“I believe in process. I believe in four seasons. I believe that winter’s tough, but spring’s coming. I believe that there’s a growing season. And I think that you realize that in life, you grow. You get better.”
Thankfully, the annual forecasting season is almost over. The yearly ritual when strategists fool investors into thinking that they can gaze deeply into their crystal balls and predict the future. Please, don’t misunderstand me, investors want to be fooled. They are complicit in this silly business. Despite overwhelming evidence to the contrary, investors desperately want to believe that there are so called experts who can accurately and consistently forecast investment outcomes.
As the Chief Investment Strategist for the US SPDR business, I must play the annual prediction game. This will be the eighth consecutive year that I reluctantly forecast three surprises for investors.
Over the previous seven years, I’m a respectable 14 for 21 (67%) in my prediction accuracy. But quants and stat geeks know this is far too few observations to determine with any statistical significance whether I have forecasting skill or just dumb luck.
I credit my investment process. That’s why each year I take this opportunity to remind investors that while outcomes are always highly uncertain, a consistent, disciplined and repeatable investment process is firmly within their control. A thoughtful approach combined with a little luck provides investors the best opportunity for long-term success.
My annual reminder takes on even greater importance as we begin 2023. After one of the most challenging years in history, behavioral biases will likely seduce investors into making investment process changes — often at exactly the wrong time. Frequently, when the temptation to make changes reaches its peak, it’s best to do nothing. Stay the course and trust the process.
So again in year eight, I have applied the same formula. I forecast three surprises. Predicting a small number of high conviction surprises has helped my forecasting success. Too many predictions reduce accuracy as correct and incorrect forecasts cancel each other out.
My forecast period is the calendar year. Attempting to identify surprises over longer time horizons increases prediction and measurement errors.
And perhaps the most important ingredient to my surprise forecasting formula is identifying unloved assets with compelling valuations where a lot of bad news is already priced in and investor sentiment is decidedly one-way.
When these conditions are in place, the potential for a surprise is at its greatest. Applying this simple forecasting formula, here are my three surprises for 2023:
US financial sector exchange traded funds (ETFs) had outflows of nearly $20 billion over the trailing 12-months through January 20, 2023. That’s 2½ times more than US consumer discretionary ETFs which had the second-largest outflows of the 11 economic sectors for the period.1 Growing recession fears, volatile capital markets, falling home prices, poor earnings results and an inverted yield curve have made the financial sector an unloved asset with decidedly negative investor sentiment.
Fourth quarter earnings season has gone from bad to worse for the financial sector. Back on December 31, earnings-per-share (EPS) growth was expected to decline by 7.5% year-over-year for financial companies. After a poor start to the earnings season, EPS growth is now expected to fall by an even more terrible 12.4% year-over-year.2
Most financial companies, especially banks, earn profits by borrowing short and lending long. For example, they borrow short by taking demand deposits, such as checking and savings accounts. And, they lend long by creating long-term loans such as mortgages. Financial companies earn profits by pocketing the difference between the lower short-term rates that they pay on demand deposits versus the higher rates that they collect on long-term loans.
However, when long-term interest rates are lower than short-term interest rates, as they are today, the yield curve is inverted. Historically, an inverted yield curve has been a harbinger of recession. But it also flips financial companies' profitmaking model on its head. The inverted yield curve has negatively impacted the outlook for the financial sector in 2023.
