This has been a challenging year for investors. Political shocks, like the Russian invasion of Ukraine, jolted the global economy. Inflation has remained elevated for much of 2022 despite the best efforts of central banks, inflicting a painful rise in the cost of living.
But could these issues subside? And are there indications of a better 12 months ahead? The Nutmeg investment team offers a short summary of its outlook for 2023, highlighting eight key themes which we will explore in more detail in the weeks ahead.
In trying to tackle soaring inflation, central banks have fought back by raising interest rates, which has raised the cost of financing for business and investments. In turn, equity and bond markets have been very volatile. An especially bad year for bonds has emphasised the challenge facing policymakers, with bond prices falling as interest rates rise. Central banks have to some extent been playing catch-up, having vowed to be cautious in normalising interest rates from near record lows, and markets remain very sensitive to policy moves that could further harm economic growth.
So, what might change in 2023? As the last few years have shown us, trying to predict the future is a tricky business. So, rather than making grand forecasts, we’re thinking about 2023 in the context of several key themes that we think will continue to dominate investors’ thinking.
We’re sharing these to help you understand what may affect the performance of your portfolio in the months to come. We’ll be monitoring and analysing them throughout the year, and of course, these themes are likely to drive our thinking when it comes to making any adjustments to the asset allocation of your portfolio too.
Going into the New Year, we’ll publish a series of blogs which go into more detail on each theme. But for now, here’s an overall summary. We hope you find it useful.
1. Geopolitics will remain influential – but may stabilise
Geopolitics took centre stage again in 2022. Sanctions against Russia politicised and weaponised the global financial system, while China became ever more inward looking with its zero-Covid policy. The UK will finish 2022 with its third prime minister and fourth chancellor of the year.
The geopolitical themes that dominated 2022 will carry over into the months ahead. But, on paper, we think it could be a year where the pace and volume of change calms down. There are no elections planned in major economies such as the US, France, Germany, Italy, or the UK, and global leaders are likely to be prioritising domestic issues as economies head into potential recession or at least lower growth. Russia’s actions meanwhile have strengthened Western nations’ resolve to work together after a period of increased fragmentation.
A calmer world would help rebuild market confidence, supporting equities and bonds, the two main asset classes in Nutmeg portfolios.
That said, we’re keeping a close eye on China in particular. The latest G20 summit showed some improvement in US-China relations despite Chinese policy shifting to be more inward focused in 2022, while more recently we have seen the lifting of the most severe Covid policies, both positive signs for the future. However, the Chinese government’s hostile stance on Taiwan could be a continued source of political volatility and heightened risk.
Key takeaway: Geopolitical events can have direct and immediate impact on markets – such as we’ve seen from Russia’s invasion and the subsequent rise in commodity prices. While we would hope for a more peaceful 2023, the tail risks from geopolitics remain as present as ever for investors
2. Inflation should moderate
As 2022 draws to a close, signs of an economic slowdown are growing. Supply chain issues – one of the key drivers of inflation – are easing. On a global level, interest rates are also higher, which should lower demand-led-inflation.
However, the cost of goods and services remains elevated as food and energy supply impacts are still passing through. Inflation lowers household spending power, and unless companies can pass on their own cost increases into prices, corporate profit declines could create a more challenging environment for equities.
While we think that inflation will moderate in 2023, the path remains uncertain. As supply chain blockages unwind and consumer demand slows, we’re seeing signs that inflation in goods prices is falling. Raw materials costs have largely fallen from their 2022 peaks, but as the Chinese economy reopens, we’ll be watching commodities prices closely for signs of a revival.
In the West, service sector inflation remains a concern, and we’ll be keeping a close eye on the labour market (employment levels and wages) and rent costs as a key barometer of when inflation may recede.
Key takeaway: We may well be past the worst when it comes to price rises on a broad basis, though that doesn’t necessarily mean an end to the current cost-of-living crisis. We expect inflation to moderate in 2023, relieving pressure on policy makers. But cuts to interest rates remain a long way off.
