New year, old themes: markets dare to dream

It’s 2023, but for investors 2022’s themes are still very much front and centre. In particular, the dominance of the inflation outlook and concerns about the monetary policy response.

December provided a weak end to a disappointing year, with the primary catalyst being the European Central Bank (ECB)’s hawkish pivot around mid-month. At the start of the new year, a series of data releases stoked hopes that we could be approaching the light at the end of the inflationary tunnel. In quick succession, we’ve seen weaker-than-expected European inflation and US wage growth, and natural gas prices in Europe have fallen by 50% since early December.

This constellation of events has raised hopes that a recession can be avoided, with consumers receiving a much-needed boost from falling commodity prices which, in turn, could alleviate the pressure on wages.

Temper that optimism

However, well-meaning resolutions made at the start of the year have a nasty habit of turning to dust relatively quickly. Half of new gym memberships lapse within six months, for example. We worry that ‘soft landing’ hopes will prove similarly ephemeral.

Aggressive rate-hiking cycles almost always end in recessions as credit conditions become tighter and households and corporates retrench from interest rate-sensitive expenditure on housing, durable goods and capex.

Markets might dare to dream that this time will be different, but we doubt it will play out like that.

From festive season to earnings season

Earnings season begins this week, and with it an increase in bottom-up news flow. Overall, we don’t expect it to significantly move the needle.

Three-quarters of early reporters managed to beat sell-side analyst estimates, which are on the high side by historical standards. It seems that analyst estimates for current earnings are not unusually far away from reality and the scope for big disappointments in Q4 results is limited, at least at a broader level. However, this measures only backward-looking earnings.

Impressing investors also requires positive surprises on forward-looking guidance. But this has been more difficult for early reporters, with only around half outperforming the market the day after results.

Overall, this suggests that the next few weeks will bring a mix of solid Q4 earnings, but with cautious outlooks from most management teams. At the same time, although the current situation remains relatively healthy and recession is a risk rather than a reality, there is no incentive for managements to kitchen sink earnings outlooks  and sound extremely pessimistic.

On balance, we expect this to result in continued modest downgrades to analyst earnings forecasts, but not yet the sharp cuts that occur in recessions. Chances are there will be something to like for both the bulls and bears, and the macro debate on recession will have to wait to be settled another day.

Gifts from the East

It’s the time of year for wise men from the East bearing gifts. Rather than gold, frankincense and myrrh, investors this year have had:

• The pivot from zero COVID to zero restrictions on COVID
• The easing of restrictions on property developers
• The apparent end of the regulatory campaign against the Chinese tech sector

On zero-COVID, we saw an initial collapse in measures of population mobility (inter-city travel, subway use etc.) as the virus spread rapidly through urban centres, but we are now seeing activity start to normalise. Likely winners from this are the recipients of tourist and student flows (notably Japan and Australia).

The easing of restrictions on property developers are exemplified by the softening of the totemic ‘three red lines’. These guidelines were introduced in August 2020 and constrained the ability of the most indebted property developers to refinance. Stories have emerged in the past week of plans to ease borrowing caps and push back the deadline for implementing debt targets.

Finally, we’ve had statements in the last few days from the Party Secretary and Deputy Governor of the People’s Bank of China that increased regulatory pressure on Chinese tech is “basically” over.¹

Taken together, those measures have provided a strong backdrop for Chinese asset prices in recent weeks. In particular, the first two measures have lit a fire under the prices of property companies’ debt.

The unfolding economic weakness in North America and (most notably) Europe makes it hard to be especially optimistic about commodities, but the risks are much more balanced with China’s self-imposed restrictions on growth being lifted.

1. Source: https://www.centralbanking.com/central-banks/financial-stability/7954155/crackdown-on-internet-firms-is-basically-done-pboc-party-chief