2023 Outlook for investment markets

January 2023 has come and gone so quickly, and we are already in February. Despite this we still have a long way to go this year. Our investment professionals provide their outlook on investment markets for the rest of the year, and we hope it gives you, our valued clients, some insight into what the rest of the year may look like from an investing perspective.

 

Economic outlookDomestic equity outlookDomestic bondsDomestic listed propertyGlobal listed propertyGlobal development market equity outlookGlobal emerging market equity outlookGlobal developed market bondsPrivate markets outlook

 

Economic outlook – Arthur Kamp

As we enter 2023, uncertainty abounds, and investors have a lot of unanswered questions. Arthur Kamp, our economist, believes the key macroeconomic questions for investors to consider are as follows:

• How fast and how low will inflation go?
• How much further will the US Federal Reserve (Fed) and the South African Reserve Bank (SARB) increase their policy interest rates?
• Will developed markets get away with a soft-landing?
• How strong will the expected rebound in economic activity in China be?
• What is the outlook for commodity prices?
• Can Eskom improve its Energy Availability Factor (EAF)?

An improvement in supply chains, reflected in shorter global manufacturing sector delivery times and lower prices paid, in addition to lower commodity prices, notably for energy, suggest the inflationary environment of 2022 is likely to be replaced by a disinflationary environment in 2023.

However, although supply chains appear to be mending, the large developed market central banks are concerned about tight labour markets, which continue to support robust wage growth. In the US, for example, the total of employment plus job openings exceeds the size of the labour force, implying a structural shortage of workers. The resultant low unemployment rate is contributing to firm average hourly earnings of all private employees, which increased 4.6% in the year to December 2022. Absent an improvement in productivity growth, current labour market dynamics are inconsistent with the US Federal Reserve’s inflation target.

The unknown is how much further the Fed’s Federal Open Market Committee (FOMC) needs to hike its policy interest rate to ease these labour market and, by extension, inflationary pressures. Real economy data has been holding up better than expected in the US (and Europe). For one thing, US employment growth remains firm. Typically, US recessions are characterized by a contraction in wage growth.

However, the risk is that inflation remains above the Fed’s inflation target by a significant margin, in which case the US economy may need to be tilted into recession to achieve the desired outcome.

Domestically, the South African Reserve Bank appears reasonably close to the end of its current interest rate hiking cycle. Historically, periods of material Rand undervaluation have, typically, given way to a firmer domestic currency once the SARB has begun hiking its repo rate.  Stronger commodity prices also help.

However, more aggressive US interest rate hikes than currently expected may weigh on the Rand and boost local inflation expectations, which would filter through into the SARB’s interest rate decisions.

Meanwhile, although China’s economy appeared to endure a contraction in the final quarter of 2022, the end of its zero-COVID policy is expected to pave the way to a strong bounce in real GDP growth by mid-year. The question is to what extent this can be expected to support commodity prices.

In turn, commodity prices exert a strong influence on the terms of trade of commodity producing economies. In late 2022, lower export commodity prices weighed significantly on South Africa’s terms of trade. A recovery would provide a welcome boost to domestic purchasing power in what is fast becoming a challenging local environment for growth.

Meanwhile, given a fall in Eskom’s Energy Availability Factor (EAF) to 50% in the first week of 2023 and the concomitant implementation of stage 6 loadshedding, the most important immediate question for the SA economy is whether the utility can improve its EAF, failing which already soft growth forecasts are likely to be revised lower as analysts ponder the chances of a recession.

 

Domestic equity outlook – Andrew Kingston

Most of the factors that have caused the turbulent global market conditions that characterised 2022 last year remain in play as we enter 2023 – high inflation across many key economies of the world, rising interest rates, lingering Covid pandemic issues that have impacted global supply chains and lastly, war in Europe, between Russia and Ukraine. South Africa is not unscathed by these factors and therefore, one of the key themes to watch from a domestic equity market perspective this year will be the impact of slowing global growth and potential recession in key trading partners of the South African economy. We remain in a tightening monetary framework in South Africa, and we expect the South African Reserve Bank to announce further interest rate hikes in the early part of 2023. We anticipate that we are close to the peak of this cycle, and we expect interest rates to stabilise this year and possibly even potentially begin declining towards the end of 2023. This will, of course, depend on inflation, which remains elevated in the South African context, but is showing early signs of rolling over, which bodes well for potential interest rate relief going into 2024.

