Investment Strategy Insights: Globalization Is Not Dead, It’s Just Shifting Shores

Stance: For a second month in a row, US Core Goods Consumer Price Index (CPI) numbers have surprised to the downside, with increases in core goods prices showing a year-over-year deceleration from 5.1% to 3.7%.1 With the market less focused on inflation, at least for now, attention could turn to employment and housing, which have remained stable. A bigger question may involve the consumer. Pandemic savings are beginning to run dry in Europe and the US, and while consumer defaults remain well below the historical average, they have begun to move higher, with consumer revolving credit balances reaching pre-pandemic highs. Consumer sentiment surveys are generally flashing yellow, but the issues that concern consumers and the degree of their concern are split along socioeconomic and demographic lines.

China remains one of the bright spots for 2023, with chances rising for an earlier reopening. While some weak data can be expected in the early part of the year, the 12-month outlook is positive.

Outlook: First and foremost, if the market continues to see inflation falling, the focus will realign on growth. Recent data have been positive, and the market has reacted; however, monetary policy operates with a lag, which creates a challenge in the second half of the year.

Risks: 1) Inflation falling faster than expected or the Fed looking through services inflation and pivoting earlier; 2) systemic issues in either Europe or the US; and 3) more resilient economic fundamentals across Europe and the US.

After a November marked by giant moves in the US Treasury market — from 4.21% on the 10-year at 7 November to 3.40% on 7 December — the Fed increased rates by only 50 basis points (bps) in December to 4.35%, saying it will continue quantitative tightening (QT) at $60 billion per month on a $9.0 trillion balance sheet. In a similar 50-bp increase, the European Central Bank pushed rates to 2.50% and said it will begin a €15 billion QT program in March on an €8.5 trillion balance sheet. On the surface, the ECB looks more dovish than the Fed, but Madame Lagarde showed the world how to give a hawkish press conference by reiterating her “We will not pivot” message, which pushed European rates up between 15 and 30 bps on 10-year notes. During the last four trading days of the year, traditionally one of the least liquid periods, when many market participants are not at their desks, the Treasury had scheduled auctions of more than $135 billion of notes. We are neutral on the market but expect massive moves nonetheless. We believe the 10-year will settle around 4.00% and will buy duration on the way there as rates rise above 3.60%.

Despite central bank hawkishness, credit markets have rallied on seeming doubts about the Fed’s resolve. Investment grade (IG) spreads are on the cusp of breaching +120, and high yield (HY) looks poised to retest +400. This puzzling reaction and strong market appetite heading into a recession and deteriorating earnings leads us to downgrade our score to an even more defensive 4.0. We continue our preference for IG credits and areas where valuations have relatively lagged, such as in higher-quality collateralized loan obligations (CLOs) and other floating-rate credits that are less in favor. We also are more inclined to increase exposure outside the US due to fundamental advantages, as in segments of emerging markets (EM), or to areas where there are sufficient valuation premiums, as in Europe. Contrary to the market consensus, we expect the Fed to be less accommodative than anticipated and the ECB to be less restrictive.

While the market and most fundamental valuation models expect a US dollar correction, we continue to believe that the currency is the least-dirty shirt due to a global backdrop that has not changed significantly and to support factors that will remain in place into at least the first quarter. We remain of the view that the Fed will tighten beyond the moves of the ECB despite Lagarde’s hawkish tone at the December ECB press event. Thus, we advocate using the period of weakness to relocate to the strong US dollar but are looking at three key criteria that would trigger a reversal: a Fed peak, growth bottoming outside the US, and coordinated currency intervention to weaken the US dollar. We continue to believe those conditions have not yet been met.

Return expectations for 2023 have declined significantly from last month, suggesting now is not a time to chase risk. Corporate IG shows attractive risk-adjusted returns. While news about China’s economic growth and its property sector have been positive, the market pendulum has swung too far into optimistic territory, and our base case still calls for a broader reopening to happen in the second quarter. Our oil price outlook also remains unfazed by recent headlines. Saudi Arabia’s leadership position within OPEC overrules other demand/supply factors, pegging the average 2023 oil price at $85-$95 per barrel.

The near-shoring movement has one clear winner: Mexico. The trend further cements its long-term status as a robust BBB country, with companies in the auto and auto parts sectors lining up to benefit, along with sectors including electrical equipment, computer and electronic products, and plastics. Brazil corporates will benefit from reshoring too, while Senegal, Ghana, Algeria, Egypt, and Morocco are next in line on the sovereign side.

