Given the challenging year that markets experienced in 2022, finding opportunity in the face of economic uncertainty has surely been top of mind for advisors and investors alike.
Despite optimism that inflation would be transitory in the post-Covid economic recovery, inflation proved stickier than expected. Prices for goods did eventually ease as supply chain constraints moderated and inventories were restocked. But this easing was replaced by inflation in the cost of services when rent and wages started to rise. A stubbornly tight labour market continues to support widespread wage inflation. Furthermore, the turbulence was compounded by a series of disruptive geopolitical events, including Russia’s invasion of Ukraine and tensions between China and the West.
In response to persistent inflation, policy-makers were forced to repeatedly hike interest rates with the goal to restore price stability. Although current year earnings held in during the year, equity prices retreated due to valuation multiple contractions and a dimmed outlook for future earnings. Bond prices also retreated as rising inflation translated to higher interest rates and lower prices. This left investors very few places to hide in 2022. Even though cash appeared to be a safe bet, high inflation reduced the purchasing power of cash as well.
It became abundantly clear that the “Goldilocks era” of low inflation, low unemployment and easy monetary policy had ended and thus expectations needed to be revisited.
While a continuation of volatility is expected in the year ahead as uncertainty shifts from interest rate concerns to economic growth concerns, Mackenzie Investments’ 2023 outlook report indicates that the conditions over the past year have set up some attractive opportunities to reconstruct portfolios.
With more economic challenges to come, financial advisors should heed the following key themes expected to dominate in the year ahead as they guide their clients through yet another year of instability.
Despite central banks recently signalling that the pace of interest rate increases may slow, this doesn’t necessarily translate to smooth sailing from here on out. Mackenzie expects the hikes to moderate, but the stickiness of inflation will translate to higher rates for longer, including further tightening at the start of 2023.
The lagged impact of tight monetary policy means the Canadian economy will likely feel the impact well into 2023. Higher household debt has increased overall sensitivity to rising yields, making Canadian households among the most rate-sensitive globally.
Most businesses have benefited from low borrowing costs, and many haven’t seen new-issue debt costs this high since 2009. Mackenzie anticipates that most companies will be able to absorb the rising debt costs for a while, and there won’t be a large default wave in 2023.
Expectation for a soft landing
Mackenzie’s 2023 outlook anticipates a soft landing for the economy next year if unemployment can remain at or near historically low levels and the jobs impact is merely a reduction of job openings. This scenario allows the consumer to continue to support the economy and offset the headwinds facing the business environment. The report indicates that a soft landing can be achieved as consumer spending has thus far been supported by a healthy job market, wage gains and the ability to draw down Covid-era savings.
While a soft landing is predicted, there is evidence of slowing economic growth with declines in the housing market and global manufacturing PMIs (Purchasing Managers’ Index) and negative leading economic indicators. But if price stability is achieved with minimal damage to the economy, equities could be set for an eventual recovery later in 2023.
In the meantime, for equity allocations in client portfolios, advisors should emphasize high-quality companies with strong earnings visibility and cash flow generation, and minimal economic leverage.
Russia’s drawn-out conflict with Ukraine poses serious challenges to Europe’s food and energy supply. Economic instability hasn’t been helped by the U.S. and China’s simmering tensions, with the former’s “tough-on-China” policies unlikely to ease anytime soon.
China’s strict dynamic zero-Covid policy also had a significant impact on the rest of the world in terms of global supply chains and global demand recovery. The country’s new party leadership is taking steps to ease the policy, which would support global economic growth but place additional upward pressure on commodities and global inflation.
The geopolitical events that caused upheaval in 2022 may not create tail risk for investors in 2023, but the risk of new and unanticipated geopolitical events should always be a factor in portfolio construction.
Mackenzie’s outlook recommends a neutral stance in allocations between equities and fixed income over the next twelve months but has a nuanced view within the asset classes.
The report acknowledges the relative attractiveness of equities in Canada due to their low exposure to high growth, high multiple sectors, and the compelling valuations for foreign equities in international and emerging markets.
As yields are much more attractive in the bond market than they’ve been for a very long time, some sub-asset classes in fixed income such as high-quality investment-grade corporate bonds should also provide attractive risk-adjusted returns — including potential for yield and price appreciation.
Current trends are likely to persist for a while and thus portfolios need to adjust. The strategies that worked over the past decade are unlikely to work over the next cycle. Advisors should prepare their clients to ensure they are well positioned for this regime change.
While there is a long, winding road ahead, advisors can help their clients by taking the wheel and helping them navigate through the uncertainty.
Lesley Marks is chief investment officer of equities with Mackenzie Investments.