. The Fed has yet to sound the all-clear in terms of its comfort with inflation’s path and the market’s rate expectations. US or European equities have arguably not yet witnessed a ‘capitulation’ event often associated with a recessionary equity market bottom.

High-quality government bonds can mitigate such surprises, given yields should move lower (bond prices should rise) in such a scenario. However, maintaining neutral allocations within foundation portfolios towards portfolio ballasts in the form of cash and gold are prudent, in our view. Cash yields continue to rise alongside Fed rates. Gold should also benefit from the eventual turn lower in real (net of inflation) bond yields, though the decline in yields is likely to only come through much later in the year.

Expand beyond the traditional

We believe the unusual rise in stock-bond correlations in 2022 is unlikely to last into 2023. Nevertheless, the experience means the demand for relatively uncorrelated assets, or less volatile substitutes for traditional asset classes, is likely to sustain.

This is where a neutral allocation to alternative strategies can help. Liquid alternative strategies are one potential route. While many of these tend to be relatively less volatile ‘substitutes’ for equities, ‘diversifiers’ such as macro/CTA strategies tend to outperform during recessionary and/or trending markets. Private asset classes can be another route. Private credit strategies, for example, fit well into our preference for income and are a preferred substitute for riskier bonds (such as leveraged loans or High Yield bonds).

Opportunistic allocations – a weak USD

We expect currency markets to offer scope for opportunistic allocations as the USD weakens over the next 12 months.

Over the past year, the USD has singularly benefited from higher US bond yields and rapid upward shifts in Fed policy rate expectations. This could spill over into Q1 23, recent price action notwithstanding, as markets continue to debate when the Fed Funds rate will peak, resulting in a volatile but rangebound USD on a three-month horizon.

Looking beyond this, though, we believe the USD is likely to turn lower over the next 6-12 months as the Fed pauses in its rate hiking cycle. Elevated valuations make the USD more vulnerable as the Fed cycle turns.

History shows that most currencies tend to rise during periods of USD weakness. We are bullish on the EUR and JPY and expect them to be strong performers on a 12-month horizon. We would use any Q1 weakness to add exposure to these currencies. The other beneficiary of a weaker USD is likely to be Emerging Market assets – including our preferred Asia ex-Japan equities – which usually gain significantly from a weaker USD.

Sector buys – the Asia recovery

We expect equity sector picks to be a second source of opportunistic returns. Given our Overweight view on Asia ex-Japan, our sector preferences in the region are more pro-cyclical. In China, we would buy the communication services and consumer discretionary sectors, which we expect to benefit from increasingly supportive policies and reduced mobility restrictions. In India, we would buy the financial, industrial and consumer staples sectors, which should benefit from domestic demand.

In the US, our expectation of an economic recession and a lower equity market bottom mean our sector preferences are more defensive. We have a relative preference for the healthcare and staples sectors that have delivered positive earnings in recent recessions. We also favour energy, where we see attractive valuations.

In Europe, we are Overweight financials given inexpensive valuations and improving earnings on the back of higher interest rates. We also prefer the energy sector, given the still-significant sector discount, compared with history.

We maintain a strong conviction in income strategies, given the attractive yields on offer and income being key from a total returns perspective

Fig. 4 Yields on MAI increasingly anchored by the fixed income component

Yields, duration and allocations of bonds, equity and non-core within our multi-asset portfolio

The year of income

A key challenge facing investors over the past decade has been earning an attractive income without taking on excessive risk. With cash offering a yield of well over 4% and the proportion of negative-yielding bonds declining from a peak of close to 30% to under 5%, investors today have a wider array of assets to choose from.

We expect income strategies to outperform a balanced asset allocation in 2023. Higher yields, moderating growth and an elevated risk of economic recession support assets with stable cash flows, such as those in MAI strategies. Hence, we favour such strategies over pure growth-focused equities and balanced allocations.

Income will be an increasingly important contributor of total returns as the Fed continues to hike rates, pushing yields higher. A higher starting yield, both from dividends and coupons, offers a greater cushion against downside price volatility.

