As we head towards the end of the year, a new report from Scotiabank is highlighting key investment themes for 2023.
In a report to investors on Monday, a team of Scotiabank strategists predicted limited gains from current levels in equity markets during the new year. However, the strategists said longer-term opportunities are likely to emerge in the first half of the year and may provide an appealing entry point for investors.
“Investors’ mindset should thus transition from seeing the glass as half-empty to seeing it as half-full, as we will eventually look through the EPS [earnings per share] valley,” the report said.
Some of the key themes identified in the report included shifting concerns from inflation to recession, another prospective turn in monetary policy and potential indications of an ideal equity market entry point.
INFLATION TO RECESSION
Inflation is projected to ease in 2023; however, the report said this will likely be replaced by recessionary concerns.
“All leading indicators we track…continue to point, at best, toward a period of economic stagnation, but more likely toward a phase of contraction,” the report said.
Inflation may remain above the targets set by central banks in the new year, but it should come down from peak levels due to stabilizing supply chains and a decline in commodity prices, the report said.
It also said the costs associated with moving goods by truck and ship have “dropped abruptly,” and commodity costs are now below peak levels.
Additionally, the report noted that all U.S. recessions, since 1970, have seen receding inflation figures.
MONETARY POLICY PIVOT
Monetary policy conducted by the U.S. Federal Reserve could take another sharp turn, the report said. The Fed’s interest rate is expected to hit five per cent early in 2023 before it adopts a “wait-and-see approach.”
The Fed and other central banks around the world conducted a significant tightening campaign in 2022, the report said, in a series of moves that drove up the cost of credit and resulted in banks restricting its availability.
“Hence, what could start as a pause in the tightening phase is likely to morph into easing in late 2023 as macro data deteriorate further,” the report said.
Previous transition phases between monetary tightening and easing have been “rapid,” the report said. Dating back to the 1960s, the strategists estimated it can take around five months on average for the Fed to pivot on its monetary policy approach.
“An easing cycle starting late next year appears very likely if macro data keep worsening,” the strategist said.
ENTRY POINT
The current bounce in equity markets is unlikely to last, according to the report, which suggested investors “resist FOMO (fear of missing out) once again.”
Despite the pessimism held by the strategists on current market gains, a few things might signal an appropriate entry point for investors into equity markets.
Firstly, the report identified a pause in rate hikes from the Fed as something that will need to be seen for an entry point to emerge, not simply a slowing of the pace of rate increases.
Secondly, the strategists said a “reset” in earnings expectations would need to take place.
“Bottom-up EPS [earnings per share] forecasts are still calling for TSX and S&P 500 earnings to expand next year (about four per cent in both markets), which is unlikely to happen,” the report said.
Next, a bottoming in leading economic indicators like the yield curve would need to happen, according to the report, which notes the majority of previous market bottoms occurred after the yield curve inversion was finished.
A yield curve inversion occurs when short-term bonds have higher yields than longer-term bonds, which is the opposite of the typical pattern and is a potential signal for an upcoming recession.
Lastly, the strategists identified that signs of capitulation will be need to be seen before an entry point can be identified.
“Investor sentiment surveys are accordingly depressed, but equity allocation remains too high and cash allocation too low to call a bottom,” the report said.
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