The next measure? Allegro moderato!

The impacts of the pandemic and the war in Ukraine have interrupted the positive performance trajectory of a diversified allocation, penalising both equity and bond markets. While markets are likely to remain highly dependent, in the short term, on changes in economic data (inflation and growth), we believe that investors can once again rely on attractive yields for a longer investment horizon with greater peace of mind.

How will this next measure be written?

More than the absolute level of inflation reports or growth indicators, the real driver of performance and volatility for the financial markets seems to have been the level of surprises compared to expectations. That is, true surprises leading to sudden adjustments in investor expectations.

The story of 2022 has been that of the gap between inflation and growth expectations and the data reports, particularly in the United States. Using Citi’s indicators of surprise on inflation and growth for the main economies (G10) as a measure of these gaps, we can indeed observe that during 2022 the context remained largely unfavourable for the financial markets.

Evolution of Inflation and Economic surprises

The configuration of the first half, with resilient growth (positive economic surprises) yet inflation that also continued to surprise (that is, higher-than-expected inflation) led to an accelerated tightening of global financial conditions and expectations of rate hikes well above the level of expectations at the beginning of the year. The financial markets fell sharply, both in bonds (accelerated rise in rates) and equities (significant drop in valuation, particularly within growth-style stocks, which are more sensitive to these higher rates due to the discounting of future cash flows).

The rebound in equities observed this summer coincided with a slowing of inflation surprises and negative economic surprises, leading to hopes of an ease in the pace of monetary policy tightening... quickly denied by the Fed at its late-August Jackson Hole meeting. At the same time, there was a recovery in economic surprises, which returned to positive territory, and a stabilisation in inflation surprises, once again creating a hostile environment for the financial markets and a new low for equities. Since the end of October, inflation surprises have slowed again while economic surprises remain slightly positive, which has favoured the strong rebound observed in bonds and equities.

How will the history of the coming months be written? According to our economic expectations, inflation surprises should continue to decline, which would be a more positive anchor for financial markets. Uncertainties are now likely to focus on economic growth. It remains resilient overall for the time being, with persistent positive surprises. In our central scenario for the United States, with a form of soft landing, economic surprises are unlikely to fall sharply. Europe could be more vulnerable due to its energy dependence on gas. China, meanwhile, is expected to experience higher growth than this year with the gradual easing of its restrictions. Surprises on inflation and growth closer to the breakeven point would constitute an overall favourable environment for credit and equities in 2023, with less economic uncertainty and therefore less volatility.

Might we see a new low point in the financial markets?

In October, we started from extreme levels on the financial markets: extremely negative investor sentiment on the economy and expected market trends, historic high volatility in all asset classes.

Cross-asset implied volatilities

These extreme levels of pessimism are generally quite powerful contrarian buy signals. However, the year ended with an anomaly: we did not see any significant outflows from investors on equities, as we generally observe when such a level of pessimism prevails. They seem to have maintained a larger exposure to equities than suggested by their expectations for the economy and the markets. Several reasons, in particular the absence of an alternative, might explain this behaviour...

In short, among the indicators we analyse, there is therefore no real capitulation combining sentiment and flows.

What could trigger a new capitulation of investors in 2023?

In our view, a potential new low point would come from a slippage of economic expectations:

  • Or, as in 2022: surprises on inflation could pick up again with fairly resilient economic growth, dashing hopes of a central bank pivot;
  • Either a hard landing with a deeper recession than currently anticipated by the financial markets;
  • Or a financial accident with broader contagion (scenario similar to 2008). Central banks are remaining vigilant and aiming to contain inflation as well as risks to financial stability.

Against the backdrop of our current economic scenario, with a deceleration in inflation and economic growth but without a severe recession, we do not expect to see a new low point in the next measure. We see equity markets moving within a fairly broad range: limited to the upside by the actions of central banks, which will ensure that financial conditions do not ease too quickly if the economy is holding up well, and supported by a faster monetary policy pivot if the economy is too hard hit.

With regard to bonds, the carry that was reconstituted by the rise in yields in 2022 seems attractive to us. The deceleration in inflation should lead to a drop in volatility on bonds, allowing for an easing of volatility on other asset classes.

What is the outlook for a diversified portfolio over the medium term?

There are now alternatives

Cross Asset Yields in percentage

We compared the expected medium/long-term expected return on equities and government bonds this year to those of last year. We have taken the “yield to Maturity” for bonds and the “earnings yield” for equities.

we draw two conclusions:

  • All current yields are higher than at the end of 2021 due to rising rates and lower equity valuations.
  • Less than a half-note now separates equity and bond yields. In the US, yields have even swung in favour of bonds. The equity risk premium in the United States is at a 15-year low.

As a result, the expected return on a diversified portfolio has risen sharply this year and returned to the expected levels of return in 2018 and 2019, even in real return. This expected return is based on equities and bonds in a much more balanced way.

Similarly, after a year of positive correlation between equities and bonds (both asset classes posted equivalent negative returns), we expect this correlation to decline. This means that the bond portion of a diversified portfolio could once again play its role as a cushion in periods of falling equities, or at least not add additional negative performance.

Are we heading for another lost decade?

US 50/50 portfolio (real TR)

The yield of a diversified portfolio has remained, overall, close to zero over the past three years. If central banks succeed in what they have aimed to achieve this year, i.e. controlling inflation without causing a severe recession, we will remain constructive overall for the years to come. Historically speaking, "lost decades" have occurred during the first two world wars, the period of stagflation in the 70s and the bursting of financial bubbles in the 2000s. Apart from exceptional events, we believe that investors should be able to extend the period of harmony that the Covid pandemic and the outbreak of the war have interrupted since 2020, probably Allegro moderato.

The concert of our outlook 2023 is coming to an end. We hope you enjoyed it and wish you great compositions in 2023!

  • Nadège Dufossé, CFA
    Nadège Dufossé, CFA
    Global Head of Multi-Asset, Member of the Executive Committee

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