Risky assets continue to react to the central bank action with expectations that interest rates will remain higher for longer. Developed market equities valuations are challenged as earnings growth in 2023 as higher borrowing costs compress margins despite sales growth or share buybacks. Higher valuations, particularly for US equities will continue being under pressure as the relative attractiveness of risky equity assets are challenged by higher yields offered on the fixed income asset class. Although European equites are better placed in terms of entry valuation levels, they would still face challenges due to the macro environment.
Emerging market equities should benefit relative to developed markets as they start from a lower valuation and earnings standpoint. Although they are not immune to the overall macro challenges. We can expect the macro environment in 2023 to worsen in the first half with economic activity recovering from recession and inflation lowering in the second half of the year. Emerging market equities would also benefit from the weakening of the US dollar.
Commodities, FX and Bonds
Bank of Japan announced on Tuesday that it will allow 10 year yields to trade as high as 0.5%. In the past, Japan has implemented a dovish stance on monetary policy, Historically, the rate was maintained at 0% and quantitative easing was followed on a large scale. Recently, BoJ switched its strategy from targeting a quantity of bonds to buy (QE) to a more qualitative measure –the Yield Curve Control(YCC). This YCC band was increased by Kuroda to allow movement between -0.5% and 0.5% and inflation is expected to stabilize around 2% in 2023. This paves the way for a future shift in policy with fixed income investors now pricing in 35 bps of hikes in the future. As one of the world’s largest capital exporters (Japan has accumulated more than USD 1 trillion in USTs). the possibility of earning higher yields domestically would have a negative impact on foreign fixed income assets and we can expect the Yen to strengthen further.
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