Fig. 6 DM sovereign bonds have been most resilient, while dividend equities usually suffer in a recession

Performance during past recessions (2001, 2008, 2020)*

Compelling income in bonds…

Investors today can achieve an attractive income in many bond segments by just taking on relatively modest interest rate and credit default risks. We have increased our allocation to Developed Market Investment Grade bonds, where yields have been near the top end of their historical range since 2014 (e.g., DM IG government bonds yield over 3%, compared with 1.3% at the start of 2022). We have also added to Asia USD bonds where the spreads over Asia local currency bonds are the highest in nearly a decade. We expect Asia USD bonds, in which China makes up more than 50% of the asset class, to benefit from China’s easing of mobility restrictions and greater support to the property sector. Importantly, valuations of Asia USD bonds are at a much more inexpensive starting point. Spreads are wide relative to history and could offer room for tightening if China’s economy offers further signs of recovery.

We have, however, closed our preference for leveraged loans that benefitted from the surge in yields YTD. While default rates have remained low, they will likely pick up as loan rates get progressively reset higher over the coming quarters. In contrast, DM HY issuers allowed more issuers to lock in low borrowing costs when rates were low.

We also continue to like subordinated financials, such as Contingent Convertibles (CoCos) and preferred securities relative to DM HY bonds for their income and capital appreciation potential. CoCos yield over 9% and European banks today are in a much better capital position with common equity ratios above the 7% write-down threshold for most AT1. 

Fig. 7 Narrowing gap between forward earnings yield and 10y US government bond yield gives us more confidence to add to fixed income within the MAI basket

S&P500 forward earnings yield vs 10y US Treasury yield

…but equity income is still relevant

While we believe additional equity downside is possible, we are only slightly Underweight dividend-paying equities in our MAI allocation. Given the size of the equity drawdown thus far from its 2022 peak, getting excessively defensive at this stage is likely be counterproductive. Historically, high dividend equities have outperformed global equities during periods of high inflation, though the track record during recessionary periods has admittedly been mixed.

Fig. 8 Dividend payers have historically outperformed global equities and the gap has been widening

Performance of relevant indices since 1 April 2007 rebased to 100

With the macroeconomic outlook remaining uncertain, a diversified income portfolio offers a prudent way to maintain an equity allocation. Additionally, income strategies present attractive opportunities given the high yields on offer, allowing investors to be paid, while riding out the impending recession.

The inversion of the global and US bond yield curves are signalling that short-term policy rates, especially in the US, are now so tight that they are likely to cause an economic downturn in the coming year

Fig. 9 We expect a global recession in 2023, led by mild US and Euro area downturns

US bond yield curves*; average of the past eight US recessions, excluding 2020

Developed Market recession, China reflation

The US and Euro area are likely to see a mild recession in 2023 as central banks keep tightening policy to bring inflation back towards their 2% target, while China is likely to gradually recover from its downturn as it relaxes mobility restrictions and eases fiscal and monetary policies.

US recession monitor: As we come towards the end of 2022, more and more indicators are suggesting a recession is around the corner. The global bond yield curve inverted for the first time in over 20 years, following earlier inversions in US yield curves, including the Fed’s preferred recession indicator. The inversions mean bond investors are signalling that short-term rates have tightened enough to cause a downturn.

Meanwhile, the ISM Manufacturing business confidence index fell below 50 in November for the first time since the depths of the pandemic, while the forward-looking ISM New Orders PMI remained in the contraction territory for the third straight month. These indicate that the goods sector has likely started to contract. Bank lending standards for corporates are tightening at a rate consistent with a recession. However, the services sector, which accounts for two-thirds of US output, is still expanding strongly. The services expansion is sustained by a shift in consumption patterns from goods to services as more people venture out for work, holidays and entertainment. Excess savings built during the pandemic (estimated at USD 2trn) and plentiful jobs are likely to sustain consumption through to Q1 23, in our view. However, there are signs that the lower-income segment is running out of pandemic-era savings and taking on debt to sustain consumption. This means consumption could flag if the job markets slow sharply.