The big challenge in the South African macro context that affects the outlook for South African equities that are more domestically orientated, is the issue of inadequate real growth in our economy. With Eskom in deep crisis-mode, their critically low energy availability factor continues to pose a major risk to the effective daily functioning of the SA economy. We remain extremely concerned about this aspect and focused on ensuring that we have adequate risk measures in place to mitigate this prevailing theme of low growth within the SA investment context. Notwithstanding this, we highlight that the South African equity market remains very attractively priced and trades at a substantial discount within a global context, and even within an emerging market context. It is thus fair to say that the exceptionally challenging year we had last year in 2022 has yielded many attractive investment opportunities that we hope to continue to identify, invest in and potentially harvest over the coming years, as some form of recovery gets underway perhaps in the latter part of 2023 and leading into 2024 and beyond.

 

Domestic bonds – Mokagtla Madisha

Mokgatla Madisha, the Head of Fixed Interest team answers some pertinent questions on the outlook for 2023 with a focus on fixed interest markets.

1. What is your view of the outlook for your part of the business in 2023?
   Emergency action taken by central banks following the Covid-19 pandemic left cash returns at multidecade lows. Normalisation of interest rates which began in earnest during the second half of 2022, is making cash attractive again as an asset class. In fact, the risk is that central banks go too far in their quest to quell inflation, which could push the global economy into recession further enhancing returns on bonds as investors seek the relative safety of bonds.
2. What macro and micro factors do you feel are most likely to have an impact on your investments?
   Inflation is set to decline this year across most economies and central banks are nearing the end of the tightening cycles. The outperformance of the dollar relative to emerging market (EM) has left EM assets rather cheap compared to developed market (DM) assets. A stable to weaker dollar creates an environment conducive to EM outperformance. We will pay close attention to the US dollar. However South Africa has a relatively unique challenge of lack of adequate power which could counter global forces and make the SA fixed income market lag their EM peers.
3. What asset classes do you expect to perform best in 2023 and why?
   On a risk adjusted basis cash is very attractive. We are looking for returns of about 8.5% or 3% above average inflation for the year. From bonds we are looking for 10 – 12% – while they will prove to be good returns the journey will be quite bumpy. We are not looking for a meaningful rally because a low growth environment leads to poor government revenues and higher funding requirements.
4. Can you comment on market volatility and how it is playing out, considering the market downturn in 2022? Any key things investors should be looking out for?
   We expect a number of risk events in the first half of the year – i.e. possible grey listing by the Financial Action Task Force (FATF), a cabinet reshuffle and there is still political risk from the Phala Phala investigation. The market is looking at the Fed to start cutting rates from the middle of the year, if the Fed should disappoint then the dollar could strengthen, challenging the positive EM view.
5. What should investors be thinking about in terms of their investment strategies this year?
   As with any investment, an investor’s time horizon is very important. A well thought out investment strategy will balance short term liquidity needs and long-term compounding and capital gains. With cash rates at currently levels, the risk to being cautious in the first half of the year is quite low.

Domestic listed property – Mvula Seroto

The outlook for SA and the global economy for 2023 is still one of uncertainty, with economists warning of recessionary risks in the short term. In this uncertain environment, occupiers of physical real estate will generally remain hesitant to expand their premises or hire new employees, which places downside risk to the demand for space going forward. In the current environment, it is important to have exposure to companies with good quality portfolios, strong management teams and sustainable capital structures which will be able to adapt to the structural changes expected. We continue to assess the portfolio risks and actively screen for opportunities that market dynamics such as these are likely to offer. Our rolled 1-year funds available for distribution (FAD) yield is circa 9.5% with growth in distributions forecasted in the short term to medium term. The listed property sector continues to trade at a significant discount to NAV with a material dispersion between SA centric companies at a discount to NAV of 33.8% and offshore companies trading at a discount of 16.3%. Although the uncertain macro environment will likely continue to drive elevated volatility in asset prices locally and abroad, we currently expect total returns of between 11% – 13% per annum over the next 5 years.

