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We come into 2023 with an outlook for the global economy that is more optimistic than consensus. The economy will bend, as the lagged effects of substantial monetary tightening filter through into the economy. But the economy will not break, as nominal and real incomes remain resilient. Moreover, 2022’s headwinds – Europe embroiled in an energy crisis, and zero–COVID-19 policies weighing on Chinese activity – are shifting to be tailwinds for global growth in the first half of this year.

Still, a better-than-expected economy is not all good news for all markets. Resilient labor markets means wages stay elevated, meaning central banks keep rates elevated for some time. Higher rates for longer means ongoing de-risking in more expensive equity markets, namely the growth-biased US market. When it comes to taking risk in 2023, we prefer to pick our spots, allocating capital where cyclicality is more pronounced, like China. In our overall allocation, we prefer high grade credit over equities entering the year, as higher all-in yields have shifted the relative attractiveness for risk assets.

The US consumer is the lynchpin of the global economy. Real spending in the US increased at a solid pace in 2022 despite surging inflation thanks to elevated levels of excess savings and strong nominal wage growth. In 2023, the US consumer starts the year with an extra boost in the form of much lower gasoline prices compared to mid-2022.

We do not anticipate a significant deterioration in the US job market – a prerequisite for a retrenchment in real consumption – to happen any time soon. Resilience in the services sector has kept a host of labor market metrics (including payrolls, wage growth and initial jobless claims) at very robust levels even amid some softening in goods sector activity as well as layoffs in the technology sector. Excess savings will be depleted for lower income households, but high-income earners, who are the biggest spenders overall, continue to spend in the services sector. Consumers and businesses have had the opportunity to term out debt at extremely low interest rates, making them less rate sensitive than has historically been the case. Higher social security payments and fiscal transfers from state and local governments should also cushion the economy.

Exhibit 1: US stocks quite expensive versus global peers

Source: ÃÛ¶¹ÊÓƵ-AM, Bloomberg. Data as of December 26, 2022.

An unfaltering US consumer is putting a floor under the growth outlook that is being reinforced by these global tailwinds of Chinese mobility and improving European energy access – especially the former.

There is one key theme from 2022 we expect will carry over into 2023: the stock market is not the economy.
In 2022, the positive impact of strong nominal growth for corporate profits was completely overwhelmed by the most aggressive monetary tightening from the Federal Reserve in more than four decades. Higher rates caused a massive valuation compression.

This trend may be poised to continue in 2023. A more resilient growth environment and still tight labor market means central banks will likely keep rates higher for longer. We believe a continuation of downward pressure on valuations would be primarily a problem for US equities, which comprise about 60% of global equities at the index level and trade at a forward 12-month price-to-earnings ratio approximately 15% above the broad market.

During the pre-pandemic economic cycle, the increasing valuation premium of US stocks relative to their global counterparts could be somewhat justified by their consistent earnings outperformance. However, recent profit revisions have been more negative for US stocks than their global peers. This dynamic leaves US stocks vulnerable to another leg of valuation compression to bring equity multiples closer towards the global average.

In our view, there are much more attractive ways to benefit from surprisingly resilient activity than equities at the indexÌýlevel. Within equities, we favor emerging markets (EM) over developed markets (DM), and also find short-term US investment grade (IG) credit attractive.

The most meaningful change to the global backdrop over the past three months is China’s abandonment of zero–COVID-19 policies. This about-face may cause some acute near-term challenges to activity as public health outcomes deteriorate. But it also means that investors will likely have much more visibility to price in an upcoming rebound in Chinese consumption.

The removal of mobility restrictions and spread of the virus in China are playing out faster than we had anticipated. Already, there are signs that the cities hit the worst and hardest by the recent wave are seeing a pickup in mobility. As a durable reopening takes shape, we anticipate that valuations and earnings expectations for Chinese equities will continue to move higher.
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Source: ÃÛ¶¹ÊÓƵ-AM, Bloomberg. Data as of December 26, 2022.

Exhibit 2: Earnings estimates for EM already discounting a lot of profits pain

Source: ÃÛ¶¹ÊÓƵ-AM, Bloomberg. Data as of December 26, 2022.

Exhibit 3: Short-term US investment grade credit attractively valued relative to global stocks

Source: ÃÛ¶¹ÊÓƵ-AM, Bloomberg. Data as of December 26, 2022.

China’s elevated weighting in major indexes of emerging market equities drives our view that EM equities will outperform their DM counterparts. Even though China’s reopening is primarily a story of recovering domestic consumption, we believe it will still produce positive, but measured, spillovers for its trading partners as well as commodities. Emerging markets have already derated and had meaningful earnings cuts. We believe that means they are less susceptible to additional downside if economic growth disappoints, and have asymmetric upside if cyclical upside is underestimated.

The income available in short-term US investment grade (IG) credit is compelling, in our view, on both an outright basis and relative to Global stocks, and in particular, US stocks.

The spread between the earnings yield on global equities (~7%) and the yield-to-worst for 1-3 year IG US credit (~5.25%) is quite narrow vs recent history. This suggests that investors are getting relatively little extra compensation by moving to a riskier and longer-duration part of the capital structure (from near-term debt to equity).

The corporate credit curve is also very flat due to the inversion of the US Treasury curve, which allows for a similar amount of income to be generated in short-term (vs. longer-term corporate credit) with far less duration risk. Corporate fundamentals, particularly interest coverage ratios, also suggest US companies are in a healthy place and would remain so even if profits moderate somewhat.

Conversely, the range of scenarios for equities are quite wide, with an unfavorable risk-reward profile. Even if activity and earnings hold up well, stocks still have to contend with expensive valuations relative to bonds and discount rates that are unlikely to move much lower in such a backdrop – so upside is relatively capped. Meanwhile, in the event our optimistic view on the economy is wrong, the downside for stocks is likely much more significant than for short-term US Investment Grade credit, outside of any unexpected, extreme negative shock.

Carry and cyclicality are our preferred exposures for the start of 2023 as the US labor market remains resilient while China reopens and Europe’s energy crisis abates.

We believe emerging markets are well-positioned to outperform developed markets if activity exceeds low expectations amid a durable recovery in Chinese consumption. On a sector basis, we also prefer energy and financials.

Short-term US IG credit is particularly attractive given high coupons and relatively low near-term domestic recession risk, in our view. Elsewhere, given our view that the US dollar is rangebound, but with a bias lower from here, we also favor positive carry long positions in Mexican peso. Our most preferred currency is the Japanese yen. The recent move from the Bank of Japan to increase how high the 10-year yield can trade is, in our view, a catalyst that will allow a long-inexpensive currency to have an extended, powerful period of mean reversion. The yen also serves as a useful risk-off hedge if growth deteriorates more than we expect.

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness as of January 5, 2023. The colored squares on the left provide our overall signal for global equities, rates, and credit. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, rates, credit and currencies. Because the ACA does not include all asset classes, the net overall signal may be somewhat negative or positive.

Source: ÃÛ¶¹ÊÓƵ Asset Management Investment Solutions Macro Asset Allocation Strategy team as of January 5, 2023. Views, provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.

Source: ÃÛ¶¹ÊÓƵ Asset Management. As of January 5, 2023. Views, provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.