Executive Summary

Economic Outlook

• The global economy started 2023 on an unexpectedly positive note. The US economy was on a strong footing, supported by a robust labor market and a reduced drag from high energy prices that peaked in mid-2022.
• Euro area growth held up better than anticipated over the winter, partly due to unseasonably warmer weather. Economic activity in China rebounded swiftly after the December 2022 relaxation of its extreme COVID lockdown policy.
• The failure of Silicon Valley Bank and two other US regional banks, along with the shotgun wedding of UBS and Credit Suisse arranged by the Swiss National Bank, has brought systemic worries to the front.
• While the bank crises appear limited in scope for now, the odds of recession have notably increased from before the banking sector turmoil. Tighter lending standards will further crimp economic growth even if the banking crisis does not spread.
• On the inflation front, there is evidence of weaker goods inflation dragging down headline inflation. But stickier prices, like core services excluding housing, are expected to prevent inflation from swiftly falling back to the US Federal Reserve's (Fed) 2% target.
• The Fed has the unenviable task of trying to engineer a further decline in inflation, still far above its 2% target, while simultaneously maintaining depositor confidence in a suddenly shaken banking system.
• A faster pace of hikes by the European Central Bank as it remains committed to its 2% medium-term inflation target, potentially sets the stage for disappointing growth in 2023 and more headwinds for the European banking segment.
• The Bank of Japan is in transition, with incoming Governor Kazuo Ueda expected to focus on policy continuity in the near term but eventually embark on policy changes, such as the end of yield curve control.
• China has the potential to post an upside growth surprise following the government's fast-tracked reopening. With China's inflation still low, and the "two sessions" meeting behind us, policymakers there have more of a free hand to boost the economic recovery.

Market Outlook

• Global markets were off to the races in January with broad-based gains across equities, sovereign bonds, and credit. Investor risk appetite was boosted by a decline in energy prices, particularly in Europe, and the surprisingly fast reopening in China.
• However, uncertainty around inflation and Fed policy led to a tug-of-war between risk-on and risk-off in markets, even before the banking sector blowups occurred in mid-March. Long-term bond yields fell precipitously as rising risk aversion gripped markets.
• US equity market valuations still do not fully price in possible downside scenarios, despite the visible recession signals like a deeply inverted yield curve and a tightening Fed.
• With an increased possibility of a tail-risk situation, we expect equity valuations to adjust to this new reality as historically high earnings and profit margins likely deteriorate in an environment of increased economic risk.
• Non-US equities have a relatively better risk-reward tradeoff. While Europe and Japan have more favorable starting points with forward PE ratios comfortably below historical median levels, these markets are also more cyclically oriented and sensitive to downside economic risks.
• China seems to be a bright spot. While China-based stocks have lagged so far this year, market valuations are attractive and the country's economic reopening is expected to pick up steam on the back of easing monetary policy and measures to support growth.
• Real estate remains a concern, especially within the commercial sector, which has to contend with expensive valuations and low occupancy rates. Banking sector stress could further tighten credit given the significant commercial real estate exposure in banks' loan books.
• As a cyclical asset, commodities will likely struggle in the face of a broad economic slowdown. While China's reopening is a positive, rising recession worries are contributing to near-term volatility. However, we remain positive on this space in the medium to long term.
• The team is defensively positioned across multi-asset portfolios: overweight in cash and bonds and underweight on risk assets.