Investors disillusioned by diversification and management teams wielding a limited toolkit will need to exhibit resilience during 2023.
China is poised to shift its Covid-19 stance, but faces a challenging outlook given a demographic headwind and a focus on “Common Prosperity.”
Risks may become opportunities as U.S. manufacturers invest in improvements while Europe and the United Kingdom chart a course for greater energy independence.
Overcoming the issues testing investor resiliency
The past year was extraordinary. A foundation of highly accommodative monetary and fiscal policy around the globe coupled with stretched supply chains acted as a springboard for global inflation, and this inflation was further compounded by Russia’s invasion of Ukraine. Jobs remained plentiful, even while certain industries, particularly those with ties to technology, began shedding headcount as liquidity in the form of operating cash dried up. Consumers in the U.S. saw prices skyrocket for everyday goods, while Europe and the U.K. faced the reality of their dependence on foreign oil and natural gas. China remained closed for business as Covid-19 immunity has proved elusive, and the drag of slowing global demand weighed on developing economies.
As the calendar turns to 2023, it is important to note that many of these challenges remain, albeit with improvement on the horizon. Inflation is trending lower, the Fed and other central banks are approaching the top end of their estimates for interest rates, and the softness in global demand has allowed for the loosening of supply chains.
Two challenges remain, however. Higher prices are embedded in the system, particularly as it relates to wages and shelter, and interest rates are going to remain above levels not experienced since the financial crisis at least through the middle of this year. U.S. corporations are facing an environment where revenues likely to slow because of macroeconomic weakness, and earnings will remain under pressure as opportunities to improve margin will be increasingly hard to find. Historical precedent in terms of equity return expectations point to a strong bounce back, and while over longer periods of time my team and I are optimistic about that rebound coming to fruition, and are more likely to call this the year of resilience versus the year of the rebound.
The much maligned 60-40 portfolio that has given investors resiliency during past crises, and the underperformance of bonds in 2022 undercut the confidence of many investors who thought they were doing it right. In past equity market declines, bonds have acted as a steadying force, cushioning the blow of equity declines and rewarding investors for diversification. This commitment to diversification was challenging in the years leading up to the pandemic as accommodative central bank policy persisted and equities soared on the back of outperformance of growth names buoyed by low interest rates, strong balance sheets and copious amounts of free cash flow.
The acute pain felt last year, therefore, was a double-edged sword. Not only did diversified investors forego some of the sizable equity gains in the preceding years, but bonds put up their all-time worst returns just when they were needed the most. Overemphasis on short-term performance is likely to create less-than-ideal outcomes, which is why investors need to continue to diversify despite the pain.
Resilience will be required from investors as well as corporations. While most can admit that there are few C-suite executives leading Fortune 500 companies today that were in leadership positions in the 1970s grappling with stagflation, one could argue that going back to a more normal rate environment weeds out many of today’s major players.
Management teams will be forced to be highly disciplined and prescriptive in the coming quarters, ruthlessly prioritizing initiatives that can yield top line growth while protecting increasingly skinny margins. Imprudent allocation was hardly a concern when capital was essentially free, and projects could be funded with both cash and labor as investors lauded any opportunity for growth, thus compensating management teams for those costs.
It is this emphasis on resilience that my team and I believe is critical to the delivery of positive equity returns in 2023. Investors are grappling with a wide range of multiples and earnings expectations for the S&P 500 next year. In fact, my team’s view is that the S&P 500 could be justifiably priced anywhere from 3,000, as represented by 15x $200 NTM earnings to 4,200, as represented by 18x $235 NTM earnings.
In addition, many investors are actually allocating more money to bonds versus equities, despite last year’s performance, as the increase in yield and low default outlook create a more attractive option. Sentiment, therefore, will be paramount, and that sentiment is likely to be closely tied to investors’ view on the economy. But it is not all about the price that investors are willing to pay. Earnings estimates have been declining. Fears of an earnings recession are an overhang going into next year, and therefore it is imperative that management teams can deliver against multiple headwinds to lessen the impact of higher rates and prices. The capacity to recover from difficulties will be tested in 2023, but my team and I believe that investors and management teams need to take a different view in order for the equity markets to experience that rebound.
China’s growth impeded by multiple obstacles
Resilience is not solely defined as toughness – and indeed, the ability to bounce back from a challenging situation is perhaps more valuable. China finds itself in this situation as the year begins. A bastion of consistency over the last decade in terms of growth, China experienced significant economic contraction in 2020 along with the rest of the world, posting only +2.2% GDP growth for the year, and then rebounded on a year-over-year basis in 2021 to grow +8.4% year-over-year.
However, 2022 marked a divergence from the rest of the global economy, as the Chinese government’s decision to maintain restrictive Covid-19 mitigation policies while the rest of the world moved back towards pre-pandemic posture likely resulted in year-over-year GDP growth of less than +3% for the world’s second largest economy in 2022.
In addition, through the last two months of the year, the Chinese government faced rising discontent particularly from Chinese youth as it related to the restrictive environment. In fact, this group is reported to be experiencing unemployment of over 11%, compared with less than 6% for the broader population. More dramatic is the unemployment rate for youth ages 16-24, which sits close to 20%. It was on the heels of these protests and a very dismal year of growth that China’s National Health Commission lifted most of the restrictions as of January 8, 2023. While efforts will continue regarding vaccinations for the elderly and prioritization of medical supplies and treatment, travel restrictions will change significantly.