Needless to say, given the dire circumstances, it would be a surprise if financials outperformed the market this year. Yet, a lot of bad news may already be priced into the sector. This creates a compelling relative value opportunity for investors. The Financial Select Sector Index trades at a more than 20% discount compared to the S&P 500 Index using forward 12-months price-to-earnings (P/E) ratios, 13.6x versus 17.4x.3 Financial companies are also aggressively returning capital to shareholders through share buybacks and dividends. That’s attractive in today’s volatile capital market environment. The Financial Select Sector Index has a dividend yield that’s 24% greater than the dividend yield on the S&P 500 Index.4
Despite the challenging early start to the fourth quarter earnings season, the financial sector is still expected to grow its year-over-year revenues faster than the S&P 500 Index. And, according to FactSet, the financial sector has the third highest net profit margins of the 11 economic sectors. In fact, financials’ net profit margin of 15.5% is more than 35% higher than the S&P 500 Index net profit margin.5
Meanwhile, the Federal Reserve (Fed) has expressed its desire to normalize the yield curve from its current inverted state. After the Fed’s tightening cycle concludes this year, interest rates are likely to remain elevated, further flattering the financial sector’s profitability. And, while the Financial Select Sector Index outperformed the S&P 500 Index last year, it has significantly underperformed over the last 3- and 5-year annualized periods through December 31, 2022.6 As investors begin to price in an economic recovery later this year and the yield curve normalizes, I expect Financials to regain market leadership.
For my first surprise, I predict that the Financial Select Sector Index will outperform the S&P 500 Index in 2023.
Europe has many well-known structural challenges. It’s a monetary union without a fiscal union. Like too many wealthy nations, Europe has massive debt and lousy demographics. Compared to the US and some Asia-Pacific countries, Europe has lagged in the creation of innovative and disruptive new technologies. All of this has restrained European economic growth. As a result, European stocks have routinely traded at lower P/E multiples than US stocks.
The Russia-Ukraine war has further complicated the outlook for Europe. It created a humanitarian crisis as millions of people fled the Ukraine. The economic sanctions on Russia exposed Europe’s dependence on Russian oil and natural gas. Already coping with rising prices in the aftermath of the pandemic, the Russia-Ukraine war sent food and energy prices soaring across Europe. Painfully, the European Central Bank (ECB) has been forced to raise rates to stabilize prices at the same time the economy is slowing and recession fears are rising.
If investors thought European stocks were cheap before the Russia-Ukraine war, the STOXX Europe Total Market Index now trades at a nearly 30% discount compared to the S&P 500 Index on a 12-month forward P/E basis.7 This has created a compelling valuation opportunity in an unloved asset with a lot of bad news already priced in for European stocks. For example, investors can purchase European stocks at a sizable discount compared to US stocks but with comparable EPS growth expectations over the next three to five years. In addition, the STOXX Europe Total Market Index has a dividend yield that is almost double the dividend yield of the S&P 500 Index.8
Favorable relative valuations alone shouldn’t be enough to compel investors to purchase European stocks. After all, European stocks have been persistently cheaper than US stocks for a long time. Investors need a greater catalyst to go bargain shopping for European stocks. So far, a mild winter combined with elevated oil and natural gas stockpiles has bolstered consumer sentiment in Europe. A resolution in the Russia-Ukraine war this year would also raise Europe’s spirits. Similar to the US, inflation measures are beginning to show signs of deceleration, welcome news for European consumers and businesses.
Perhaps the biggest surprise for European stocks is that despite recession fears, revenues, earnings, and profit margins have remained resilient. So, while US corporate profitability has slowed dramatically, European fundamentals have held firm. China’s re-opening from the pandemic also brings back Europe’s biggest customer. This makes the notable discount in valuations all the more interesting for investors.
Finally, another catalyst for US-based investors in European stocks is the weakening US dollar. As the Fed’s tightening cycle matures, China re-opens and Europe avoids an energy crisis, the US dollar has started to soften, boosting non-US returns for investors.
Let’s face it, European stocks have been cheap for a decade but with solid fundamentals and a weakening US dollar as catalysts, the widening valuation gap is too big to ignore. The STOXX Europe Total Market Index has massively underperformed the S&P 500 Index over the last 3-, 5- and 10-year annualized periods through December 31, 2022.9 That performance gap could narrow this year.
For my second surprise, I predict that the STOXX Europe Total Market Index will beat the S&P 500 Index in 2023.