Our return expectations, by category, are EM hard currency sovereign broad at 4.9% (IG 2.3%, HY 7.5%); EM hard currency corporate broad at 6.3% (IG 5.3%, HY 7.7%); and EM local market sovereigns broad at 6.7% (FX -1.6%, rates 8.4%).

The recent market pivot clearly triggered debate on the timing of a Fed pivot, but we need more evidence to change our global macro scenario weights. “Classical recession” remains our base case scenario at 60%, with a pivot at 20%, stagflation at 10%, and a soft landing at 10%.

Continuing to be cautious, we maintain our Conviction Score of 3.75. While China is signaling support for its ailing real estate sector and is ending Covid-related restrictions, effectively reopening its economy, these encouraging moves for risk assets do not completely offset the rising risk of recession elsewhere. We expect that once China’s economy is on sounder footing, the government will return to policies that pursue social equity, which likely will slow the country’s growth once again. Before then, we expect a recovery centered around domestic consumption. Europe also is offering reprieve, driven by a sharp drop in energy prices and surprisingly resilient growth, leading some to believe that a deep recession might be avoided. In our view, these reprieves are temporary, and a global recession still will unfold, with the Fed pivoting only after a recession has begun. While transitory goods deflation soon will reduce core inflation, we expect the Fed will focus on rising service inflation, given tight labor markets. Even after policy rates reach their terminal level, tightening will continue through ongoing QT — unless falling goods prices, slowing demand, and sticky labor costs hurt profits so much that employment takes a big hit, long before the Fed belatedly responds. And where most market participants anticipate a soft recession in the second half of 2023, we fear the inflation-spurred spike in corporate profits may unwind sooner, pulling forward job cuts and a downturn. In Western markets, while we welcome falling inflation, we associate it with falling profits, and await a better entry point for risk assets. We continue to position conservatively, with low equity exposure favoring high quality in Western markets, and have high conviction in long-dated Treasuries.

At the start of 2023, companies continue to feel good about orders and end-market demand and about their ability to meet it. Supply chains and labor are ongoing headwinds, but manageable. It is becoming the consensus that rate hikes inevitably will cause slower growth in 2023, along with lower earnings. Evercore ISI company surveys, which held up relatively well throughout 2022, are starting to show demand moderating somewhat. We expect that inflation also will moderate in 2023 but stay above Fed targets. Market volatility related to perceived potential changes in Fed policy continues to present us with opportunities to upgrade the portfolio and invest in companies at attractive valuations. As always, portfolio style balance remains a key component of our risk management.

With the market now pricing in our earlier optimism, we have modestly dialed back our bullishness. In China, November industrial production and retail sales came in worse than expected, with particular weakness in household electronics and appliances. The Covid reopening has thus far resulted in higher infections, but the government is emphasizing prevention through vaccination, which we believe is a long-term positive. US regulators were allowed access to audited results of Chinese companies listed in the US, lowering the risk of delisting, while US blacklisting of several mainland tech companies is increasing trade tensions.In Peru, what seemed like a short-lived political standoff is turning into a political crisis. In Brazil, President Lula seeks to change the SOE law and raise social spending, which worries the markets. In EMEA/CEE, companies are still contending with the war’s impact, while those in the Middle East and Africa generally are neutral or beneficiaries.With synchronized rate hikes in the US and the EU, some of the market’s fears have returned. Nevertheless, we believe that once near-term concerns subside, global EM equities again will be driven predominantly by underlying company fundamentals. We adjusted our portfolio by taking profits in some of the top-performing consumer-driven names and added to cyclicals in IT and financials in Asia.

Our US Conviction Score is little changed from last month, with curve flattening (-29 bps) offset by credit spread tightening (-26 bps). Our global credit forecasts remain positive on EM and negative on developed markets (DM). In DM, the industries our model favors are energy, insurance, banking, and industrials, while it dislikes financials, REITs, communications, and technology. In EM countries, it favors Argentina, China, India, and South Africa; it dislikes Poland, Columbia, Chile, and Peru. Among EM industries, the model likes metals, real estate, and oil and gas; it dislikes diversified industries, technology/media/telecom, infrastructure, and pulp and paper.

Our Global Rates Model continues to forecast lower yield and a slightly flatter curve. The rates view expressed in our G10 model portfolio is overweight global duration. It is overweight North America, underweight Europe, Asia, and Japan, and slightly overweight Australia/New Zealand. Along the curve, it still positions for flattening, although much muted, with overweights in 10- and 20-year durations versus underweights in 30- and 50-year durations.