What does the crystal ball say for 2023?

– 2022 will be remembered as the year of things that could be… but never was or did… 2022 could be just another year with decent returns for investors with most markets up and only a handful down…but it wasn’t. 2022 closed with a month that looked exactly like the rest of the year. It was just topsy-turvy. So what happened this year and what is in the cards next year?

– As of December 23^rd the real winner in equities for the year was the Turkish stocks, bringing the return on Istanbul 100 stock exchange to 194% in Turkish Lira (a whopping 109% in US dollar basis) year-to-date, making it by far the highest returning stock market globally in both local and US dollar terms. On the flipside investors who held US dollar against Turkish Lira also had a great 2022 with 40% return since the end of 2021. In fact, most of the developed and emerging market currencies slid against the US dollar in 2022.

– If history is any guide, the FTX saga will likely continue into 2023 and beyond with many shocking new details that will come to light similar to Enron and Madoff scandals. Despite the clout over digital currencies, the bloodshed in Bitcoin seemed to slow down although Ethereum continued its slide. As of December 23^rd Bitcoin was down by only -2% while Ethereum dropped even further by -6% since the beginning of the month. Bitcoin and Ethereum are now down -64% and -67% respectively year to date.

– Central banks battling supply chain inflation are all hiking their funding rates. However, they do not know how effective the rate hikes will be. Central banks are experimenting because this is a very different macroeconomic environment than anything we have seen in the past. Case in point, US is experiencing the highest inflation it has seen in the last 40 years which is accompanied by record low unemployment over the same period.

– The markets are not convinced that central banks will be able to battle inflation effectively. US stock markets have already incorporated FED’s most recent rate expectation of 5.1% vs. 4.75% they had mentioned at their November 2^nd meeting. However, considering FED’s and other central banks’ poor  track record of forecasting inflation, markets may be in for a big surprise in 2023. 

– In 2023 equities would likely continue their slide alongside the bonds. The US yield curve would likely remain somewhat inverted (that is the short term yields would be higher than long term yields) due to continued rate hikes by the FED and higher chance of recession hence stagflation on the long end of the curve. 

– That would likely mean corporate bond spreads over the government bonds may once again expand, with US dollar continuing to claim victory against other currencies in a risk off environment. This is because investors tend to prefer less risky investments like government bonds as opposed to higher risk investments like corporate bonds during higher rate and risk off environments.

– This would not bode well for crypto markets, but would likely lift gold prices up. Oil would likely go up due to a harsh winter. However, assuming OPEC doesn’t reduce production, US sticks to its plan to refill its Strategic Petroleum Reserves around $70 and in the absence other geopolitical risks, in the long run oil prices may stabilize between $70-80 range. 

– It is impossible to predict the future perfectly. However, looking at our crystal ball in light of the information above, most likely the end of this year will not be the end of the bumpy downward ride for the markets. It is highly probable that at least part of the above scenario will materialize in 2023 and that the decline in the markets will continue for at least a while.

2022 will be remembered as the year of things that could be… but never was or did….

Covid could be eradicated, but never was. Supply chain issues could go away, yet they but they never did. The conflict between Russia and Ukraine could just dissipate but never did. FTX could survive its liquidity crunch but it never did. Inflation could be transitory as expected, but wasn’t.

Equities and bonds could recover, but never did… same as the UK Prime Minister Liz Truss who could be “it”, but she wasn’t… and France could win the World Cup, but didn’t.

2022 could be just another year with decent returns for investors with most markets up and only a handful down…but it wasn’t.

So what happened this year and what is in the cards next year?

2022 closed with a month that looked exactly like the rest of the year. It was just topsy-turvy.

TURKISH STOCKS INDEX WAS THE BEST PERFORMER IN EQUITIES IN 2022

As of December 23^rd the real winner in equities for the year was the Turkish stocks, bringing the return on Istanbul 100 stock exchange to 194% in Turkish Lira (a whopping 109% in US dollar basis) year-to-date, making it by far the highest returning stock market globally in both local and US dollar terms. Russian stock exchange booked the largest year to date loss with -40% in local currency.