Thus, job market indicators need to be watched closely.  Jobless claims have been rising slowly since hitting 50-year lows in March this year, but the strong pace of monthly hiring has kept the US unemployment rate well below the Fed’s long-run target of 4%. A tight job market is fuelling wages, a key component of services sector inflation, even as goods inflation slows sharply. This explains why the Fed is aiming to cool the job market. As the chart below shows, there is a narrow path towards an economic soft landing and bringing inflation towards the Fed’s 2% target, but that would involve raising the jobless rate towards 6%, from this year’s 50-year

Fig. 10 Lower US inflation means a higher jobless rate

US Phillips curve*: Inflation vs unemployment rate

low of 3.5%. That would be in line with the average 3.0ppt rise in US jobless rate over the past eight recessions (excluding 2020; see chart). Given the tight balancing act involved, we expect the Fed to stop hiking rates at 5.25% in H1 23. Once a recession hits by mid-2023, we expect the Fed to cut rates to 4.5% by year end. The biggest risk to this view is a policy mistake, where the Fed overtightens in its inflation fight (inflation is a lagging indicator), causing a deeper-than-expected recession.

Euro area entering a recession: The Euro area economy, facing the brunt of the Ukraine crisis, started contracting in Q4 22, according to consensus estimates. We expect the contraction to extend into 2023 as high inflation curtails disposable income and consumption, while tighter financial conditions curb business spending. Governments are partly shielding consumers and businesses from surging energy costs, and record gas stockpiles, aided by soaring LNG imports, should help partly offset the plunge in Russian energy supplies. The EU’s Recovery Fund is also boosting defence and energy infrastructure. These factors and a structurally tight job market should help prevent a deeper recession. Nevertheless, with inflation estimated to remain above 5% in 2023, the ECB has a tough balancing act given its sole mandate to return inflation to 2%. We believe it will be constrained by politics as recession hits. Thus, we see the ECB Deposit Facility rate peaking at 2.5%, up from 2% today. 

China to recover in 2023: In contrast to recessions in the US and Europe, we expect China’s economy to grow close to 5% next year as the services sector and consumption normalise. Measures to speed up vaccinations for the elderly have led major cities to gradually relax mobility restrictions. Authorities have also eased property sector policies, helping stabilise the sentiment. We expect more targeted fiscal and credit policies to revive consumption and boost credit towards priority sectors, such as advanced technology hardware and green infrastructure, once mobility restrictions are further relaxed by Q2 23. The key risk to this view is a sharp revival of COVID-19 during the winter delaying the economic reopening, increasing geopolitical tensions with the US and a persistent slump in the demand for properties, despite the ongoing measures to stabilise the sector.

Fig. 11 China to ease credit further to revive growth

China’s leading index and credit impulse 12-month net change

Yields across bond asset classes are well above their long-term averages; history shows DM IG bonds usually outperform when the Fed pivots

Fig. 12 DM IG bond yields are close to their highest levels since 2010

Current bond yields vs 10y average; yield changes during Fed hikes and pivots since 1971

Overweight high-quality bonds

Against the backdrop of heightened US recession risks, we believe defensive assets will outperform in the next 12 months. Hence, as we discuss in the SAFE framework, we are Overweight bonds, including both government and high-quality corporate bonds, relative to other major asset classes.

Overweight Asia USD bonds

Asian USD bonds outperformed global bonds in 2022, helped by lower interest rate sensitivity and recent policy support in China. We expect this outperformance trend to continue into 2023 as bond yield premiums decline on expectations of more policy easing measures by the Chinese authorities. This contrasts with the US where both fiscal and monetary policies are much less accommodative.

Valuations of Asia USD bonds are attractive, with yield premiums (and the yield itself) having surged to over 310bps and c.6.5%, respectively. Although occasional defaults or restructuring could bring about higher volatility, we see current bond prices to have largely priced in such risks. In addition, the yield on offer has surpassed the local currency bond yields for the first time in nearly a decade.

In 2022, Asian HY bonds underperformed their IG counterparts owing to rising defaults in the Chinese HY property sector. Although we expect similar pricing shocks should be largely behind us amid several rounds of rescue measures, the recovery road ahead is likely to be bumpy and, hence, we have a slight preference for Asia IG bonds.

