Global equities closed a weak year with a very strong quarter. The large cap MSCI World ex USA Index advanced 16.2%, its best quarter since 2009. The MSCI World ex USA Small Cap Index also gained 15.2%, but did not set any multi-decade records. For the full year the markets were still down, although well off the lows earlier in the year, with large cap falling -14.3% and small cap down -20.6%. Similarly, the US Dollar Index declined -7.7% in the quarter, but still finished the year up 8.2%.
Looking across both regions and sectors, the theme for the quarter appeared to be ‘relief rally’ as all the concerns earlier in the year turned out to be not quite as bad as feared. The MSCI World ex USA Small Cap Index saw double-digit returns in all major regions, but Europe was the strongest. Clearly the worst-case scenarios of energy shortages and a hollowing out of the industrial base have not yet come to pass and the markets adjusted accordingly. All sectors were higher with the worst, Real Estate, ‘only’ up 9.0%. The Financials sector, up 22.1%, was best as it rallied off the bottom on higher interest rates and still muted credit concerns. Consumer Discretionary and Industrials were also very strong, likely for similar, relief-rally reasons. For the full year, however, Energy remained the only sector higher, with significant weakness in prior Covid beneficiaries — Health Care, Communication Services, and Information Technology.
We fully grasp the futility of forecasting macro events so what follows is not a forecast. Rather, we’ll lay out some important events from the fourth quarter of 2022 and how we think they will likely impact the market in 2023.
This quarter the Bank of Japan (BOJ) expanded the interest-rate band around which the 10-year Japanese Government Bond (JGB) trades. The BOJ would strongly argue that this was not an interest-rate hike, but the market sees it for what it is: the start of the long-awaited Japanese rate hikes. In financial markets, danger does not lurk in volatility, but instead within instruments that should be volatile, yet are not. Years of Yield Curve Control by the BOJ will probably come to an end in the spring of 2023 and the market will finally learn the correct price for JGBs. We expect, given that JGBs have been a premier funding currency for global carry trades, that something in the global financial system will break, but it will likely be something different than most expect (i.e. outside of Japan). In fact, as we have previously discussed, we believe there is a strong bull case for Japanese equities if, and when, Japanese interest rates finally move higher.
China finally ended their ridiculous zero-Covid policy and they did it by replacing it with “zero” Covid policies. All at once they ended testing, surveillance, travel restrictions, and quarantines. In addition, the government has decided to take a dramatic about-face and reverse many of their recent nonsensical policies: new video games are being approved, the tech crackdown is loosening, real estate support is coming from the central government, and they are even showing signs of trying to improve their tattered reputation with the West. Many issues remain that we believe are not easily fixed. However, after a period of intense Covid spread, the Chinese economy should see a sharp rebound just as North America and Europe are entering recession. This global divergence in economic cycles should be a tailwind to active equity performance.
North America and Europe have avoided the worst-case fears from earlier this year. However, higher costs, especially labor, and higher rates, which may last longer than the market currently expects, will put pressure on historically high margins. Some type of consumer-spending led recession remains likely, even if highly forecast. Somewhat offsetting these concerns, equity investors should see a tailwind from FX, China reopening benefits, and easing of supply-chain constraints.
On balance we are bullish on our global equity strategies in 2023. Many long-term problems remain, which are far from fixed, but we also believe there are some amazing developments in technology and opportunities for growth. Our focus for the next year remains constant: finding companies which can help address the former, and take advantage of the latter, while maintaining a diversified, active, and differentiated portfolio.