Source: Bloomberg

Note: Above list incudes only the countries open to foreign investors. Returns are calculated based on index closing prices in local currency between 31 December 2021 and 23 December 2022. In countries with more than one stock market index, those that are considered the benchmark have been utilized.

On the flipside investors who held US dollar against Turkish Lira also had a great 2022 with 40% return since the end of 2021. In fact, most of the developed and emerging market currencies slid against the US dollar in 2022. DXY index which is the value of US dollar against a weighted composite of Euro, Japanese Yen, British Pound, Canadian dollar, Swedish Krona and Swiss franc, continued to mark its victory in the battle of returns. Despite weakening since September, DXY delivered a respectable 9% on the year at the close of December 23^rd.

BOTH GLOBAL EQUITIES AND BONDS CLOSED THE YEAR WITH A LOSS

As of December 23^rd equities and bonds closed the year in the negative territory whereas main commodities managed to not lose much or deliver slightly positive returns. Global equity indicator MSCI All Country World Index (ACWI) was down -19.5% dragging ACWI back to the cusp of the bear market territory. The emerging market index MSCI EEM remained firmly in the bear market territory with a loss of -22.5% year-to-date. As a brief reminder to our readers, a bear market is generally defined as losses larger than 20% or more from recent highs.

On the bonds front, the returns were all in the red and clustered together over the same time frame. Both the Bloomberg Global Aggregate Bond Index and the Bloomberg Global High Yield Bond were down -10.6% year to date. The benchmark for global corporate bonds Bloomberg Global Corporate Bond Index had a bit bigger drop with -13.6% return year to date. Following some volatility, the first month futures contract for US crude oil WTI managed to return 5.5%  on the year while the first month futures contract for gold was slightly down with -1.2% as of December 23^rd.

FTX’S RIPPLE EFFECT CONTINUED TO WEIGH ON CRYPTO

The ripple effect of the spectacular blow up of the multi-billion crypto exchange FTX and its sister firm Alameda Research in November continued into December. As more information came to light as to how billions of dollars of FTX client and investor money was misappropriated and was used to fund Alameda research, FTX’s architect and ex-CEO Sam Bankman-Fried was arrested in Bahamas to be extradited to the US to face criminal charges there. If history is any guide, the FTX saga will likely continue into 2023 and beyond with many shocking new details that will come to light similar to Enron and Madoff scandals. Despite the clout over digital currencies, the bloodshed in Bitcoin seemed to slow down although Ethereum continued its slide. As of December 23^rd Bitcoin was down by only -2% while Ethereum dropped even further by -6% since the beginning of the month. Bitcoin and Ethereum are now down -64% and -67% respectively year to date. Just to put the erosion of wealth into perspective, Bitcoin and Ethereum investors would need to gain roughly +175% (that is 2.75 fold) and 200% (that is 3 fold) from here on to reach the close at the end of 2021. As we noted in our previous issue, such drawdowns underline the basic rules of investing – avoiding large losses is more important than locking in large gains.

MARKETS WHIPSAW TOWARDS THE END OF THE YEAR

In December equity markets couldn’t make up their mind whether they should go up or down, but eventually decided down was the way. This is not at all surprising. As we discussed in our previous issue, when markets move closer to the holidays at the end of the year, investors tend to take down their positions which reduces the liquidity. Consequently, markets get more sensitive to any buy or sell pressure and tend to whipsaw more towards the end of the year.

Yet there is more to the story than just liquidity. Earlier in December investors were quite excited at the prospect of lower than expected US inflation data. Indeed the US equity index SP500 had a nice 2% rally running up to December 13th when the data said annual core inflation had dropped to 6% vs. 6.3% in November and headline inflation had an even bigger drop from 7.7% in November to 7.1%.

That was great news. Yet, the markets did what they generally do. They bought the rumour and sold the news. They slammed on the brakes. Because markets figured inflation wasn’t going anywhere.

