Capital Perspectives February 2023: Putting the Crystal Ball Back in the Drawer

Investing is a profession that can resemble predicting the future. Investors are made to think they need a crystal ball, when of course, no crystal ball exists. In today’s environment, even the most clairvoyant crystal ball would likely be cloudy. Instead, investing is about assessing probabilities of many micro and macro scenarios. Over the last few weeks, the probability we give to a soft-landing scenario has increased, while the probability of a mild recession remains uncomfortably high. The prospects for Europe’s economy have meaningfully improved. As a result, we have reduced our cash overweight in portfolios and deployed it into international developed equities. We retain a slight underweight to the asset class and equities more broadly, favoring U.S. over non-U.S. Additionally, we continue to hold some excess cash versus our strategic benchmark and an above-benchmark weight to investment-grade fixed income.

Europe catches a break

Looking back just a few months, Europe (Germany, in particular) was unequivocally staring down the barrel of a recession. The war in Ukraine—coming up on its February 24 one-year anniversary—had weaponized Europe’s energy supply, and winter was coming. While natural gas storage levels had increased to 90%,¹ it was unclear if this would be enough to avoid rationing of energy by the industrial sector in the face of a harsh winter. Fast-forward three months and Europe has been blessed with a mild winter, preserving precious gas supplies, and maintaining storage levels of 80%. This improvement of circumstances has ushered in a recovery of confidence among consumers, businesses, and investors.

In addition, over this same period, China has made a rapid about-face on its zero-COVID policy, abandoning it, more or less, cold turkey. Cases have risen enormously, but supply chains continue to operate and mobility-based data show activity is resuming in China’s cities. Global growth expectations are being revised up, with export-dependent economies in Europe, Japan, and other emerging markets the greatest beneficiaries.

Further dampening the headwinds to international equities—at least for American investors—is a reversal of the U.S. dollar. After strengthening by 17% between January and end-September 2022,² the fourth quarter brought a reassessment of relative monetary policy paths and global interest rates that has continued into January 2023. Since October, the dollar has depreciated by almost 10%. For U.S.-based investors, a weaker dollar boosts the currency-adjusted returns for international equities.

Given the rapidly improving facts on the ground, we have moved some cash into international developed equities. Make no mistake, risks remain, and we continue to hold a modest underweight to the asset class. International developed economies are unlikely to deliver robust growth over the next nine to 12 months even if a recession is averted. The war in Ukraine is a key risk, and NATO’s latest round of military support for Ukraine along with warmer spring temperatures will likely bring an even more severe stage of fighting. Additionally, Europe’s energy dependence still leaves the region vulnerable. Meanwhile, over in Japan, the central bank will inevitably have to start unwinding the most accommodative monetary policy in history.³ While this should push Japanese equities higher in U.S. dollar terms, a stronger yen would also present challenges or Japanese export-biased economy. These factors all point to volatility later this year for international equities.

¹ Gas Infrastructure Europe, Deutsche Bank. Europe Thematic Research Strategy, January 20, 2023.

² Represents a trade-weighted basket of currencies as measured by the DXY Currency Index. Source: Bloomberg, as of January 26, 2023.

³ Source: Bloomberg.

Please see important disclosures at the end of the publication.