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Investor playbook: a tale of two very different halves could have a happy ending
Published in the Financial Post on December 27th, 2022 – by Joel Clark, CEO of KJ Harrison Investors
The headwinds of the first half of next year could well set the stage for phenomenal returns in the second half.
Let’s not whitewash how bad 2022 was for markets. To the end of November, the S&P 500 was down almost 15 per cent; and the S&P/TSX composite, whose commodity heaviness insulated it from some of the downdraft that swept other markets, declined by more than five per cent. Bonds, meanwhile, abdicated their traditional role as equity hedges and got hammered, too.
This is what happens when the cost of money goes up: the value of assets across the board — from stocks and bonds to real estate and cryptocurrencies — goes down. For beaten-up investors, there was nowhere to hide, and they are no doubt looking forward to turning the page on 2022.
And so in 2023 they can move on to Chapter 2: Global Recession.
It is almost certainly coming, given the unprecedented monetary tightening by global central banks in their war on inflation. In the first half of 2023, the debate will be less about whether there will be a recession and more about how bad it will be.
But lest investors despair that 2023 will simply push them out of the frying pan and into the fire, take heart, because the headwinds of the first half of next year could well set the stage for phenomenal returns in the second half.
Before we get there, let’s consider why we see a recession in the next couple of quarters as well-nigh inevitable. Central banks — most importantly, the United States Federal Reserve — have been raising interest rates at the fastest pace in history and drying up liquidity through quantitative tightening at the same time. Their goal is transparent: combat inflation by destroying demand. And it’s working: inflation is showing signs of rolling over.
The cost of approaching this so-called victory, however, is transparent as well. Despite hopes that the Fed might engineer a soft landing and avoid tipping the economy into recession, history is not on the side of optimism.
Since the 1960s, the U.S. central bank has managed to avoid recession in only four of 12 tightening cycles; in none of those cases was it raising rates from zero, and it cushioned a slowdown in all of them by lowering rates — something Fed officials have suggested they have no intention of doing anytime soon.
Bond markets are certainly signalling a sharp downturn. The yield curve is now more inverted than it has been at any time in history. A curve inversion has preceded the last 10 recessions.
So, what will the next recession (assuming it occurs) look like and, perhaps more importantly, where will it lead?
Over the next three quarters, we expect data will show the economy slowing materially, along with corporate earnings growth. There will be job losses, perhaps massive ones, and we would anticipate issues arising in bond markets over credit quality (that is, more defaults).
We will likely see some sort of financial “accident,” the downfall of a major financial institution, perhaps, or a liquidity crunch in secondary markets. No one knows where they might surface, but an ebb tide will reveal shipwrecks.
And then, we believe, Fed officials will recognize they have gone too far in tightening monetary conditions. Just as in every previous recession, they will be forced to reverse course and lower rates. That is the moment to which investors must look forward to in 2023.
Geopolitical forces — the war in Ukraine, rising tensions between the West and China, or some other unforeseen globally significant event — are the wildcard in all of this, of course. But if the next recession’s dynamics play out as we expect, they imply a very investable bottom in the first half of 2023, setting the stage for outsized equity returns in the following months and years.
Where will the opportunities be? We are paying particularly close attention to physical and hard assets and their stock-market iterations. That’s in part because the U.S. dollar should decline as the Fed changes tack. Commodities and precious metals should benefit — perhaps to a spectacular degree — from the pricing effect, as well as from an economic turnaround.
It’s important to also note that the global economy has already felt the impact of years of underinvestment in energy and commodities in the form of inflation, but it will take more years (not months) to ramp up production enough to meet resurgent demand. That should allow producers to maintain healthy margins for some time to come.
Meanwhile, there could be further opportunities in infrastructure, as companies and governments increasingly look to build domestic facilities as they onshore industries — part of a secular deglobalization trend. A lower cost of capital would provide a further tailwind.
In short, we see 2023 playing out as a tale of two halves: a first-half recession followed by a second-half reversal of the rate environment and an eventual economic rebound. Because markets tend to see through recessions, however, equities should begin their recovery before the economy does, which implies that the time to look for opportunities is now.
If the year plays out as we expect, those opportunities give battle-weary investors cause to turn their collective frown upside-down in 2023.
Joel Clark, CFA, is chief executive and portfolio manager at KJ Harrison Investors.