Indeed just a day later in its last interest rate decision of the year, US Central Bank FED delivered a 0.5% increase, its smallest rate hike since June, raising its funding rate to 4.25-4.5%. This initially gave market players some hope that the rate hikes were finally coming to an end. The Federal Reserve officials however were quick to underline their resolve to battle inflation.

IT CAN GET UGLIER IN THE MARKETS

If this were an isolated rate hike, perhaps the global equity markets would shrug it off and continue on their merry way up. However, around the same time some of the other heavy weight central banks, including Bank of England, European Central Bank, Bank of Canada and even Reserve Bank of Australia, all delivered rate hikes ranging between 0.25% and 0.5% signaling more hikes to come. It finally dawned on the markets neither inflation nor rate hikes were going anywhere. If anything, it could get uglier.

Why?

For a very simple reason. Monetary tools seem to  be falling short in fighting inflation. Central bankers know it too, and they are trying to figure things out as they go along. No need to look far back; just remember FED’s meeting last December. The average dot plot (see the white line in the chart below), which is the average of all the FED members’ forecast of interest rates over the next period, shows they expected to hike rates 3 times and move the FED funds rate from 0.25% to only 0.75% by the end of 2022 which is now.

But we are way past 0.75%. We are at 4.5%!

FED GOT IT ALL WRONG

That is not just a simple margin of error. They are off by a whopping 3.5% in just one year. Clearly, they are not good at forecasting the macroeconomic conditions. Also remember last year this time the FED said repeatedly inflation is “transitory”? They argued that with covid constraints lifting up and life going back to normal, demand would pick up a bit, but that would be just a “little” bump in the road, a temporary bottleneck that would clear itself out.. except it didn’t.

FED got it all wrong and they still don’t know how this will all play out. Interestingly, they admitted to it at their December meeting this year. In short, they declared they didn’t know how far they would need to go with the rate hikes. This is not isolated to the US either. Other central banks battling supply chain inflation are also on the same boat. They do not know how effective the rate hikes will be.

Central banks are experimenting because this is a very different macroeconomic environment than anything we have seen in the past. Case in point, US is experiencing the highest inflation it has seen in the last 40 years which is accompanied by record low unemployment over the same period… and there is a major risk of recession and even worse, stagflation, which is inflation coupled with low or negative economic growth (and high levels of unemployment).

This is what the FED and other central banks fear the most as stagflation is very difficult to get out of. In stagflation, raising the interest rates would of course lower the inflation, but raising them too fast or too much could damage the economic growth and lead to recession… and not raising them enough or fast enough could create runaway inflation, which would also damage the economy eventually leading to recession. As such, currently it is vital for central banks to kill inflation before the economy enters a recession. Therefore, FED has been deploying one of its most aggressive rate hikes since what was called the “Great Inflation” of 1970s, one of the highest inflation periods in the US history on the back of two massive oil shocks. Except back then not only inflation but unemployment also was high too, which is not the case today…  and inflation was triggered by an oil shock which is not the cause for today’s inflation.

The only period that provides somewhat of a similar comparison is after World War 2 when inflation picked up due to supply shortages and increased demand, but there were price controls back then which don’t exist today.

CENTRAL BANK RATE HIKES COULD LEAD TO MORE INFLATION

 In short, today is a very unique environment in itself and whatever monetary or fiscal policy worked before may or may not work today. However, we do know one thing for sure – this round inflation isn’t triggered only by demand or an unexpected price increase in one commodity like oil. Demand is part of the problem, but it is also a supply side issue. Therefore, it cannot be fully addressed by monetary policy alone. In fact, there is a possibility the rate hikes could make matters worse.

Increased rates will indeed stifle demand, that is true. That would naturally put some pressure on inflation. However, economists can’t agree as to how much it would also suffocate the already suffering supply chain. Higher rates mean higher cost of capital for corporations. This only increases the input costs and that translates into.. yes you guessed it right.. higher inflation!

Central bankers and monetarists also concede that monetary policy may not work great for a supply side inflation. However, they surmise that inflation should eventually cave in when rates are so high that there is absolutely no demand out there. This is like treating an advanced cancer patient with extreme levels of chemotherapy. The hope is relentless level of chemo will kill the cancer… assuming it doesn’t kill the patient first!