Fig. 13 USD yields have surged above local rates, making Asian USD bonds more attractive to local currency-based investors

JPMorgan Asia Credit Index yield, JPMorgan GBI-EM Broad Diversified Asia yield

Neutral DM IG corporate and government bonds

We believe the Fed is likely to maintain a restrictive monetary policy for most of 2023. This would raise the risk of a recession, in our view – an outcome that is usually positive for high-quality bonds as investors start to anticipate interest rate cuts and a decline in bond yields (rise in bond prices).

Within this segment, we have a Neutral stance on IG government bonds as expectations of a DM central bank pivot in 2023 is offset by unfavourable demand-supply balance.

Downside risks to corporate earnings do admittedly rise as rising Fed rates raise interest expense burdens. However, we believe the positive effect of falling bond yields and preference for high-quality income assets should outweigh this. Hence, we have a Neutral stance on DM IG corporate bonds.

Fig. 14 DM IG fundamentals remain strong as rating upgrades outpace downgrades

US IG corporates quarterly upgrade/downgrade ratio and total number counts

Neutral EM local currency and EM USD government bonds

Surging recession risks in DMs likely pose a challenge to most EMs, especially if commodity prices face downside pressure. However, we believe there are sufficient factors to offset these risks, causing us to hold a Neutral stance on EM bonds (both local currency and the USD):

1. EM asset market performance, including bonds, typically has a high correlation with EM currencies. Our expectation of a modestly weaker USD on a 12-month view would likely be beneficial to EM currencies and bonds.
2. Most EM central banks have front-run DM central banks in tightening monetary policies to defend their currencies in 2022. We believe it puts EM central banks in a more flexible position to ease monetary policies in need.
3. EM USD bonds are also very sensitive to changes in US bond yields, which should prove supportive if US bond yields fall, as we expect.

Underweight DM HY corporate bonds

The one asset class that could face pressure from slowing US/European growth is DM HY bonds. Credit ratings downgrades are likely to accelerate when corporate earnings face deeper pressure as revenue growth slows and interest burdens climb. We believe these risks are not fully priced in by current yield premiums. Hence, we have an Underweight stance on DM HY bonds.

Valuation and earnings growth support Asia ex-Japan; elevated volatility amid rising recession risks in the US and Europe are likely to hurt the risk-reward for equities

Fig. 15 Asia ex-Japan cheap vs global equities; volatility is likely to be elevated vs pre-pandemic levels

Relative 12m forward P/E of MSCI Asia ex-Japan vs MSCI AC World; VIX index

Underweight global equities

We are Underweight global equities in view of a likely recession on a 12m horizon. Historically, equities bottomed only well into a recession. Fed tightening and weaker consumption are also likely to harm earnings in 2023.

Overweight Asia ex-Japan equities

We are Overweight Asia ex-Japan equities and Chinese equities within the region. In Mainland China, authorities have relaxed mobility restrictions across major cities and we expect this to continue in 2023, especially post winter. Relaxations are likely to alleviate supply chain disruptions and boost economic growth. The government also unveiled a series of measures to support the property sector, such as ensuring timely delivery of apartments and allowing re-financing through equity issuance, which opens up the possibility of the introduction of strategic investors.

Fig. 16 Chinese equities at near trough valuation vs Asia ex-Japan equities

Relative 12m forward P/E of MSCI China vs MSCI Asia ex-Japan

The weakening USD is likely to be a key tailwind for Asia ex-Japan equities in 2023. Over the past two years, the USD has been strong due to both a flight to safety during the pandemic and aggressive rate hikes by the Fed. With a potential stalling and reversal of Fed rate hikes in 2023, the USD is likely to weaken, in our opinion. A weaker USD has historically been correlated with Asian equity market outperformance.

Fig. 17 Weakening USD has historically been favourable for Asia ex-Japan equities

Relative performance of MSCI Asia ex-Japan index vs MSCI All-Country World index and DXY (inverted scale)

Finally, the region continues to be attractively valued. It is at a 13% P/E ratio discount to global equities, compared with the long-term average discount of 11%. Earnings growth in Asia ex-Japan is likely to be among the highest across regions in 2023.

