Market Update: A look ahead to 2023

Chartered Financial Planner and Operations Director at Niche, Aled Phillips, has provided his latest Market Update, reflecting on an uncertain 2022 and taking a look ahead at the potential trends through 2023.

As ever, these types of market conditions are factored into the conservative assumptions that we use for your financial planning. It is also important to remember that the media often exaggerates market movements which are largely irrelevant in a long-term investment strategy.

2022 in Review

• The past year has been very challenging for traditional risk assets with a focus for investments being on trying to limit the downside whilst also seeking opportunities.
• Inflationary pressures escalated not only from the continuing supply squeeze pressures as a result of Covid but also by the surprise invasion of Ukraine at the start of the year.
• The significant rise in inflation forced global central banks to raise interest rates more than expected and uncertainty over expectations of where interest rates will peak continues as we head into the end of the year.  In the last week we have seen US, Europe and the UK reduce the scale of their interest rate rises to 50bps from 75bps, but all have signalled more rises are expected in the New Year.
• The rising inflationary and interest rate environment broke a 40-year bull market for fixed income assets as existing fixed income bonds rates become unattractive versus the new higher rates.
• Whilst the volatility in fixed income (bond) markets crossed over to equity markets as company costs whether input costs or refinancing debt spiralled higher.
• Most equity (stock) markets have suffered over the year with Asian equities being an outlier adding positive returns largely due to the weighting exposure to Australia and its material sector.   US equities have been helped in sterling terms by the rise in the US dollar and this has softened the falls seen across all sectors of the US equity market.  Emerging markets have been the poorest performing region as headwinds from China such as their Zero Covid policy plus the stronger US dollar provided a challenging environment.  In the UK the performance has been mixed with the larger cap companies faring better supported by a weaker sterling whilst the mid and small cap parts of the market suffered from a re-rating of interest rates and a poorer domestic macroeconomic picture.
• Fixed income capital has come under continued pressure during the year from rising interest rates and in the UK government bonds were further hurt by political actions
• That said there have been bright spots supporting the importance of diversification.  Value assets have performed better after years of being a poor sibling to growth. Whilst assets that featured a hybrid of credit and equity or were uncorrelated to these, key risk assets managed to produce positive returns during the year.
• Whilst despite the rise in rates during the year there is still no sign of severe distressed debt.
• As we end the year, we have entered a strange universe where poor economic data such as signs of a slowing economy is taken as a positive as investors look to the end of the rate hike cycle with the weaker inflation outlook is currently being taken as a positive for both fixed income and equity markets with the main driver behind this optimism being the end of interest rate hikes.  This is not a scenario that can last for a long time.
• As we end the year, the inflation data is showing increasing evidence that it has turned, and weaker inflation is expected to fall during 2023 and into 2024.  Getting back to the 2% inflation target is expected to take c.3 years.

A look ahead to 2023

• As we look forward to the New Year, 2023 is expected to see a peak in interest rates with between 4 – 4.5% expected in the UK and 5 – 5.5% in the US.  China will look to return to growth whilst the US dollar is expected to weaken further boosting the potential for emerging market assets.
• Further interest rate rises especially in the first quarter of 2023 is likely to keep volatility high.  But other headwinds will also impact markets in the first part of 2023.  The outcome of lower inflation is being driven by lower demand and recession is expected in the UK and Europe with a ‘soft landing’ also currently expected in the US. 
• As such, the weaker inflation outlook is likely to see a divergence in returns for equity and fixed income markets.  For the latter this is good news but for equity markets the recession is likely to hurt earnings.  This is coupled with a general view that for Q1 2023 earnings are overly optimistic. 
• How far this will damage equity markets is difficult to judge at this time as a lot of “Bad News” has already been priced in.  Demand related surveys are already showing CEO confidence for the economy 6 months ahead in the US are at an all-time low; whilst the percent of small businesses reporting now is a good time to expand is also near record lows.
• As we look to the second half of 2023, we would expect markets to be calmer with a more positive outlook feeding through for both equity and bond markets.
• History does provide support for this view:  For the S&P 500 total returns following a 25% fall has seen on average a 27% positive return in the first year and 45% over the next 3 years.  There are 9 occasions from the 1960’s to this that we’ve witnessed a 25% plus fall out of these nine occasions only 1 year, 2007 – 2008, has failed to see a positive return in the following year.

Other key risks

• Geopolitical tensions rising
• Central Bank error in hiking rates too far and pushing economies into deeper than expected recession
• Housing market contraction is greater than expected

Into the new year

With January now upon us, we'll start to see whether or not the markets perform as predicted, or if unforeseen global events raise further questions. As always, if you have any concerns or questions on how your portfolio may be affected by the current and ongoing economic situation, please don’t hesitate to get in touch.