 

Global listed property – Theodore Freysen

Looking forward to 2023, consensus analyst expectations for general equity earnings growth were reduced during 4Q22, with some being outright bearish. For example, the equity strategy team from Morgan Stanley expects year-over-year EPS growth for the S&P 500 to come in at -11% for 2023. In contrast, we see listed real estate in the US delivering c. 6.5% FAD (Funds Available for Distribution) growth in 2023 and c. 5.4% for our global listed real estate investment universe. FAD is synonymous to Free Cash Flow after Capex requirements to maintain property portfolio quality and is a widely used measure of real estate company earnings.

Due to the nature of the contractual lease agreements, usually with built-in escalations (either fixed or inflation linked), we have reasonably high visibility to future revenue and earnings from listed real estate companies. We believe listed real estate companies could stand out in 2023, and beyond, based on their earnings stability and growth.

Rising construction costs from increasing labour and material prices should act as a limit on future supply of real estate. Supply growth has in general not been a concern this cycle. The sectors that have seen the most supply (Industrial and Data Centres) have also experienced solid demand and low vacancies. Higher construction and finance costs will therefore also dampen the external growth opportunities for most real estate companies, and we expect a lower contribution to earnings growth from development for the sector. However, companies with superior cost of capital, for example in the Net Lease sector, might find attractive buying opportunities in the current environment.

With a few exceptions, listed real estate balance sheets are generally in good shape. Companies have done a good job of taking advantage of the favourable market conditions of the past several years to lock in low rates and extend and smooth debt maturity profiles. Absolute leverage on a debt to gross asset value basis (LTV) is currently just under 30% for our investment universe. The rise in rates unquestionably has a negative effect on earnings as companies refinance at higher rates. However, the impact is smoothed over many years as expiry profiles are well staggered with very few companies having any significant refinancing in any specific year. We do however foresee some difficulty for some companies, mainly in Europe where leverage is higher and the relative move out in finance cost has been the most significant. The German Residential sector, as well as certain Retail landlords specifically have some tough decisions to make to strengthen their balance sheet, in a market that is not easy to sell into.

We seem to be on the precipice of the most anticipated recession in history. Those who have been involved in the markets long enough might be wise enough to know that usually when everyone expects one outcome, something else often happens. The path that inflation, interest rates, and monetary policy take will surely impact the returns from all asset classes. The global economy is the most complex dynamic system known to man. Attempting to predict what happens to inflation and interest rates, and investing on this basis, is a fool’s errand and a wild goose chase.

At Catalyst Fund Managers we will stick to our process of investing in the best risk-adjusted return opportunities available to us by doing thoughtful, supply and demand analysis and estimating risks to the best of our abilities. The estimated forward FAD (Funds Available for Distribution) yield for the sector is 5.4%. We believe the global listed real estate market is currently fairly valued. For investors with a similar long-term time horizon, the sector appears fairly valued with more attractively priced opportunities for astute active managers to generate superior risk-adjusted returns.

 

Global developed market equity outlook – Pieter Fourie

2022 marked the worst year for global equities since the Financial Crisis in 2008 as both developed and emerging markets declined by 19.5% and 20.1% respectively in US dollars. Fortunately, market corrections improve future return expectations due to lower valuations.

In our view, the most valuable lessons from 2022 for investors include:

• Positioning – avoid companies which clearly have unsustainable business models. We saw too many ‘story stocks’ unravel violently this year – their share prices will likely never recover.
• Don’t overpay for any company, no matter how good the business. The share price of a great business will eventually recover, but if you overpaid, this may take a decade or more.
• In a tough macro environment, secular growth industries are favoured – we were able to buy companies after violent corrections improved the margin of safety.
• Be prepared for an overreaction when bubbles burst. Overreactions are not just to the downside. For example, we were able to sell good businesses at high valuations as markets panicked into safer companies.

