What are advisers to high-net-worth clients telling them about what to expect next year and how they’re positioning their portfolios?
We have a look at what a strategy team of a private bank is saying about the probability of a recession, and which sectors and types of stocks would fare best in that environment.
After all, the rich and fat cats want to stay rich and protect their wealth.
Get this advice…
by Barclays Private Bank
It’s been a tough year for equity investors as economic growth expectations are slashed across regions, while inflation forecasts and policy rates have been revised higher.
Will 2023 be any better for financial markets?
With the US Federal Reserve (Fed) and other major central banks tightening monetary policy amid a slowing economy, unsurprisingly, the risk of a global recession has increased.
A consensus of economists puts the probability of a recession in the next 12 months at 60% in the US and 80% in Europe.
Barclays’ economists now expect advanced economies to contract next year (to -0.2% in 2023 from +2.5% in 2022), but global growth to remain positive, albeit very weak.
US bond markets have flagged for a while that a recession is likely towards the second half of next year.
Yield curve inversions have been reliable indicators of them in the past, with recessions typically starting 14 months on average after inversions.
The 2s10s US yield curve turned negative in July, reaching a 40-year low of -63 basis points (bp) in early November. (It’s more negative now)
KEY ASSUMPTIONS AROUND THE NEXT RECESSION
The key question for investors is around the timing, depth, and duration of the next recession.
Equity market performance in such periods, and the time it takes for investors to recoup their losses, depend on the severity of the downturn.
Unfortunately, recessions are difficult to predict, and they vary enormously in duration and magnitude.
The current environment is particularly hard to assess with inflation running at multi-decade highs in leading economies and the geopolitical situation adding further uncertainty, there are few historical precedents.
The most severe recessions tend to be the ones triggered by a financial crisis.
Encouragingly, we do not see any major imbalances in the economy for now.
US consumer and corporate balance sheets remain healthy, large excess savings provide some cushion, and the labour market remains strong.
Therefore, if a global recession materialises, we believe it is more likely to be mild and short-lived.
WHAT IS PRICED IN, AND WHAT ARE THE DOWNSIDE RISKS?
At current levels, the market seems to be discounting a mild recession, in line with our base case scenario.
This view is based on the level of economic activity and earnings growth we believe is reflected in equity prices at present.
If we were to see an average recession, we believe that global equities could decline by a further 10% or so.
This would be approximately 33% below the January peak levels on the MSCI All Country World Index.
NECESSARY CONDITIONS FOR A TROUGH
For equity markets to bottom, certain conditions generally need to be in place:
- Cheap valuations
- Depressed sentiment
- Cautious positioning
- A sense that the worst is over in terms of economic activity, inflation, and interest rates.
Two of those conditions appear to be in place, but they may not be sufficient, on their own, to trigger a sustainable rebound:
- Equity valuations have already plunged on the back of this year’s surge in real yields.
- Sentiment is very depressed amongst individual investors
- However, risk appetite measures across major asset classes are more neutral, suggesting that we have not seen a capitulation yet.
- With regards to positioning, it appears to be cautious, but not yet extreme.
For markets to look beyond heightened levels of volatility, we will need to see signs that economic activity has troughed and that central banks’ hiking cycle are coming to an end.
Historically, rate cuts have been a key catalyst for equities to rebound.
But we do not expect a dovish pivot soon, unless something breaks — in which case, obviously, markets may struggle.
Until clarity emerges, we do not exclude more rallies, similar to the ones we saw in March and from mid-June to mid-August, which were violent but short-lived.
i. Defensive sectors are too expensive
Following the substantial rerating of defensive sectors in the past year, as recession fears gained traction, the sectors appear expensive, especially in the context of a risk-free rate of 4%.
Defensives are now trading at a 46% privce-to-earnings (PE) premium to cyclicals, globally, much higher than the average premium of +18% in the past 20 years.
This is two standard deviations above the long-term average.
Attractive investments can still be found, but on a very selective basis, at the stock level, or in some regions as opposed to globally.
Given this year’s surge in yields, we generally see better opportunities for defensive positioning in the fixed income universe at present.
ii. Value versus growth
Equity performance has been primarily driven by stocks’ sensitivities to rising real yields this year.
Value plays have been more resilient in the market sell-off than the more expensive growth stocks, with long duration cash flows.
The MSCI World Value index has outperformed growth by 38% (and the market in general by 17%) since November 2021, as US real yields surged by close to 300bp.
While most of the rise in yields seems to be behind us, value stocks could still perform well into next year.
Indeed, we believe that their relative performance does not fully reflect the higher yields, and they continue to trade at a large valuation discount relative to growth stocks, and the market in general.
In keeping with the value tilt at the sector level, we see interesting opportunities in banks and energy.
Banks should be one of the main beneficiaries of rising yields.
Since the start of the year, the relative performance of banks has disconnected from US 10-year yields.
This disconnect reflects market concerns over recession risks, and the negative impact one would have on banks’ profitability, given their sensitivity to the business cycle.
We continue to expect the disconnect between the relative performance of banks and yields to narrow.
Net interest margins may surprise positively, and loan-loss reserves have already been built up in anticipation of worsening asset quality.
Banks are also better capitalised today than they were during the global financial crisis.
As we get more clarity on the shape and magnitude of the slowdown, we think the sector could re-rate further and catch up with the recent rise in yields, despite rising recession risks.
And finally, valuations and earnings revisions are supportive.
Within the MSCI World index, banks are trading at a -42% discount to the market, based on forward PEs, versus a -26% discount on average in the past 20 years.
They also offer a superior dividend yield (4.7% forward 12-month dividend yield for MSCI World Banks versus 2.3% for the broader market).
The energy sector should continue to profit from high fuel prices and offer some protection against escalating geopolitical tensions.
While global demand for oil and gas would be at risk in a recession, energy prices should be supported by tight supply in the coming months.
The EU’s embargo on Russian oil supplies will take effect in the next few months, and the OPEC+ group of oil producers recently announced production cuts starting in November.
Despite surging so far this year (the MSCI World Energy index is up 52% while the broader market is down 21%), the sector continues to trade at a significant discount versus the market, based on forward PE multiples (1.4 standard deviations below 20-year average).
Energy shares also offer a superior dividend yield (3.6% for the next 12 months compared with 2.3% for the market).