After the year-end rally stalled in December, investors entered 2023 with negative sentiment and cautious positioning. January then turned out to be one of the best months on record, much to the surprise of most observers who believe that we are still in a bear market. Our view has stayed the same since we proclaimed the end of the decline last October: We have entered a new bull cycle that will last for many months.
In 2022, we found it challenging to navigate the markets, as the technical indicators were giving a cautious signal, while our fundamental reading of the US economy — and, to a lower extent, the European economy – gave us no clear signal of an imminent recession. The latest US economic data seems to be confirming the US expansion scenario.
On a seasonally adjusted basis, the US economy created 517,000 jobs in January, and the leading indicator by the Institute for Supply Management for the services sector rose sharply into positive territory. US unemployment is at its lowest level since 1969 (see chart 1). If we are in a recession, it will be a new kind — a full-employment recession.
Wage pressures have also eased. After the confinements related to the pandemic ended, there was still a gap of three million workers that had yet to return to the US labour market compared to pre-pandemic levels. One possible interpretation of the current positive employment figures is that some who had left are returning to work, easing the supply shortage of available workers.
The pessimists quickly suggested that this resilience in the labour market would finally kill off any prospect of a rate cut by the US Federal Reserve (Fed) in the year’s second half. As a result, equity markets are bound to be disappointed soon. This hypothesis does not convince us.
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We are, however, delighted that inexorable disinflation and zero or negative interest rates have been buried. It is healthy for the capitalist system that capital has a cost. The most sensitive sectors to rising interest rates have already made considerable progress in adapting to the new post-disinflationary economic reality.
The US housing sector should see further price declines, estimated between 7% and 10% on average, and the financing structure of the owner-occupied property is infinitely healthier than in 2006, with a high proportion of equity. In a context where the private sector is not in a situation of structural imbalance, there is no endogenous reason for the US economy to come to a sudden halt. At the same time, as Fed Chair Jerome Powell indicated at the last Federal Open Market Committee press conference, the disinflationary process is now underway and, above all, increasingly visible. This is particularly important for Europe, even though it lags in this process.
As Julius Baer’s macroeconomic research team predicted last spring, the energy market is global and fungible. Fossil fuel trade flows have been redrawn in a matter of months. On the other hand, the energy transition has accelerated, especially in Europe. In a few years, this could be a significant economic advantage for the region, where fears of deindustrialisation have been exaggerated in the wake of the war in Ukraine. Barring a desperate move by the Kremlin, the outcome and potential resolution of the conflict is far more likely to be favourable than negative for risk assets.
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China and Japan
On the pandemic side, recent signals are encouraging after an initial spike in cases and deaths, and the health system’s worst-case scenario appears to have been averted. As a result, Chinese consumers should be quick to spend at least some of their inadvertently accumulated savings. Our reading is optimistic, but we do not expect a significant surge in economic activity like the one in the US.
Chinese consumer confidence has probably been hit hard by this long period of zero-Covid policy and the crisis in real estate, their asset class of choice. On the economic side, government support is welcome, but its effectiveness is not guaranteed in the current Chinese context. Their monetary policy shows signs of a liquidity trap (that is, the transmission of monetary stimulus to the real economy appears to be impaired; money supply growth is currently not fully reflected in private-sector credit creation). We are, therefore, not counting on a prolonged boom in consumption and commodity demand.
The two consecutive exogenous shocks of the pandemic and the war in Ukraine have made reading the economic situation particularly difficult. The distinction between temporary effects and permanent changes is now harder to deduce.
Although inflation fears have been greatly exaggerated in the short term, we expect inflation in the West to average around 3% in the coming years. Japan has been a valuable laboratory for understanding the implications of the last two decades of deflationary regimes in the West. It was the first economy to enter into a balance-sheet recession in the mid-1990s and reached zero interest rates around 2000. Most critically, it has been at the forefront of the demographic ageing trend that is now emerging also in Western Europe and China.
There is no consensus on the monetary consequences of ageing societies. So far, the weight of evidence from Japan is leaning towards deflationary implications, as older people tend not to borrow but instead reduce their overall consumption, except for healthcare.
However, as the age dependency ratio continues to rise, showing a shift of a more significant part of the population from working to non-working (see chart 2), the trend could become inflationary, as workers in high demand and low supply enjoy more substantial wage-bargaining power. Interestingly, we have just witnessed the first wage increase in Japan in decades.
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Meanwhile, the Bank of Japan (BoJ) remains committed to controlling the yield curve even though it adjusted the target for the yield on its 10-year government bonds from 0.25% to 0.5% in December. Some expect the BoJ to abandon this policy, which involves massive purchases of Japanese government bonds, in the not-too-distant future.
Acting Governor Haruhiko Kuroda is due to retire on April 8 this year, and thus the transition to a new governor could be the catalyst for a policy change in Tokyo. Observing Japan’s inflation trends might provide exciting clues for Western economies, where yield-curve control is still possible if government refinancing costs exceed nominal gross domestic product growth in the coming years. The most obvious beneficiaries of the end of yield-curve control in Japan would be Japanese banks.
Next shift in leadership
Each decade, the markets are dominated by a different sector or asset-class leadership. There is growing evidence that the information technology giants’ era has ended. The search for the next leadership is always tricky in the early stages.
As we do not believe a broad-based commodity supercycle will occur this decade, it is not a given that the next shift in leadership after information technology will follow the usual pattern and take us to materials or oil and gas stocks.
In the last decade, nominal economic growth was very low, and digital platforms enjoyed a rare niche of solid growth. With a new paradigm of much higher average nominal growth going forward, sectors that previously struggled in an environment of low nominal growth have a tailwind.
Public equity markets continue to constitute a cash-returning mechanism instead of a cash-raising one. Banks are a new addition to this situation, which might last longer than is currently discounted.
Yves Bonzon is the group chief investment officer at Julius Baer
