Where will financial markets take investors in 2023?

Cape Town - Will 2023 be more kind to investors than 2022? That’s the question on everyone’s minds. Developed economies are widely expected to enter economic recessions in 2023 because of elevated interest rates, which have been raised to combat higher inflation. Higher interest rates act to dampen demand for goods and services in economies. Europe is likely to bear the brunt.

Even though recessions are looming, central banks are expected to continue hiking interest rates in early 2023, because they believe high inflation is a bigger problem for economies than recessions. The base case view is that the US Federal Reserve Board (the Fed) will implement two hikes of 0.25% each before pausing to maintain interest rates for the duration of 2023.

Alan Wood, Head of Investment Consulting at Simeka says, “Global inflation is expected to come down in 2023, but perhaps not as quickly or by as much as anticipated initially. The current inflation experience was fuelled by central banks around the world lowering interest rates to unsustainable levels in 2020 and 2021 and holding rates low for too long.” Supply constraints in the labour market as well as the goods market have added to the inflation problem. Going forward, the average inflation rate may well be much higher than the inflation average experienced over the last two decades.

South Africa’s inflation is expected to fall sharply in 2023. Recently, inflation was driven by higher fuel prices and higher food prices. The price of fuel has already come down because of the lower oil price and the improved rand/US dollar exchange rate. Likewise, food inflation – to some extent driven by higher fuel prices – should follow suit. As fuel inflation recedes, so lower food inflation should follow in South Africa.

Financial markets are forward-looking and discount expectations of future developments. The elevated interest rates and probability of economic recessions contributed to the headwinds experienced in financial markets in 2022. The consensus view is that inflation will edge down in 2023 and that further interest rate increases beyond the initial increases in the first half of 2023 are unlikely. “Assuming that inflation becomes less of a concern, financial market participants will likely see interest rate reductions in 2024 (some even expect the first interest rate cut late in 2023). Looking forward and discounting expectations of future developments, 2023 could likely see pleasing investment results, as long as inflation behaves itself.”, says Wood.

After experiencing recessions in 2023, developed economies are expected to recover by 2024. The central question is how much of the anticipated damage to earnings has been priced in. Investors are looking for the opportunity to expand their equity exposure. If recession-driven damage to corporate earnings has been discounted sufficiently, developed equity markets currently provide investors with good entry levels. If not priced in sufficiently, it means developed financial markets could continue to provide modest outcomes. The currently good long-term entry point to invest in developed market equities may become even more favourable if earnings are more severely impacted by the recession.

Investment returns of selected MSCI indices for 2022 in USD

After declining by approximately 20% during the year, local share prices recovered well to close the year down only 0.9% (but up 3.6% when dividends are included), and investors believe these shares are attractively priced. SA share prices are sensitive to developments in China, particularly Naspers, because of its exposure the Chinese internet company Tencent and commodity producers that could benefit as China lifts lockdown restrictions. It is equally possible to foresee conditions for SA shares to achieve a return of either 20% or 5% for 2023, so any return expectations are to be approached with the necessary caution, especially because we have seen a fantastic bounce in share prices in January 2023. Foreign investors view SA shares with caution and seem to prefer emerging market shares from other countries.

Domestic listed property is expected to provide investors with a reasonable yield in 2023. It would require a brave heart to project a repeat of the record levels of 2017, but a double-digit return driven by income yield certainly seems possible. Such an advance would restore the listed property yield to pre-Covid levels.

As inflation recedes and central banks are likely to pause interest rate hikes towards the second half of 2023, global bonds should offer attractive opportunities. Globally, high quality credit bonds are preferred over government bonds (a risk-seeking approach). Emerging market bonds (including SA bonds) are also particularly attractive.

One of the central themes that dominated financial markets in 2022 was US dollar strength. The rand was volatile and traded at R18.40/ US$ one month later. Subsequently, the US dollar has weakened. The rand initially strengthened into 2023, but then receded from the beginning of February 2023, because there is renewed concern that inflation in the US may be more sticky than was expected and load shedding has drawn the attention if the rating agencies. The outlook for the rand in 2023 is very uncertain. The risk of South Africa scoring “own goals” is always high. This dampens enthusiasm for the rand but at levels in excess of R18.40, the rand feels oversold, so we should see some strengthening in 2023. A stronger rand could impede the contribution made to investment returns by offshore exposure.

Finally, investors should consider geopolitical risks. “One of the lessons learnt in 2022 is that despite the American hegemony, armed conflict overturning expectations of global financial markets remains possible. In addition to armed conflict, other geopolitical disruptions may occur, such as enhanced technology rivalry, an energy crunch, or dire consequences from the global climate change crisis.” concludes Wood.