There were very few places for investors to hide last year. The rapid increase in interest rates produced by global central banks to combat surging inflation resulted in a re-rating of nearly all assets. Energy stocks, the US dollar and commodities were among the few investments that offered investors positive absolute returns last year. Strangely, US energy sector ETF flows were about flat last year, while commodity ETFs suffered outflows in 2022. In fact, of the six major asset class categories (equity, fixed income, commodity, specialty, mixed allocation and alternative), commodity ETFs was the only category to experience outflows in 2022, primarily driven by outflows from gold ETFs.10
Peak inflation combined with growing global recession fears have dampened investor enthusiasm for real assets — a category that includes commodities, real estate and infrastructure investments. Increasing real interest rates and a soaring US dollar also conspired to negatively impact the outlook for real assets, particularly gold. And continued post-pandemic aftershocks like return-to-office dynamics and noticeably higher interest rates have clouded the outlook for real estate.
As a result, the unloved hodgepodge category of real assets now provides investors with a relative value opportunity, especially when compared to traditional stocks, bonds and digital assets.
China’s re-opening and the global transition from fossil fuels to clean energy are increasing the demand for real assets, while supply remains constrained. And the powerful one-two punch from the $1 trillion Infrastructure Investment and Jobs Act signed into law in November 2021 and the Inflation Reduction Act signed into law in August 2022 should keep demand robust over the longer term.
Real assets are also natural beneficiaries in an inflationary environment. And although global inflation may have peaked in 2022, it likely will remain elevated for at least the next year, possibly longer.
Investors are skeptical of a prolonged rally in real assets. But real asset rallies are rarely just one and done. Like the last commodity super cycle from earlier this century, these rallies often last years.
Yet, even in today’s supply constrained, higher interest rate and inflationary environment, commodities, real estate and infrastructure investments are under-owned. Investors should consider increasing allocations to energy, materials, commodities, infrastructure, real estate, gold and industrial metals in diversified investment portfolios. Given the consensus outlook for more volatility this year and a wide range of potential outcomes, holding real assets seems prudent.
For my third and final surprise, I predict that a diversified portfolio of real assets will outpace the traditional 60/40 investment portfolio in 2023.
After such a painful year for investors, it’s difficult for me to gloat about my three surprises success from 2022. Most people aren’t pleased with their 2022 investment performance, including me. At least I did break The Compound & Friends podcast curse mentioned in last January’s article by successfully predicting two of three surprises. It’s good to be back, after my powers of prediction failed me in 2020 and 2021.
For 2022, I predicted that Chinese stocks would outperform global stocks. That was a dud. Interestingly, I did consider doubling down on that forecast for 2023. And Chinese stocks have performed very well so far this year. Better late than never, I guess. Speaking of doubling down, last year was the first time I repeated a surprise forecast from the previous year by predicting that aerospace & defense stocks would rebound. The S&P Aerospace & Defense Select Industry Index did beat the S&P 500 Index by 13.4% in 2022. But regrettably, neither investment provided investors with a positive absolute return. And, finally, I successfully predicted that gold would beat Bitcoin last year. The spot price of gold was essentially flat for the year, while Bitcoin plummeted by roughly 65%. Like the saying goes, “Two out of three ain’t bad.”
Just like most years, 2023’s consensus opinions about the Fed, interest rates, inflation, earnings, stock prices and the US dollar will likely be off the mark. And, that’s okay. Investment outcomes are always random, especially in today’s highly uncertain environment. What investors can control and count on is that a consistent, disciplined and repeatable investment process provides them with the best opportunity for long-term success. After an extremely challenging 2022, I hope that all investors are pleasantly surprised by their investment portfolios in 2023.
1 Bloomberg Finance, L.P., January 20, 2023.
2 Earnings Insight, FactSet, January 20, 2023.
3 Bloomberg Finance, L.P., January 25, 2023.
4 Bloomberg Finance, L.P., January 25, 2023.
5 Earnings Insight, FactSet, January 20, 2023.
6 Bloomberg Finance, L.P., December 31, 2022.
7 Bloomberg Finance, L.P., January 25, 2023.
8 Bloomberg Finance, L.P., January 25, 2023.
9 Bloomberg Finance, L.P., December 31, 2022.
10 Bloomberg Finance, L.P., December 31, 2022
The views expressed in this material are the views of Michael Arone through the period ended January 25, 2023 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements.
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