We are Neutral on Indian equities within the region. India’s Q2 FY23 earnings beat expectations and are the strongest since 2008. However, valuations (20x 12-month forward P/E) remain elevated vs historical averages, despite some moderation from 21 October’s peak of 23x. This is also why we prefer large-cap equities over small- and mid-cap equities.

Neutral Euro area equities

We are Neutral on Euro area equities. We acknowledge that the region is still suffering from the Russia-Ukraine war and the resultant disruption in energy supplies, leading to elevated inflation. However, Euro area equities are trading at their biggest valuation discount vs the US in 40 years. Also, the EUR’s weakness over the past couple of years is likely to be positive for earnings growth.

Neutral UK equities

We are Neutral on UK equities. The recent political and economic uncertainties, with four-decade high inflation, have hurt investor and consumer confidence. However, UK equities remain inexpensive on an absolute basis and continue to trade at their biggest discount vs global equities in 20 years. We believe UK equities still offer a balance between income and growth and a dividend yield 2% higher than global equities.

Neutral US equities

We are Neutral on US equities. Consumption-driven growth is flagging, with rising auto and credit card delinquencies. Electronics and sporting goods consumption has also been slowing over the last 3-6 months. This, combined with the high likelihood of recession, is likely to impact corporate earnings. Of course, valuation has become more reasonable, with the 12-month forward P/E at 16x earnings, in line with the long-term average. Also, a likely pause in Fed hikes next year could revive growth stocks, as it alleviates the impact on discounted future earnings.

Underweight Japan equities

We are Underweight on Japan equities. Japan’s reopening is positive in supporting consumption. China’s gradual reopening should also boost exports. Valuations remain attractive on an absolute and relative basis to global equities. The risk is a further rise in inflation – which could force the BoJ to end its easy monetary policy. The strengthening JPY is also likely to slow Japan’s economic recovery by hurting exports and impacting corporate earnings.

Buy the recovery in China

• We are positioned defensively in US and Europe equity sectors, in line with our cautious view on global equities due to likely recessions across Developed Markets.
• Meanwhile, the economic reopening and policy stimulus in China supports the case to buy consumption-driven sectors, such as Communication Services and Consumer Discretionary.

US

We see three sectors that are likely to outperform the broader US market. Healthcare provides defensive exposure with steady earnings growth that is less volatile than the broader market. Valuations remain reasonable. We also see margins in the sector staying resilient amid rising costs. Consumer Staples is historically a reliable outperformer heading into recessions and cyclical slowdowns. Energy remains an Overweight as valuations remain attractive, at a deep discount to the broader market. Producers’ capex and cost discipline is keeping the supply tight and generating healthy cashflows. Meanwhile, policymakers support energy security.

Other views: We are Underweight Consumer Discretionary and Industrials as they are vulnerable in a cyclical slowdown. In addition, Communication Services’ recent weak earnings has exposed concerns about growth. We are Underweight on Real Estate (listed equities) given the valuation headwind from rising interest rates. In contrast, we see US private real estate as a Neutral holding that can perform in line with US equities. It is less affected by investor liquidity flows and has greater exposure to industrial and residential assets that are buoyed by strong rental growth.

Fig. 18 Healthcare and Staples offer less volatile and positive earnings growth through the economic cycle

Consensus 12m forward EPS growth for MSCI US Healthcare, MSCI US Consumer Staples and MSCI US

Europe

We see two sectors as likely to outperform the broader market in Europe. Energy continues to offer attractive valuations and is at a deep discount to the broader market. The sector is highly cash generative and sector leaders have shown the ability to innovate and adapt to a cleaner energy portfolio. The Financial sector also offers attractive valuations. Consensus 12m forward P/E of 8.0x is at the bottom of its historical range, despite rising interest rates supporting higher interest income for banks.

Other views: We are Underweight Industrials and Discretionary due to their cyclical earnings pattern amid recession concerns. Real Estate is also Underweight due to the valuation headwind from higher interest rates.

China

We see value in two sectors that we consider a Buy. Communication Services is dominated by media and entertainment companies that we believe will benefit from China’s economic reopening, greater consumer spending and easing regulatory headwinds. We also see Consumer Discretionary as a beneficiary of the economic reopening. A domestic consumption recovery should boost e-commerce volumes and benefit online retailers in the sector.