3. Bonds are more attractive than they have been for some time
Bond yields (the rate of income return you get for holding government or company debt) rise and fall in line with interest rates. For the last 15 years, yields have been very low. But in 2022, as central banks started raising rates once again, they have risen significantly.
Government bonds in developed markets (like the Americas, Europe, and Asia Pacific) are now offering the highest yields we’ve seen in decades. The 10-year US treasury rate was at over 3.5% as at the beginning of December, compared to an all-time low of 0.55% in July 2020.
In the context of Nutmeg portfolios, this means we expect bonds to contribute more meaningfully to returns through this income stream (though note that as the yield on a bond goes up, its price decreases and vice versa).
This an important theme for all investors. After the worst year for bond market returns in 25 years, and after the extent of further monetary policy tightening is better understood, there is the possibility of more healthy returns from the bond market in 2023 and beyond.
Key takeaway: The pace of central bank interest rate normalisation caught bond markets by surprise in 2022, and with bonds over-valued at the turn of the year, returns have been among their worst in 25 years. But 2022 has restored the ‘income’ component of return, and with central banks having tightened monetary policy considerably already, we expect bonds to play a positive role in portfolios in 2023.
4. The US dollar should decline
The US dollar facilitates global trade and helps the wider global economy function by acting as its reserve currency. When the value of the dollar rises relative to other currencies, it means one of two things: either the US economy is outperforming significantly against the rest of the world (resulting in a higher demand for US assets), or conditions are getting riskier, and investors are getting nervous.
In 2022, we saw the latter. The dollar rose as investors wanted a ‘safe haven’ when confronted by the rapid rise in inflation, and the Federal Reserve’s aggressive actions to combat it relative to other economies spilled over into other asset classes.
A stronger dollar creates a headwind for the global economy because it contributes to rising inflation (sometimes known as ‘importing inflation’) and makes debt repayments harder in developing countries if they have dollar-denominated debt.
In 2023, we think the dollar will begin to weaken as global financial conditions stabilise. This should give the global economy some room to breathe, and be a boost for global asset markets, notably emerging markets.
Key takeaway: Investors sought out stability in 2022 via the dollar. We expect financial conditions to stabilise, providing scope for the dollar to begin weakening during 2023 to the benefit of the global economy, notably emerging markets.
5. Europe will continue to face challenges
The energy crisis has engulfed Europe this year. It has prompted political, social, and economic upheaval, and a dramatic rethink in energy supply and security.
In 2023, we think the European economy will continue to face significant challenges, with critical focus being on the energy transition away from Russian gas. The European Central Bank (ECB) will also be in the headlines as it battles inflationary pressures in common with other regions.
Should the Euro begin to rise because of the measures the ECB takes, it will provide additional headwinds to the recovery of trade-orientated economies like Germany.
The challenges facing the region have made European equities cheaper. We think this could lure value-orientated investors into the region, as they tend to look for companies which, in their view, are mispriced by the market based on their analysis.
Key takeaway: We think that the region is likely to experience bouts of volatility through 2023 across all facets of the economy, so will be treading carefully before adding to any of our positions here.
6. Emerging markets are finely balanced
Emerging markets have suffered in 2022, impacted by the stronger dollar, higher inflation, and rising interest rates. Higher commodity prices have supported exporting regions or countries like the Middle East, Brazil or South Africa. In contrast, commodity importers like China and Taiwan, with large technology sectors vulnerable to higher interest rates, have suffered the most.
In 2023, we think that a weaker dollar, improved supply chains, and the end of interest rate rises could reveal opportunities in emerging markets. Those willing to take a higher level of risk could find a higher level of return in both bonds and equities alike.
However, China remains the Achilles heel for emerging market growth in 2023. As the engine room of global trade and the world’s largest manufacturing base, its cautious stance on Covid has restricted exports. Worse still, its domestic economic growth has also been subdued as consumers face extended restrictions and policy risks have risen as China’s leadership consolidated behind President Xi and policy turned more inward focused.
