Insights
Transitional year for energy markets
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January 05, 2023
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Transitional year for energy markets
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January 05, 2023
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Transitional year for energy markets
Transitional year for energy markets |
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Following a two-month rally, in December equities across the globe sold off. The S&P 500 Index returned -5.8%1, whilst the MSCI Europe and MSCI Japan returned -3.5%1 and -5.2%1 respectively, in local currency terms. Although the MSCI Emerging Markets (USD) fell 1.4%, a notable exception was the MSCI China (USD) index, up 4.8%1 due to the accelerated reopening of China’s economy with limited setbacks so far. Despite U.S. inflation falling,2 the year-end market slump can be attributed to the hawkish tone of the December Federal Reserve meeting. The Fed is worried about inflation not only falling enough but remaining anchored near target levels by 2024. Recessionary concerns, the abrupt rise in government bond yields and reduced liquidity in the second half of the month likely contributed to the decline in markets in December. The U.S. 10-Year yield moved up, ending the month at 3.8%3. The VIX index remained range bound, reaching 21.7 by month end3.
Energy markets in transition in 2023
We expect a transitional year for energy markets in 2023, with higher oil and gas prices leading to some market rebalancing after disruptions last year. However, sanctions on Russia are likely to result in tight supplies globally and remain a key inflation challenge. Recessionary headwinds are likely to dent oil demand in 2023, but we expect sanctions on Russia, and gas-to-oil switching, to be offsetting factors that could sustain relatively high prices. OPEC’s announcement[1] of a production cut in an already tight market, underscores the necessity to keep prices higher, to incentivise the investments in supply needed to rebalance the market. A fall in prices now could disincentivise investment and spell higher prices when demand recovers. Essentially, whether central banks can push inflation down and successfully anchor it is likely to be one of the most important determinants of assets’ performance in 2023 and energy dynamics are clearly key to the inflation story.
Investment implications
We remain cautious with respect to U.S. equities, due to the concern that earnings are still likely to fall in the first half of 2023, but we are more optimistic on global equities ex-U.S. However, the recent market retracement after the hawkish Federal Reserve and European Central Bank (ECB) announcements, and the light macro event calendar before year end, provided a window for us to tactically increase risk from defensive levels. Furthermore, investor positioning should provide support to the market, especially if economic and corporate data surprise to the upside. We believe it is prudent to separate our Chinese equities exposure from other Emerging Markets, hence we made the following tactical changes in December:
U.S. and Eurozone Equities
We moved from underweight to neutral Eurozone equities and added to the U.S. equity underweight. Eurozone equities are still trading at a substantial discount to the S&P 500.
Japanese Equities
We moved from overweight to neutral Japanese equities. Often viewed as a safe haven, Japanese equities seem to be moving past their peak and may no longer outperform. However, we are moving overweight Japanese yen relative to the U.S. dollar as there are some biases for further upside.
Emerging Markets ex China equities
We moved from neutral to overweight Emerging Markets ex China equities, as peak inflation in the U.S. and EM suggests that central banks are near the end of their tightening cycles. Markets expecting cuts in EM rates by the second half of 2023 coupled with peak Fed hawkishness, also suggest that the U.S. dollar peak might be approaching, which has positive FX transmission for EM balance of payments. China's reopening could potentially be another positive catalyst that could have a positive impact on its Asian trading partners.
MSCI China equities
In December, we moved overweight MSCI China equities as near-term reopening could boost consumption and support growth in China, earlier than previously anticipated, given a softening of China’s zero-covid stance and reprioritisation of economic growth.
U.S. Health Care equities
We initiated an overweight to U.S. Health Care equities in a bid to lower our exposure to U.S. equity beta. We see continued downside to overall U.S. equities and together with its defensive characteristics, Health Care possesses structural, higher-quality growth characteristics over other defensive sectors such as Consumer Staples and Utilities.
Duration
We shortened U.S. duration as we are concerned that at current levels, the market is underestimating the impact of the resilient labour market, with strong wage growth and potentially misinterpreting the seemingly dovish tone of the Fed from the November FOMC meeting. At the time of our reduction in duration, the market was discounting 2-3 25bps rate cuts towards the end of 2023 and another 100bps worth of cuts in 2024. While this is certainly a plausible outcome, we believe it is premature to price this with certainty given persistent, core inflationary pressures and little visibility on the level at which inflation will ultimately settle over 2023.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.
We have provided our tactical views below:
We have provided our tactical views below:
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Managing Director
Global Balanced Risk Control Team
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