High inflation and rising bond yields were responsible for the 2022 equity bear market, however in our opinion, both factors may reverse in 2023. While equity bears argue that leading economic indicators point to rising odds of the U.S. and European economies heading into recession, we believe that there are some mitigating factors which may help the global economy including: a weakening dollar; falling inflation expectations and interest rates peaking by the second quarter of 2023.

Within the U.S. in 2022 there was a rush to stable, predictable businesses with mostly dollar earnings like healthcare insurance businesses such as Elevance for example. We have sold such names and our attention is now on faster growing U.S. based companies.

At the beginning of 2022 multinational growth stocks were under pressure due to their expensive valuations: a strong dollar leading to negative earnings revisions and the lasting impact of travel restrictions on revenue acceleration and staff shortages impacted these companies. A weakening dollar, fewer travel restrictions and valuation multiples back to relatively attractive levels means we are positive on companies like Edwards Lifesciences, Thermo Fisher and Visa. As valuation levels stabilise we also believe new positions like Intuit and London Stock Exchange Group should demonstrate the benefits of being in predictable industries with strong recurring revenues.

 

Global emerging market equity outlook – Feroz Basa

2022 marked the worst year for global equities since the Financial Crisis in 2008 as both developed and emerging markets declined by 19.5% and 20.1% respectively in US dollars. Global stocks and bonds lost more than $30 trillion in what was one of the most eventful years on record for negative news flow. Russia’s invasion of Ukraine and China’s stubborn zero COVID policy led to severe supply chain disruptions and higher global inflation, cascading into higher borrowing costs as central banks around the world increased interest rates to tame rampant inflation. Global investors had become accustomed to low interest rates which drove both equity and bond returns post the COVID-19 pandemic, but higher interest rates in 2022 reduced the appeal to hold equities as investors received higher returns on low risk investments and cash. As we head into 2023, we remain optimistic on emerging market equities as the selloff in 2022 has provided further margin of safety.

The divergence in performance between developed markets relative to emerging markets, particularly the US for the last decade has created a significant opportunity for long term investors. As we always stress, markets move in cycles and in the long term, the starting valuation matters. Emerging markets trade on decade low multiples relative to their developed market counterparts and have better growth potential in the long term. A recent bottom-up analysis of our portfolio highlighted a staggering 74% upside in local currency, a number we find extremely attractive post the sell-off in 2022. This upside combined with undervalued emerging market currencies, make us positive on global emerging markets as an attractive asset class for long term investors.

 

Global developed market bonds – Peter Doherty

2023 offers an attractive entry point for selective parts of the global credit markets. We expect total returns from investment grade bonds to be robust (i.e. c. 5% in US dollars) and selective areas such as hybrid capital to return c.7 % in US dollars.

Credit market returns were abysmal in 2022. The Bloomberg Global Aggregate Index returning -16.25% for the year, with the rate moves being the largest factor. 2023 yield starting levels provide room for error from credit spreads widening in a recession. We expect a higher frequency of defaults and idiosyncratic risks in corporate bonds and leveraged finance. Against this backdrop, it is prudent to avoid weaker higher yielding credits.

By way of example, Allianz Trade, the global leader in trade credit insurance  and a recognized specialist in the areas of surety, debt collection, fraud insurance, structured trade credit and political risk anticipates a 36% increase in insolvencies in Italy in 2023, followed by France (29%), Germany (17%) and the UK (10%). In China, the company expects 15% more insolvencies on the back of lower growth and a limited impact from monetary and fiscal easing. In the US, the company anticipates an increase of 38% on the back of tighter monetary and financial conditions. They give three main reasons for the expected increase in insolvencies:

• The major profitability shock due to the energy crisis for European firms;
• The interest rate shock and higher wage bill due to a sharp increase in inflation, and;
• Only limited intervention expected from governments.

Amid a challenging macro environment, corporate fundamentals will be challenged by slowing growth globally, with a recession in the developed economies. This will create a tough operating environment for corporates. In this environment our focus is on:

• Remaining invested in high quality, investment grade companies which can sell assets, reduce headcount, and raise equity long before asking bondholders to share losses
• Pick up additional yield by investing down the capital structure into bank and insurance hybrid capital securities.