Other views: We are Underweight Utilities as we expect the sector to lag a recovering equity market in China.

Fig. 19 Our sector views by region

Reduction in real (net of inflation) interest rate differentials, end of Fed rate hiking cycle and correction of expensive valuation (REER) to drive DXY lower in 2023

Fig. 20 Decline in real interest rate differentials and valuations to drive the USD lower

USD Index (DXY); BIS USD REER (Real Effective Exchange Rate)

A bounce back in the EUR and JPY

We expect the EUR and JPY to be the key beneficiaries of the broad USD weakness on a 12-month horizon. However, the path is unlikely to be linear. Over the next 1-3 months, EUR/USD is likely to weaken towards the 1.00-1.03 level, as we see some consolidation of the recent rally. The recent decline in European inflation is likely to increase the risk of a less hawkish ECB. The EUR is likely to sustain an energy risk premium, heading into winter months. However, as we move through 2023, we believe (i) a reduction in geopolitical risks, (ii) an improved BOP position (due to lower energy prices), (iii) faster decline in European inflation relative to the US, leading to more favourable real rate differentials, and (iv) growth rebound in China to act as tailwinds pushing EUR/USD towards 1.10-1.12 by end 2023.

The JPY is likely to be one of the outperformers in 2023. In the near term, USD/JPY could consolidate after the recent declines, trading in the 132-135 range. On a 12-month horizon, we expect USD/JPY to decline towards 125-130, driven by lower interest rate differentials, Japan’s improved BOP position and the ongoing concerns around global growth. Additionally, any reduction in the BoJ’s current accommodative monetary policy settings, such as changes to the Yield Curve Control (YCC) policy, could act as a further tailwind pushing USD/JPY lower.

Fig. 22 Less monetary policy divergence and a decline in US bond yields to drive USD/JPY lower

USD/JPY and US 10y government bond yield

GBP/USD is likely to underperform other major G10 currencies. In the near term, the pair looks overbought after the rebound from the 2022 lows, and we see a high likelihood of a pullback towards the 1.1400-1.1790 range. On a 12-month horizon, we believe the downbeat growth outlook is likely to force the BoE to hike less than market expectations, which combined with high inflation and elevated twin deficits, are likely to cap gains around the 1.23-1.25 range.

Commodity currencies (AUD, NZD, and CAD) are likely to trade rangebound over the next 1-3 months as the risk of a global growth slowdown is likely to cap commodity prices. However, as we move through 2023, the broad-based USD weakness, expected improvement in China’s growth outlook and the correction of the fundamental undervaluation based on Terms of Trade, especially for AUD/USD, are likely to enable commodity currencies to appreciate by 3-5% vs the USD.

We see a high likelihood of USD/CHF appreciation towards the 0.9400-0.9550 range over the next 1-3 months. The SNB has limited room for rate hikes due to weak domestic demand, while lower absolute bond yields are likely to mean CHF remains a favoured funding currency. On a 12-month horizon, though, we see USD/CHF declining towards a 0.90-0.92 range due to broad USD weakness and the SNB’s willingness to sell FX reserves to reduce imported inflation.

Fig. 23 Higher growth in China and catch-up with undervaluation vs Terms of Trade to support the AUD

AUD/USD and Australia’s Terms of Trade

USD/CNY is likely to move higher in the near term (3m) towards 7.05-7.10 amid risks of a slower-than-expected pace of reopening in China in the winter months. However, over the next 12 months, we expect a more broad-based relaxation of mobility restrictions and supportive fiscal and monetary policy to drive a growth rebound in 2023, pulling USD/CNY below the psychological threshold of 7.0, towards 6.90.

We expect USD/INR to decline only modestly towards the 77.6-79.5 range over the next 12 months. While the INR is likely to benefit from the broad USD weakness, we expect extremely strong domestic growth, especially relative to other major economies, the elevated current account deficit owing to substantial oil and gold imports and the RBI’s rebuilding of FX reserves to cap the gains. 