Yet the situation is now improving and a Chinese economy reopening and re-engaging in the global economy could help emerging markets to roar again 2023, improving supply chains and boosting trade volumes.
Key takeaway: Emerging markets have not fulfilled their promise of higher growth in recent years, but their catch-up potential remains. A weaker dollar, re-opening of the Chinese economy and appealing valuations mean emerging markets offer opportunities for investors in the coming 12 months.
7. Large UK companies are looking good
The UK’s biggest blue-chip companies (collectively referred to as ‘large cap’ firms in reference to their market capitalisation or overall value) have outperformed most other equity markets in 2022.
The constituents of the UK large-cap market, the FTSE 100, generally make most of their revenue abroad – with much of their profits derived in dollars – and are spread across various sectors, including energy, healthcare, and consumer staples, which are typically thought of as essentials people buy regardless of how the economy is performing.
Despite the prospects for a weaker USD, we think UK large cap firms could be resilient and perform well in a world with lower growth, therefore playing an important role in diversifying multi-asset portfolios. They also continue to offer an attractive dividend yield (that’s the percentage of their share price that they pay out to investors each year) relative to their developed market peers.
Dividend income has always been an attractive part of UK equity returns, and while many large companies cut their dividends during the 2020 downturn, these have now largely recovered, with an average yield for the FTSE 100 of around 3.72% in 2022.
Key takeaway: The fortunes of the FTSE 100 are often divorced from the health of the UK economy, with many of its constituents global facing businesses in terms of their revenue streams. The recovery in dividends has restored an attractive source of return for UK investors, while valuations remain below their long-term average.
8. Don’t write ESG off just yet
Environmental, social and governance – or ESG – investing has had quite the year. Russia’s invasion of Ukraine revealed how dependent we still are on fossil fuels and consequently, energy and commodity companies have performed excellently year to date. In comparison, ESG-focused funds have underperformed mainstream indices, because they exclude many of these companies on the grounds of involvement in fossil fuel extraction.
Looking ahead to 2023, we expect that outside of a significant deterioration in the macro-economic outlook, energy companies will continue to fair well given the structural change in energy supply that has taken place, and an outlook for sustained elevated prices. Higher oil prices in the medium term may well be the unintended consequence of an energy transition, given the lower supply capacity and capex of the past five years.
Yet elevated energy prices, alongside supply and security challenges, heighten the need to move away from fossil fuel dependence. In this regard, the policy impulse is as strong as ever, as the recent United Nations COP 27 reaffirmed: climate policy regarding lower future fossil fuel emissions is here to stay.
So, after a reversal in fortunes for ESG investment strategies in 2022, does this mean the future is dimmed for ESG? We do not believe so.
Key takeaway: ESG is intended as a holistic framework for the consideration on non-financial factors in investment decision making. It is more than just simply investing in a greener or more sustainable way. It is intended to help investors determine how long-term structural changes, such as climate and social policy, will change competitive dynamics and risk reward equations for investment.
ESG has a different type of sustainability at its heart than many immediately recognise – the sustainability of profits, risk taking and operational models in fast changing global economy. In that regard, ESG is long term in nature and growing in its importance.
There you have it – our key themes for 2023. So, how should you be feeling about your investments?
We know that recent months have been frustrating. The next few months are likely to be testing as well. We’re in a painful period where central banks are “tightening” (raising interest rates and buying back their own debt) to try and curtail inflation while keeping the economy on the right track.
For investors, much of 2023 will depend on the path of inflation and the overall health and stability of the global economy. Those with the discipline and the patience to stay invested should be rewarded in time: conditions should start to look more promising as interest rates stabilise and inflation cools.
We’ll be sharing regular updates to keep you up to date with markets, performance, and our thinking.
For now, we’re wishing you a healthy and happy end to 2022.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.