2022 Review and 2023 Investment Outlook

2022 Review and 2023 Investment Outlook

What happened in 2022?

The COVID-19 pandemic finally started to become endemic in 2022, though it continued to cause issues in China. Despite this, the past year has been challenging for investors due to various factors. Inflation rose significantly in 2021 and continued to increase, largely due to pandemic-related supply chain disruptions and an increase in demand due to stimulus measures. Additionally, flooding in Australia contributed to the rise in prices. The invasion of Ukraine by Russia led to increases in energy and food prices.

To address these issues and rising inflation expectations, central banks implemented aggressive measures such as withdrawing monetary stimulus and raising interest rates at a rapid pace. This caused bond yields to rise in response. China’s economic growth slowed considerably, partly due to its zero-Covid policy and ongoing issues in the property market despite policy efforts. Geopolitical tensions also increased with the conflict in Ukraine and concerns about China potentially invading Taiwan after President Xi Jinping consolidated his power. These events caused investors to worry about the possibility of a recession. Tech stocks and cryptocurrencies, which had previously benefited from the lockdowns and easy monetary conditions, were negatively impacted by the reopening of the economy and tightening monetary policy, ultimately failing to provide protection against inflation.

Growth weaker than expected

While there were various challenges faced in the past year, global GDP is still predicted to have reached around 3.2%, which is weaker than the approximately 5% growth anticipated a year prior and lower than the 6% seen in 2021. However, this is still considered to be a reasonable outcome due to the impact of reopening and stimulus measures. Similarly, Australia’s GDP is expected to have been around 3.5%, lower than originally expected and a decrease from the 4.8% seen in 2021, but still considered to be reasonable. The slower growth resulted in a decline in profits. The main issue for investment markets was the increase in inflation, interest rates, and bond yields.

Investment returns for major asset classes

Total return %, pre fees and tax 2021 actual 2022* actual 2023 forecast
Global shares (in Aust dollars) 29.6 -7.4 4.0
Global shares (in local currency) 24.3 -11.9 7.0
Asian shares (in local currency) -6.8 -18.0 10.0
Emerging mkt shares (local currency) -0.2 -13.8 10.0
Australian shares 17.2 2.2 10.0
Global bonds (hedged into $A) -1.5 -11.1 3.0
Australian bonds -2.9 -7.8 4.0
Global real estate investment trusts 30.9 -23.0 9.0
Aust real estate investment trusts 26.1 -17.1 9.0
Unlisted non-res property, estimate 12.3 11.5 4.0
Unlisted infrastructure, estimate 12.0 10.0 5.0
Aust residential property, estimate 23.0 -7.0 -7.0
Cash 0.0 1.0 3.1
Avg balanced super fund, ex fees & tax 14.3 -3.0 6.3

*Year to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP

In the past year, global shares experienced a significant decline of 23% in October due to concerns about inflation, interest rates, and the possibility of a recession. However, a rally later on helped to reduce the losses. Chinese shares experienced the most significant weakness, partially due to the zero Covid policy, followed by Asian shares due to their connection to China and sensitivity to economic cycles. US shares also underperformed due to the high tech industry’s exposure and the Federal Reserve’s aggressive tightening measures. Australian shares performed better, aided by strong commodity prices and the Reserve Bank of Australia’s less stringent approach.

Government bonds declined as yields rose due to high inflation and interest rate increases. Australian bonds had their worst year since either 1973 or the 1930s.

Real estate investment trusts also fell as bond yields increased. Unlisted property and infrastructure returns remained strong, being less affected by short-term changes in the share market and bond yields. Home prices decreased significantly due to poor affordability after a prior boom and the rise in mortgage rates, which reduced homebuyers’ ability to afford them.

Cash and bank term deposits saw improved returns, but they remained low. The value of the Australian dollar declined along with share markets due to growth concerns and the Federal Reserve’s relatively aggressive interest rate hikes in October, before partially recovering.

Balanced superannuation funds had negative returns due to poor returns in shares and bonds, following very strong returns in 2021.

Outlook for 2023 – lower inflation and lower growth

There are both negative and positive outlooks for the coming year. On the negative side, inflation is still very high at around 7% to 11% in many developed countries, tight labor markets increase the risk of wage-price spirals, central banks are warning of more interest rate hikes, the possibility of a recession is high due to inverted yield curves and weak confidence largely in response to rate hikes, the US government is divided again with the risk of debt ceiling and funding standoffs, the conflict in Ukraine continues, and tensions persist with China and Iran. Additionally, COVID-19 continues to cause disruptions, particularly in China as cases increase as the country reopens. These factors suggest that the coming year will be volatile and could potentially see the continuation of the bear market in global shares.

