Investors can look forward to four powerful tailwinds this year

After last year’s dismal market performance, another year of negative returns for both bonds and equities looks unlikely
Disinflation, lower interest rates, China’s reopening and the transition to renewable energy will sustain returns going forward

Chris Iggo

Published: 10:00pm, 25 Jan 2023

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The gloom spurred on by 2022’s dismal market performance has given way to optimism this year. Indeed, markets have been performing well since October. It was always unlikely there would be another year of negative returns from both bonds and equities.

Higher interest rates have created a better platform for positive returns from fixed income markets while a modest improvement in the economic growth outlook has supported equity returns.

Four themes will help sustain returns going forward.

First, disinflation. It is happening where inflation has been a huge problem. Consensus forecasts have consumer price inflation falling in the US, Canada, major European economies and across a range of emerging markets. For global financial markets, what happens to inflation in the US and Europe is key.

In 2022, key upside inflation risks came mid-year as energy and food prices responded to Russia’s invasion of Ukraine. However, by year end, monthly increases in consumer prices started to normalise to historical averages. While some inflation indicators might turn out to be somewhat sticky, the general theme of disinflation is likely to be a major investment narrative this year.

This is good for market returns. It means we are close to the peak in interest rates as central banks will be happier once inflation is falling. Bond market returns should continue to be healthy with investors benefiting from better income returns, reflecting higher yields.

Customers buy gas in Chevy Chase, Maryland, on January 12. Helped by falling fuel prices, consumer inflation in the US slipped in December to the lowest level in more than a year, signalling the worst of price increases may be over. Photo: AFP

Right now, investors are getting higher yields on – typically – less-risky shorter maturity bonds. However, there are signs that confidence in longer duration and credit fixed income assets is improving – new issues in early January from emerging markets including Saudi Arabia and Israel were very well received.

Disinflation is historically good for equity returns. In recent decades, when the year-on-year rate of inflation has been declining, equity returns tend to be strongest. If central banks in the developed economies can steer inflation back to the desired level of around 2 per cent, the quality of returns is likely to improve – that is, higher average returns with lower volatility.

The second theme is related. Real bond yields rose sharply last year as central banks tightened and quantitative easing comes to an end. Higher real bond yields, along with higher inflation expectations, pushed up nominal bond yields, generating negative mark-to-market returns for bond investors.

This also affected equity markets, with long-duration growth stocks underperforming value stocks for much of the year. Real yields remain high – the 10-year real yield in the US is at 1.3 per cent compared to -0.5 per cent – in January 2022.

As growth and inflation moderate and central banks retreat from their hawkish stance, real yields should start to ease. This will provide a tailwind for bond returns but should also provide some relief to growth stocks. Overall equity returns tend to be strongest when real yields are falling. If they don’t fall, then non-US equities might continue to outperform the S&P 500, given lower real yields in the rest of the world.

However, if US real yields start to reverse, this should spark a recovery in growth and technology stocks at some point, and provide some solace to those who think technology remains a good long-term investment.

A hot dog cart stands near the New York Stock Exchange on Wall Street. A fall in US real yields should spark a recovery in growth and technology stocks. Photo: AFP

The other two themes are more structural. The first concerns China’s reopening. The lifting of Covid-19 restrictions should boost Chinese growth, directly impacting global gross domestic product.

There will also be a multiplier effect as Chinese demand for commodities, and industrial and consumer goods, bolsters demand worldwide. This should offset some of the weakness expected in US and European growth, and boost sectors such as travel and tourism, luxury goods and autos.

However, as demand for energy and other commodities increases, investors will need to watch whether China’s recovery adds to global inflationary pressures.

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Busy Lunar New Year fair brings some relief to Beijing’s small business owners

Finally, 2023 should mark a renewed focus on the energy transition. The disruptions to energy markets have elevated concerns about energy security across countries. Furthermore, higher energy prices have reduced living standards, intensifying the need for more stable pricing.

Accelerating the shift towards renewable energy sources and efficient energy usage will create incremental investment opportunities.

The US’ Inflation Reduction Act provides generous subsidies for investment in renewable energy and technologies like electronic vehicles, hydrogen and carbon capture. The European Union has set out its Next Generation plan; more public sector incentives for green investment are likely to be seen.

China is also rapidly increasing its renewable energy capacity. There are multi-year opportunities for investment in companies contributing to the transition. Related policy stimulus is likely to be a factor in the performance of some equities this year.

How China can solve its energy ‘trilemma’ and avoid a policy swing

Investors underestimated the impact of the Ukraine war on the global economy, coming as it did when the post-pandemic recovery was still under way. This created imbalances and inflation. But the global economy should become more balanced and financial markets are again focusing on how this will boost returns.

Ultimately, disinflation, lower rates, China and long-term transition focused investments could be powerful tailwinds for investors this year.

Chris Iggo is chair of AXA Investment Managers Investment Institute and chief investment officer of AXA IM Core

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