CIO Views - In the midst of difficulty lies opportunity

Contrasting economic prospects but surprises are possible

Economic growth has slowed significantly in recent months, to the point where a large majority of economists are now forecasting a recession for 2023 on the old continent. Sharp increases in energy, gas and electricity costs affected industrial production at the end of the year and the end of the restocking period is weighing on new orders. However, these factors could quickly be reversed. On the energy front, gas inventories are at their highest and the availability of French nuclear power plants will improve significantly in the coming months. The economic surprises index, which measures the difference between published economic data and economists' estimates, has recovered strongly in recent months. Growth could therefore prove more resilient than expected. 

Citigroup Economic Surprise Index

Source: Societe Generale Private Wealth Management, Bloomberg, January 2023
Past performances are not a reliable indication of future performances.

In the United States, the uncertainty in economic forecasts lies in measuring the effect of the monetary tightening policy. These effects on activity are, by nature, delayed, which creates a very high degree of uncertainty in growth forecasts. The monetary tightening phase came after a period of strong savings accumulation, which tends to reduce the impact of monetary policy tightening on activity. The most visible impact is on the real estate market, which is suffering from the increase in mortgage rates. However, the consequences on household income should be fairly contained in the short term, as borrowers have largely refinanced their fixed-rate loans. The debt ceiling and the resulting risk of a US default are also issues of concern to investors and could lead to considerable tension.

The labor market situation is interesting because it can be seen as both an opportunity for growth and a risk to price stability. Employment has reached record levels on both sides of the Atlantic. This healthy labor market can be explained by the development of digital-related services and the relocation of supply chains post covid. However, the dynamism of the labor market complicates the task of central bankers, raising the risk of second-round effects on inflation and the establishment of a price-wage loop. If this risk were to be avoided, the decline in inflation could then lead to a marked rebound in consumer confidence and herald a recovery in consumption in 2023.

While questions remain about the growth outlook in the developed world, there is consensus on the potential for a rebound in China. Indeed, the abrupt end of the "covid zero" sanitary policy, after three years of containment and travel restrictions, should lead to a marked recovery in consumption and economic activity. China had the longest and strictest health policy in the world. As in developed countries, Chinese consumers have accumulated significant savings reserves. But some of these savings will remain hoarded to counter the negative "wealth effects" of the real estate crisis. Economic policy will remain particularly expansionary with an accommodating monetary policy (China is not experiencing an inflationary surge) and significant fiscal support. Despite medium- and long-term uncertainties about the trend growth rate of the Chinese economy, particularly given the negative demographic effects and the strong expansion of the debt, the potential for a rebound is clearly present in 2023.

Uncertainty about the magnitude of monetary policy

Inflation has been the key word of 2022 in monetary and financial terms, surprising the economist community by its duration and magnitude. Apart from the real effects observed during the initial phase of the reopening of the economies, it was the monetary effects that were underestimated. Central bankers had already used the so-called "unconventional" tools of stimulating liquidity by expanding the balance sheet since the period of the great financial crisis, without generating such effects on inflation.

Two elements must be taken into consideration. First, the size of the interventions is unprecedented: the Fed and the ECB injected more liquidity into the economy during the 8 weeks following the confinement of the Western economies than during the 18 months following the 2008 crisis. As a result, the money supply will have grown by more than 40% in the US between April 2020 and December 2021. The second key factor is the combination of monetary stimulus and fiscal expansion.

The monetary component is therefore crucial, and we can measure empirically that the money supply precedes inflation by 18 months. Thus, the decline in the money supply observed since the end of 2022 should lead to a sharp drop in inflation in 2023. The phenomenon will be accentuated by the drop in energy prices. This is one of the hazards of properly designing a monetary policy, which is by nature uncertain. The difficulty is to avoid under or overreacting.

Source: Societe Generale Private Wealth Management, Macrobond, January 2023
Past performances are not a reliable indication of future performances.

After the Fed's massive rate hike in 2022, there are significant uncertainties. The rise in credit costs is so quick that it could lead to a drying up of credit in the economy. This is already evident in the real estate sector with a sharp decline in credit extended. In addition, the Fed and the ECB have begun a phase of reducing their balance sheets. Here again, it is difficult to measure the effects on the economy, but these operations are equivalent to rate hikes. The reduction of the Fed's balance sheet will add to the twin US deficits and should weigh on the dollar.

New opportunities for investors

There are real uncertainties about the economic scenario and monetary policy. Nevertheless, if 2022 was in many ways a difficult year for investors, 2023 is looking much better.

The sharp rise in interest rates is giving a new outlook to many asset classes. In December 2021, there was a stock of nearly USD 15tr of negative yielding bonds. Investors in these securities were exposed to a certain loss at maturity. The drying up of the U.S. Treasury bond market following the Fed's purchases greatly complicated the situation for investors, who were forced to switch to lower-rated securities and often looked to the equity markets for credible alternatives yo these yield-deprived markets.

Today is a different time, and the fixed income market offers the prospect of high returns and is once again attractive to investors. Over the past year, government bond yields have risen from 0.1% to over 3% in the eurozone and are over 5% in the United States. With such high yields, we should see a return to the historical behavior of government bonds, which tend to appreciate in price during periods of marked economic slowdown. Investors are also regaining interest in money market investments, which has not been the case for many years.

For equity markets, the situation is more contrasted, as credible and less risky alternatives exist. Europe and the emerging countries currently offer discounted valuations, with multiples at their lowest levels in 15 years. Earnings momentum is robust in Europe, with corporate earnings expected to grow by nearly 30% by 2022. The rise in interest rates is creating favorable conditions for the financial sector, which should benefit from renewed growth momentum. Consumer stocks, which were badly hit in 2002, also offer better prospects. Emerging countries should regain positive momentum, driven by the recovery in consumption in China.

On the other hand, valuations remain stretched in the US markets despite the correction that began in 2022. Earnings momentum seems to be stalling, particularly in the technology sector. Fourth-quarter results are quite worrying in this respect, with declines in earnings for all the FAANGs and more generally for the Nasdaq.

But the novelty of 2023 lies mainly in the renewed potential of diversified portfolios. Expected returns have increased significantly over the past year and the decorrelation potential offered by the bond markets is now back.

With the economic outlook uncertain to say the least, investment opportunities are real in 2023. Although caution is still the order of the day, expectations are low and growth surprises can also be positive. Staying invested, knowing one's risk tolerance, maintaining margins of safety and adopting a balanced and diversified approach remain the founding principles of a successful asset allocation over time.

Written in February 2023 by

David Seban-Jeantet

Chief Investment Officer - Societe Generale Private Wealth Management.