However, there are reasons for optimism as well. First, inflationary pressures may have peaked and are slowing quickly. Supply chain pressures have eased, demand is decreasing, and labor markets are showing signs of levelling off. In fact, a slight reduction in demand (which would push capacity utilisation back to normal levels and increase unemployment above the non-accelerating inflation rate of unemployment, with the return of immigration helping in Australia) could significantly lower inflationary pressure. This suggests that inflation could fall faster than central banks expect in 2023. Second, central banks are likely to reach a peak in interest rates soon. The Federal Reserve has already started to slow its rate hikes, and conditions are likely to be soft enough for it to pause around March, before potentially implementing rate cuts later in 2023. Meanwhile, the Reserve Bank of Australia is likely to be at or near its peak (with a base case of 3.1% and a risk case of 3.35%) by February or March, at which point conditions are likely to be weak enough for a pause, before potentially implementing rate cuts in late 2023 or early 2024.

Third, the risk of a recession in 2023 is widely discussed and seen as a likely outcome (with a probability of over 50% in the US and Europe), which is likely to keep markets volatile due to the threat to earnings. However, the recession may not be as severe as feared. In the US, it could be a mild recession or sharp slowdown in 2023 if the Federal Reserve starts easing up on the brake soon and given the lack of other excesses that need to be addressed (e.g., no overinvestment in housing and capital expenditure, and low leverage). Europe has rapidly diversified its energy sources away from Russia and may fare better than expected if the winter is mild. Additionally, there may be a lag in the way that interest rate hikes impact the economy, meaning that a recession may not occur until 2024, which means it is too early for share markets to fully account for this possibility. After initial COVID-related setbacks, Chinese growth is likely to rebound in 2023 as the country reopens. Similar to what happened in other countries upon reopening (such as Australia’s Omicron disruptions earlier in 2022), China is likely to see an initial increase in cases. However, markets are likely to largely look past this to the boost in growth from reopening, which will offset slower growth in the US and Europe. Australian growth is expected to slow but avoid a recession, due to the Reserve Bank of Australia’s less aggressive approach, the pipeline of homebuilding work yet to be completed, and the strong business investment outlook. Finally, geopolitical factors may not be as concerning in 2023, as there are no major elections in key countries, the conflict in Ukraine may not escalate further, and tensions between China and the US may ease.

Implications for investors

There are likely to be ups and downs in the coming year, particularly regarding the risk of a recession, which could result in a retest of the lows seen in 2022 or even new lows in shares before a rebound. However, easing inflation pressures, central banks moving to ease monetary policy, stronger economic growth than anticipated, and improved valuations should lead to better returns in 2023. Global shares are expected to return around 7%. Normally, US shares see above-average gains in the year following a mid-term election, but they are likely to remain relatively underperforming compared to non-US shares due to higher price-to-earnings ratios (17.5 times forward earnings in the US versus 12 times forward earnings for non-US shares).

The US dollar is also expected to weaken, which should benefit emerging and Asian shares. Australian shares are likely to outperform again due to stronger economic growth compared to other developed countries, ultimately supported by stronger growth in China and resulting in higher commodity prices, as well as investors continuing to favour the grossed-up dividend yield of around 5.5%. It is expected that the ASX 200 will end 2023 at around 7,600.

Bonds are likely to provide returns around the current yield or slightly more as inflation slows and central banks become less stringent.

Unlisted commercial property and infrastructure are expected to see slower returns due to the delayed impact of weaker share markets and higher bond yields on valuations. Australian home prices are likely to fall further as interest rate increases continue to impact, resulting in a decrease of 15-20% from peak to trough, but prices are expected to bottom out around the September quarter, before rising late in the year as the Reserve Bank of Australia moves toward cutting rates.

Cash and bank deposits are expected to provide returns of around 3% due to the increase in interest rates throughout 2022. The Australian dollar is expected to trend upwards over the next 12 months due to a downward trend in the currently overvalued US dollar, the Federal Reserve moving to cut rates, and solid commodity prices supported by stronger Chinese growth.

This article was originally produced by Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital. You can read the full article here.

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