GM House View 2023: Investing after the great repricing

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Financial markets rebounded strongly after the downward surprise of October’s US CPI inflation figure. Despite this rally, both fixed income and equities have delivered significantly negative returns YtD in 2022. We continue to believe that inflation will be the most important driving force for markets, but there are also additional factors in play related to the reaction function of central banks and its impact on the cycle, geopolitics and other structural elements associated with demographics, the labour market, and China’s future. All these forces are likely to reshape financial market returns and preferences in 2023.

In this new framework, with central banks once again more vigilant on inflation, it is more likely that we see a return to a traditional economic cycle model with possibly more frequent mini cycles. We also expect more cyclical divergence between countries, as policymakers make different decisions about the growth/inflation trade-off and as globalisation is unwound. Cyclical volatility will likely translate into increased volatility in macro-driven assets, including rates and currencies. 

In addition, more cyclicality will also mean a higher and more volatile discount rate, which would impact asset valuations. In the new world we think we are entering, the discount rate will be higher and more volatile, and the cost of capital will remain elevated. The implications of this should be steeper yield curves than in the past, wider credit spreads, and lower equity valuations, particularly for growth stocks. 

Against this backdrop, and after the sharp re-pricing of fixed-income markets, high-quality credit looks more competitive vs. equities on a risk-reward basis. Overall, with yields of around 5.5% in investment grade and more than 9% in high yield, there is no doubt that credit has become an attractive option for investors seeking income and as an alternative to equities. Credit could offer a more attractive risk-reward, particularly if the slowing cycle gains traction. This said, we are moving up from HY to high-quality IG credit, as we see more opportunities in short-end credit, particularly given its attractive carry.

In equities we are also differentiating more between US, Europe and EMs, with a relative preference for Europe vs. US on valuation grounds, potential positive tailwinds from the war and further fiscal stimulus, with lower rate hike expectations. We remain selective in EM markets, with a clear preference for those EM markets that have been ahead in the tightening cycle, and where the downside risk to inflation is higher. Within EMs we highlight China, and in LatAm specifically we favour Brazil, Mexico and more opportunistically the Andeans.

Turning to micro fundamentals, for both credit and equity, we believe that the spotlight in equity and credit should be on companies with pricing power, long-term margin stability, and healthy balance sheets, given their potential to fare relatively well amid cost pressures and volatility. Sector-wise, we remain overweight Energy, Financials and Health Care in the first part of the year. However, consumer cyclicals and some industrial stocks will likely become increasingly attractive as we get closer to and have more visibility on the bottom of the cycle. 

We believe that stock-picking will continue to be a differentiating factor in 2023. We have selected global subsector and strategy winning ideas that we believe will allow investors to continue to play global equities/credit. These are: (i) High Dividend/FCF Yield and low-leverage stocks; (ii) Value chain improvements; (iii) Cloud Computing; (iv) Inflation higher for longer; and (v) Financials vs. NFCs credit strategy. We have also included long-term winner Thematic ideas for 2023: (vi) Hydrogen; and (vii) Demographics.