The move has been met with optimism and enthusiasm from investors, but my team’s view is that caution is warranted. The last several years have been marked by a shift in rhetoric from officials in Beijing led by President Xi Jinping. Attempts at sweeping reform, defined as a renewed focus on a Chinese Communist Party mantra termed “Common Prosperity,” have led to a significant increases in involvement of the government in private businesses.
Even before the pandemic shut down global supply chains, non-Chinese companies operating in China were becoming increasingly wary about this increased involvement. This perception created volatility in Chinese equity prices and accelerated some of the shift in manufacturing to lower-cost labor markets.
In short, a renewed focus on socialism and equity in response to the widening social inequality facing the Chinese economy speaks to the need for a new playbook for China. Continued monetary and fiscal stimulus can only fill the gap for so long, and thus a reset in terms of growth drivers for the economy will be necessary.
The question for this year, and likely for the next several years, is how Chinese leadership will navigate a transition from a production and export-based economy to one that is increasingly reliant on domestic demand and internally generated growth against the backdrop of an aging demographic. Either way, my team’s view is that Chinese growth will continue to moderate and approach that of other developed economies, and that investors should view opportunities for investment in the country with that expectation in mind. Exposure to the growing Chinese consumer base historically was enough to offset the risks of government intervention, but my team and I believe it necessary to tread lightly, and await evidence that this economy can spring back to life.
Addressing critical supply chain and energy dependencies
One last point about resilience is that it is almost never delivered without cost. There are two main areas that have been laid bare as weaknesses over the past two years. First is the reliance on long global supply chains to satisfy U.S. demand for goods.
The offshoring of production of goods destined for the U.S. has been a strategic win for manufacturers for the last several decades. The combination of globalization and the implementation of technology advances have allowed companies producing goods for higher income markets to move production from high-cost labor markets to low-cost labor markets – first China, then Vietnam and now India and Mexico. However, the disruption experienced during the pandemic created higher costs to fulfill end demand and highlighted the concern that similar disruption could occur again, particularly with the threat of military conflict rising.
Admittedly, the tariff war between the U.S. and China that waged over the course of 2018 and 2019 spotlighted the economic slippage that could result from political conflict, but should tariffs become sanctions and trade cease, the impact would be far worse. Taken a step further, protection of supply of necessities such as pharmaceuticals and semiconductors will become increasingly critical while tensions remain elevated.
Diplomacy, however, is not the only solution in my team’s view. Instead, a commitment by corporations to shorten the distance between production and distribution, and adopt a more critical view of supply chain security, will be catalysts for the U.S. economy over the next several years.
Improvement of and investment in existing facilities, the production of new facilities and the training of a new workforce to support this production will take time and capital, but in my team’s view, this will be a growth driver for the U.S. economy. Not only will private capital expenditure increase, but public infrastructure will also need to improve to support the businesses that are more reliant on it.
Steps have already been taken to support this transition, through recent acts of legislation such as the CHIPS and Science Act, the Inflation Reduction Act, and the Build Back Better Infrastructure Bill. As such, my team’s view is that by focusing on this longer-term theme, portfolios can be positioned to take advantage of the shift, acknowledging that costs are likely to rise, at least initially, as these changes in production occur.
There is likely another major shift coming in the next several years, and it relates to the dependence of Europe and the United Kingdom on energy supplies from Russia. The Russian invasion of Ukraine and the ongoing battle for the country has thrust European energy policy into an uncomfortable spotlight.
Despite maintaining strong ties to NATO, and advocating for protection of the region from potential Russian aggression, the European economy has been supported for decades by oil imports and natural gas flowing in via the Nord Stream pipeline. The reliance is so strong that despite the conflict in Ukraine, European governments have only managed to curb their consumption, rather than calling for a full ban of Russian imports; as Russia supplied over 50% of the region’s natural gas prior to the conflict, it would admittedly be difficult to move overnight to a more restrictive posture – but there has been progress.
With that said, the higher prices paid by consumers in both Europe and the U.K. are likely to plunge both the euro area and the U.K. into a recession – the latter is already there - and with restrictions on energy consumption weighing on production as well, there is little improvement likely as long as the war continues.
My team’s view is that investment in energy sustainability in Europe and the U.K. could represent a positive catalyst for these economies over the next several years. A more nuanced approach to climate policy and coordinated continental effort could put the region in a position to be increasingly better insulated against future supply disruptions, and could also usher in a renaissance in terms of competitiveness for European manufacturers. This catalyst is contingent on cooperation; however, as it will require meaningful investment across Europe and the U.K. to deliver a large-scale solution. Perhaps this cooperation could mark a new beginning for relations and create a foundation for resilience in the post-Brexit world.
The written financial and economic data are obtained from FactSet, the Federal Reserve, the Bureau of Economic Analysis, the Bureau of Labor Statistics, Bloomberg, YCharts, the Institute of Supply Management, the Wall Street Journal, the Reshoring Institute, the U.S. Census Bureau, the National Bureau of Statistics of China, the European Commission and the Financial Times as sources but not limited to such. The accuracy and completeness of the financial or economic data are believed to be reliable but have not been independently verified.
Please feel free to reach out to your SVB Private Wealth Advisor for a deeper discussion regarding the points above, or a review of your current plan to ensure it remains aligned with your long term needs and goals.