Developed market bank and insurance company balance sheets will come under some pressure as asset quality and values deteriorate but current excess capital and robust risk management offer a substantial cushion. With insolvencies set to increase this year in a potential recession, developed market banks are likely to experience an increase in impairments. Higher impairments should be broadly manageable for most banks, provided the unemployment rate does not spike up dramatically. This is because banks have decent starting capital positions, strong asset quality metrics and some existing impairment overlays put in place for the COVID pandemic.

 

Private markets outlook – Mervyn Shanmugam

Mervyn Shanmugam, the CEO of our Alternatives business answers some pertinent on the outlook for 2023 with a focus on private markets.

1. What is your view of the outlook for your part of the business in 2023?
   We believe the uncertainty will continue to support the volatility of listed markets. Our private market business should however continue to produce attractive and stable returns while still making an impact. We are particularly focused on providing access to capital to SMEs to support their continued growth and resilience to challenges such as load shedding. This will impact their ability to sustain and create jobs. We estimate a R2.7 trillion opportunity to support the development of social infrastructure in South Africa in sectors such as affordable housing, healthcare and education. To this end we intend to launch a fund that will aim to mobilise much needed capital to support the missing middle of our population.
2. What macro and micro factors do you feel are most likely to have an impact on your investments?
   From a macro perspective, inflation, interest rates and the dollar are key factors to watch. A weak dollar should be positive for emerging markets where we primarily invest. Most commentators are expecting inflation to taper by the end of 2023, which should be net positive for most asset classes. Emerging markets have typically dealt well with higher inflation over time, but the jury is out for developed markets. If inflation at elevated levels persists in developed markets, central banks will have to hike rates. This will have a negative impact on their asset prices. Private markets have historically produced good vintages when launched in recessionary years.
3. What asset classes do you expect to perform best in 2023 and why?
   Historically banks have performed well during high interest rate cycles such as we are experiencing now due to their lending books. Private debt strategies, which provide direct loan financing to companies, should therefore theoretically do well. The lack of growth in SA, high interest rates and load shedding should see large companies go into their shells again as we saw during the pandemic. Small and mid-sized companies will also be deeply impacted but can thrive should they receive significant support in these difficult times. So, we expect private debt in this segment of the market to be attractive from a return perspective.A major driver of valuations in private equity is the interest rate cycle. Investing in private companies during high inflation and interest rate cycles provides investors with attractive entry points. These investments are usually held for between 5 and 7 years. If the world is in a better place by then, with lower inflation and interest rates, it should provide an additional kicker to the growth in the underlying investments. South African equities are trading at attractive levels and private equity usually trades at a discount to listed equities.Also as discussed above a weaker dollar is usually positive for African and other emerging market equities.
4. Can you comment on market volatility and how it is playing out, considering the market downturn in 2022? Any key things investors should be looking out for?
   The listed equity market both globally and locally experienced heightened volatility in 2022. The VIX, a measure of this, certainly reflects the uncertainty we are facing. So, if you were a trader, you would have loved last year if your calls and timing are correct. In our private markets business, we invest for clients with a long-term horizon, so we don’t trade, and volatility is less of an issue. A great example is if you look at our unlisted property business against the SAPY over the last decade. The volatility of the unlisted property is minuscule compared to the listed market. The returns we’ve seen in the unlisted market, particularly in 2022 have been quite attractive. With private markets already having proved to be less volatile than listed markets over time, the increased diversity of the sector will provide investors with further options for attractive and resilient long-term investments (e.g. socially-supportive properties such as housing and student accommodation).
5. What should investors be thinking about in terms of their investment strategies this year?
   If you’re a long-term investor who is continually adding to the pot, we think that you should continue investing. We favour businesses that are cash generative and that can pass on inflation to their customers. Although African and other emerging markets should benefit, I would be careful about which markets and asset classes to invest in – I would go with teams that have deep understanding of these markets and with long track records. Lastly investing for us never makes sense if it is for financial return only. We aim to generate intentional positive social outcomes to impact job creation, climate change and reduce inequalities in the economies we participate in.