Gold shines through periods of recession

The oil market reflects tight short-term supply, with falling inventories and flat production

Fig. 25 On average, gold gained c.12% during the last 11 US recessions; US crude oil inventory hits a six-year low, while production remains largely unchanged

LHS chart: Price performance of gold during the last 11 US recessions
RHS chart: US crude oil inventory and production

Bearish equities but bullish bonds

Our US Equity-Bond Market Risk (EBMR) models the downside risks in US equities and the US 10-year government bonds. It uses 11 economic and market factors to create equity and bond risk barometers. If the value of a barometer falls below 50, it signals higher downside risks and vice versa.

The model’s equity and bond barometers are indicating higher downside risks in US equities and lower downside risks in US government bonds, respectively. This is classified as Stage 1 of the US financial market risk cycle, which favours defensive assets over risky assets. The model has worked well in 2022, with the S&P500 Index down by c.14% since the model turned bearish on equities in January 2022. Our bond barometer was below 50 from August 2020 to May 2022, capturing c.2.2% rise in the US government bond yield. It moved above 50 in June 2022, suggesting that the risks of further yield spikes are reducing.

Fig. 26 EBMR bearish on equity, but bullish on bonds

US equity and bond market risk barometers

The equity barometer consists of 11 equity indicators. The barometer improved slightly this month but remains low at 18. Except for short-term equity momentum, majority of our equity indicators are still reflecting a bearish environment due to still-elevated inflation and higher bond yields. These include a slowdown in US housing starts, lower commodity prices and reduction in total monetary base. Our model projects the equity barometer is likely to remain depressed till Apr-23.

Another key input to the US EBMR model is the bond barometer, which tracks six bond indicators. It has declined slightly to 57 from 71 this month due to the recent rebound in equities. Factors that remain supportive are falling commodity prices, US PMI and US housing starts, as they indicate a slowdown in growth, which favours defensive assets such as bonds. Other factors such as US capacity utilisation and US jobless claims are also turning much less negative for the bond barometer, as the former has seemed to form a peak since the COVID-19 recovery, while the latter has been rising slowly though it remains low.

The model’s projections are currently skewed towards Stage 1 till Apr 2023, and Stage 2 thereafter. This implies May 2023 is expected to be a more attractive time to Overweight risky assets, while government bonds look increasingly attractive as we approach peak rates next year.

Implications on global assets

Data since 1999 suggest gold and bonds are the most preferred in Stage 1. The model’s preference for the assets is based on its long-term relationship with the market cycle, which favours gold and bonds as defensive assets in Stage 1.

The model’s estimated probabilities in June 2022

The model’s estimated probabilities in December 2022

Where is diversity falling or rising this month?

Broad market diversity has increased sharply across most asset classes after the Fed’s signal of a slower pace of rate hikes led to a relief rally in both bonds and equities. Market supply and demand are currently quite balanced, which means the market structure is currently stable and, absent any sharp change in fundamentals, market price action is likely to be relatively orderly.

Within equities, our diversity signals are above the 1.25 threshold, which is the level we typically identify with a short-term reversal opportunity. The lack of reversal signals in equities is due to the large swings in equity markets in H2 22 as our diversity indicators typically spot reversal opportunities when asset prices are trending (up or down). European and UK equities currently have lower diversity vs other markets due to their more significant rallies that started earlier in October, but our indicators are not signalling a reversal in these markets from a market breadth perspective.

Fig. 28 Investor diversity remains high

Average market diversity score by asset class

Fig. 29 Major assets not signalling a reversal

Percentage of assets with diversity score <1.25

For bonds, we observed a steep rise in diversity after they staged a short-term recovery from the October lows. This follows our diversity indicators (successfully) signalling a reversal in Asia USD bonds in early November and putting DM government bonds on watch in October. Like other bond markets, the diversity of these markets has now risen above our reversal threshold.

For currencies, the recent reversal in USD strength has caused diversity across currencies to increase as well. Our indicator successfully flagged reversal risks in USD/MYR and USD/INR in October – between October and November, USD/MYR fell c.6.0%, while USD/INR fell c.1.7%.

Fig. 30 Diversity across key assets