Monetary policy is not an exact science. It never was. That is why Keynesians and the monetarists keep quibbling over whose approach is better to battle inflation as they both have been effective at some point in time. However, they both agree that monetary policy is at best a rough tool to control inflation, particularly when it is triggered fully or partially by a supply side problem, which also require a fiscal solution which could be a combination of increased government support for companies and/or reducing their taxes and/or other means to help firms reduce their costs to reduce the price pressures that lead to inflation. Admittedly, policy is not as easy to implement and to unwind like monetary policy, but  with a disciplined implementation it would be addressing the real problem rather than its symptoms.

MARKETS MAY BE IN FOR A BIG SURPRISE IN 2023

For this very reason, the markets are not convinced that central banks will be able to battle inflation effectively. US stock markets have already incorporated FED’s most recent rate expectation of 5.1% vs. 4.75% they had mentioned at their November 2^nd meeting. However, considering FED’s and other central banks’ poor  track record of forecasting inflation, markets may be in for a big surprise in 2023.

If so, what would happen?

In that scenario equities would likely continue their slide alongside the bonds. The US yield curve would likely remain somewhat inverted (that is the short term yields would be higher than long term yields) due to continued rate hikes by the FED and higher chance of recession hence stagflation on the long end of the curve. That would likely mean corporate bond spreads over the government bonds may once again expand, with US dollar continuing to claim victory against other currencies in a risk off environment. This is because investors tend to prefer less risky investments like government bonds as opposed to higher risk investments like corporate bonds during higher rate and risk off environments.

This would not bode well for crypto markets, but would likely lift gold prices up. Oil would likely go up due to a harsh winter. However, assuming OPEC doesn’t reduce production, US sticks to its plan to refill its Strategic Petroleum Reserves around $70 and in the absence other geopolitical risks, in the long run oil prices may stabilize between $70-80 range.

2023 MAY BE A YEAR OF DECLINING MARKETS

Of course these are all potential outcomes, and it is impossible to predict the future perfectly. However, looking at our crystal ball in light of the information above, most likely the end of this year will not be the end of the bumpy downward ride for the markets. It is highly probable that at least part of the above scenario will materialize in 2023 and that the decline in the markets will continue for at least a while.

As we have noted before, this is the time to ensure your portfolio is diversified beyond just equities and bonds to protect against weaker markets and higher volatility. We would like to leave you with one of Warren Buffet’s famous and very spot-on sayings “it is only when the tide goes out you see who is swimming naked”. The tide has been going out.

Happy 2023!

Who is Ela Karahasanoglu?

Ela Karahasanoglu is the CEO of EKR Total Portfolio Advisory based in Toronto, Canada. EKR advises global institutional investors and asset managers on alternative investment and portfolio construction from a total portfolio perspective. Previously, Ela was the Head of Total Fund Management team at BCI, one of the largest asset managers in US and Canada with assets over $200 billion.

Ela has over 25 years of international investments and executive leadership experience. She has worked with global asset management, consulting and pension fund companies in London, New York and Toronto including UBS, Merrill Lynch, Mercer, CIBC Asset Management and BCI. Ela is a frequent speaker and a globally published investment thought leader in institutional asset management. Amongst the awards she has received includes the “Global Leading Innovator” in 2020 and “Hedge Fund Rising Star” in 2018 by The Institutional Investor, one of the leading publications in the institutional investment field.

Ela is a graduate of Uskudar American Academy in Turkey and has earned her MBA from Georgetown University in 2000. She has been a CFA Charterholder since 2002 and a CAIA Charterholder since 2010. Ela serves as the Co-Head for CAIA’s Toronto Chapter since 2018. She is married and lives in Toronto.

Happy 2023!

Ela Karahasanoğlu, MBA, CFA, CAIA

International Finance Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrtotalportfolioadvisory.com

https://www.linkedin.com/in/elakarahasanoglu/