Welcome to 2023. Later in January we will also enter the year of the rabbit: associated with hope, peace, prosperity, and longevity. The turn of the calendar offers new possibilities. However, for markets, the 2022 legacy of inflation, aggressive monetary tightening has increased the probability of a recession and earnings contraction this year. The positive macro surprise since November 2022 was China’s faster-than-anticipated re-opening which has been bullish for China listed Hong Kong stocks, China levered equities and the region more broadly. While that development is now well appreciated (with some related assets up 50% from the October low) there is probably more upside to come in 2023.
The critical focus for investors in 2022 was the inflation episode and the monetary policy response. Following 425 basis points of rate hikes by the US Federal Reserve, the first half of 2023 is almost universally expected to bring the end of the tightening cycle. While that will represent an important shift from last year, it is hard to call a change in the prevailing bias as it is almost fully discounted by fixed income markets.
The debate has transitioned to the odds of recession versus “soft-landing” among market participants. Although many investors acknowledge the risk of recession, our sense is that beliefs are anchored on a benign outlook rather than a hard landing consistent with leading indicators such as the yield curve, housing market indicators or financial conditions indices. In our judgement investors typically prefer the narrative of hope as bull markets are more fun.
While there was a biblical draw down in a range of stocks last year, especially profitless companies based on hopes and dreams, it is not obvious that value has necessarily emerged. The S&P500 (global risk proxy) trades at 16.8 times 12-month forward earnings, almost exactly in line with the 75-year average (not at a discount). Moreover, following the rise in fixed income yields, the equity risk premium has compressed. A certain high profile auto-company continues to trade 4-5 times the valuation multiple of traditional car companies and has experienced a genuine deterioration in sales (fundamentals). For context, even some of the best growth companies experienced 90-95% drawdowns in the 2001 episode.
Stated differently, steep drawdowns from implausible levels are no guarantee that equities are “cheap.” Odds are the speed and magnitude of the tightening in financial conditions so far in this cycle, combined with the deterioration in key leading indicators, suggest that the probability of a hard landing are greater than 50/50. In the United States, most of the correction in equities last year was driven by valuation compression. In our judgement, the profit recession is still not fully priced.
The good news in Asia is that outright and relative valuation multiples are still much closer to trough levels than peak expectations. There has also a genuine shift in policy and liquidity conditions in China which is likely bullish for regional equities next year. Clearly following a 50%+ rally in many Chinese re-opening related stocks the episode is well appreciated and better priced. However, many of the key names are still more than 40% below peak levels and inexpensive in valuation terms. The other key development over the holidays was the shift in the Bank of Japan’s Yield Curve Control target (more on that to follow).