Not out of the woods yet
A great deal of global risk still overhangs markets
A few short weeks ago, strategists and market observers published their annual outlooks. Almost universally, they were cautious by predicting that 2023 would be a tough year for investors. However, as January ended with one of the strongest monthly returns we have seen in years, the biggest question on everyone's mind is: What is fact, and what is fiction? Did everything really get that much better over the last few weeks, or was that simply a technical short-cover rally?
Where we stand today, it's too early to know for certain the answer to that question, but we do know that as the calendar flipped, the market’s tone dramatically shifted to the positive.
Of course, there have been some positive developments over the month. Warm weather in Europe pushed back fears around the continent of an energy crisis. And most important for global growth, China has moved on from its zero-Covid policy to open up and spur demand for goods. These developments were able to propel long-ignored international markets higher and may provide a welcome offset if North America does stumble into a recession later this year.
For American markets, most of the fears centred around earnings. We know that the bulk of the selloff we saw in 2022 was the result of a compression in valuations that moved in reverse to higher yields. As we entered this year, the debate was around whether companies could hold their margins and pass along higher prices to consumers. Well, so far, what we have seen in the fourth-quarter reports has been far from the disaster predicted. There will probably be some sort of earnings compression, but the early results are much better than feared.
Central banks will remain a key factor in how investors will view global markets. Over the last year, we have witnessed a dramatic increase in lending rates to fend off inflation, but recent data are giving us some optimism that we are nearing the end of this tightening cycle.
The Bank of Canada was one of the first central banks to tighten and also one of the most aggressive. During January, it signalled a plan to move to the sidelines and become more data-dependent. This is a welcome development for risk assets and one that many hope other central banks follow. The recent U.S. Federal Reserve’s Open Market Committee press conference was much more dovish than feared and has built in the expectation of rate cuts by the end of the year.
While altogether these events are positive, not many would have expected to be greeted with global markets rallying to the degree they did. Yet it may have come down to positioning as much as anything else. Given how negative returns were in 2022, many investors had gone into a defensive position. Cash levels were very high, and many funds were holding their exposure to risk assets below levels seen in prior periods.
With data beginning to turn, what we have seen is a massive “re-risking” of portfolios to attempt to keep up with the market. For January, most of the companies and sectors that were the worst performers last year were the best for the month. This has led many to call this a “junk rally,” but a short squeeze is more likely.
Markets tend to do what makes the most people wrong. So far, 2023 has been the complete opposite of last year. But this doesn’t mean that everything is in the clear. There remains a great deal of risk throughout the world, and chasing returns never seems to end well. In the short term, there is the possibility that we have now priced in all of the good news we’re going to get.
There is a very real chance we will be in a recession by the summer, and central banks will be talking about rate cuts – not because they have beaten inflation but because they need to save the economy. So in that situation, earnings will very much be at risk, and stocks will be potentially much lower.
The year is off to a great start, which is welcome to many who fought through the last 12 months. However, it’s not a time to get complacent, thinking we are out of the woods. The most likely scenario remains a year of higher volatility. The fact the market has started higher doesn’t mean there won’t be any setbacks. Times like this are a great time to look at active strategies that will adjust their positioning according to the macro environment and the conditions set in front of them.
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
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