Disaster and tragedy have beset the world in recent years. History will record two black swan events in close succession – Covid and the Ukraine War – taking a heavy toll on human life while causing turmoil in the global economy and financial markets.
But history also shows that some of the best returns can be made by investing in markets in the darkest times. And as we survey global markets today, we are seeing more reasons to be optimistic. More volatility, thanks to events such as those recently seen in the banking sector, can still be expected, but a more positive undertone is gradually gathering momentum.
Fears of recession persist. Central banks do not look set to ease up on fighting inflation any time soon and the aggressive rate hikes they have implemented have yet to make their full impact. But nor will the central banks want to crash the global economy and rate increases may therefore be slower and smaller than many expect.
Inflation also remains stubborn. The latest UK figure for February was a surprise at 10.4%, but inflation was never going to return to 2% in just a few months in western economies. The narrative still appears to be that inflation will decline slowly.
We continue to believe that inflation should fall as the rolling base effects from Covid shutdowns and Russia’s invasion of Ukraine work their way through the system. Oil and gas prices are significantly below their highs seen last year, for example.
The discussion now is more about balancing interest rates and economic growth rather than raising rates, especially after the recent turbulence in the banking sector.
Certain equity markets offer reasons for optimism. Investors’ focus is switching from how much further interest rates will rise to closer analysis of companies’ valuations and whether they are delivering good results in what appears to be a steady business environment.
Equity regions we rate most favourably include the UK, Asia Pacific, and emerging markets. The UK stock market outperformed many others in 2022 but its equities are still relatively cheap after being disregarded by many international investors since the Brexit vote in 2016.
Despite its recent outperformance, the UK still has a long way to go, particularly if the rotation to value continues. UK smaller companies have suffered amid recent sell-offs, as in the US, but longer term we continue to believe in the small-cap premium and the short-term re-rating could give us an opportunity.
Overall, smaller companies in the UK should benefit from the same broad themes as the large-cap market with additional sensitivity to domestic economic conditions, whether positive or less so.
Asian economies fared well during Covid, and the re-opening of China will provide more support. Asian stocks will also benefit from strong and favourable demographics. Emerging markets have proven themselves to be better at implementing appropriate policies to deal with inflation than developed countries, creating a supportive environment for companies. Some have also benefited from being commodity producers, which have seen significant price rises.
We also see opportunities in fixed income, which saw major drawdowns in 2022 as central banks raised interest rates aggressively. We appreciate the direction of yields is still upwards over time as interest rates climb but high yield bonds, which represent the relatively low credit-quality borrowers, now offer attractive spreads versus government bonds.
We believe the yield premiums are amply rewarding to compensate for the lower credit quality. The yields on emerging market bonds are also attractive, even though their credit ratings, on average, are superior to those of their high-yielding equivalents in developed markets.
Financial markets were shaken in March by concerns over the creditworthiness of some banks. We continue to monitor the situation closely and engage with fund managers to understand their exposure to the banking sector.
However, the difficulties being faced by certain banks have yet to represent a major systemic risk for the financial sector. Memories of the global financial crisis (GFC) are still fresh, which probably helps explain why policymakers have been so quick to take appropriate action. Some banks do appear to be in less robust shape, but the sector now operates under tests and capital requirements that are much tighter than they were before the GFC.
This episode does demonstrate the benefits of broad diversification across a range of assets and taking a long-term investment perspective.
The economic outlook is still uncertain. Geopolitical risks, and their potential impact on global supply chains and inflation, cannot be dismissed. Trying to predict when a recovery will appear and which asset classes will outperform is a hazardous pursuit.
Anyone hoping for a raging bull market in 2023 is likely to be disappointed, but when markets turn upwards, it will happen quickly and investors will have to be invested to enjoy the gains.
John Husselbee is head of the Liontrust Multi-Asset Investment team. The views expressed above should not be taken as investment advice.