• Macroeconomic risks have shifted from inflation to growth. In the US we see recession risks in late 2023, with rate cuts a story for 2024
• China’s domestic demand should help it achieve growth of 5.5% this year, while Japanese economic fundamentals look healthy. Peaking local rates have stabilised the outlook in emerging markets ex-China
• In terms of asset allocation, we lean towards quality fixed income, and see selective opportunities to earn carry in emerging market local currency debt
• In equities, we prefer quality stocks, defensive businesses, and non-US markets

With price pressures gradually easing across the developed world, macroeconomic risks have shifted from inflation to growth. Recession risks for late 2023/early 2024 remain high in the US, although we would expect any downturn to be mild and short-lived. We do not expect developed market central banks to cut rates in 2023.

Overall, we maintain a neutral exposure to risk, and equities, within portfolios and a defensive tilt within asset classes. So far this year, still-strong consumption and fairly resilient corporate results have wrong-footed a generally cautious positioning among the investment community. This could endure for longer. Alternatively, equity market resilience could be put to the test in a downturn. Given the broad range of outcomes, we want to avoid narrowly pre-positioning portfolios for either a ‘soft landing’ or a pronounced recession.

Within equities, we retain a preference for quality stocks and defensive businesses. We favour markets outside the US, including China, where we expect double-digit growth in corporate earnings in 2023, with scope for margins to rebound. While our core scenario does not expect Chinese stocks to re-rate, valuations remain attractive. Meanwhile, regulatory forces should prove less of a headwind this year, and further monetary policy easing may be on the cards.

We maintain an overweight allocation to fixed income for diversification and capital preservation purposes. We prefer high quality government bonds, and liquid investment grade credit, which could do well under most scenarios.

Emerging market debt should remain supported in 2023 and local currency debt looks increasingly attractive. We keep a selectively positive view on Brazilian sovereign bonds, and a negative one on Chinese sovereign bonds, where we see room for currency weakness to persist.

In currencies, we expect modest US dollar weakness and remain underweight. The Japanese yen and Swiss franc are our most preferred currencies, while we also see relative value in the euro.

Japan – solid fundamentals

In our view, there is enough momentum in domestic demand for Japan to match or even outperform US and European growth rates in 2023. A trend towards ‘friend-shoring’ (shifting supply chains to geopolitical allies) is boosting Japan’s long-term outlook as advanced manufacturers explore the possibility of building capacity in the country.

We also expect another year of above-target inflation in 2023. Although wage growth has moderated somewhat from the sharp spike seen at the end of 2022, it will likely bounce back again as spring wage negotiations deliver one of the highest base pay raises in recent decades. Headline inflation has begun to rebound, and April’s core inflation reached its highest level in four decades. Survey-based indicators suggest part of this is driven by a shift in long-term inflation expectations.

We expect the Bank of Japan (BoJ) to respond to these signs of genuine reflation by ditching its targeting of 10-year Japanese government bond yields (or ‘yield curve control’) later this year. New BoJ Governor Kazuo Ueda has so far refrained from making such changes and has launched a vaguely defined review of policy for the next 12-18 months. We still expect the BoJ to end yield curve control before this review is over.

China – waiting for credit easing

China’s growth is showing some signs of weakness after a strong first Q1 driven by a rapid reopening from stringent Covid restrictions. The services sector will remain the main driver for growth, with relevant indicators showing healthy expansion into Q2. In our view, this will be sufficient to help the country achieve 5.5% growth this year despite headwinds from weaker overseas demand. Market sentiment has nevertheless become more negative in response to signs of fragility in manufacturing and inflation data.

We expect additional macroprudential and monetary policy tweaks from Chinese authorities in the coming months, in a bid to maintain positive economic momentum. As long as inflation remains well below 3%, the People’s Bank of China can keep its interest rate low, offer targeted liquidity support, and tolerate a weaker yuan.

Emerging markets ex-China – Financial calm despite growth slowdown

Emerging markets outside China have enjoyed a degree of financial calm this year. Although this partly echoes a general market stabilisation, we believe economic fundamentals also played their part. Declining global commodity prices and slowing growth are contributing to a steady softening of domestic inflation for all key regions. Weak exports are being cushioned by less costly imports, and service sectors remain resilient, as they are in other economies. Stagflation that drove market volatility last year is slowly turning into a more manageable slowdown.

On the political front, 2024 will matter more than 2023. Looking further ahead, the global trend towards friend-shoring could provide some support for industrial capacity building. A global race to build this capacity should anchor demand for industrial metals in the next three to five years, supporting their exporters in Asia and Latin America. Meanwhile, India, Indonesia, Vietnam, Mexico, and Poland look well positioned to become alternative manufacturing hubs to China.

Our full H2 Investment Strategy Outlook, including macroeconomic and asset class forecasts, can be found in the pdf at the top right-hand corner of this page.