Three big questions dividing fund managers at the start of 2023

Amid the usual predictions made for the year ahead, there are some things fund managers do not agree on. Kyle Caldwell considers three areas of debate.

It is the time of the year when dust is blown off crystal balls as the experts make predictions for what 2023 has in store for investors.

As 2022 proved, making forecasts is a tricky business, with heavy losses for bonds, particularly UK government bonds (gilts) and UK index-linked bonds, catching various pros off guard.

In 2023, one predictions that has been made is that now is a good time to size up cheap shares in the emerging markets and Japan. The UK has also been hotly tipped, with various fund managers pointing out that mid- and small-cap stocks have been oversold on recession concerns.

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However, there are a number of things that fund managers do not universally agree on. Below we round-up three areas of debate.

Is a recession priced into stock markets?

Generally, recessions are associated with lower stock market prices, resulting in higher levels of volatility than usual. Therefore, given the UK is at the start of a long recession, which is expected to last for two years, it is challenging backdrop for investors to navigate.

However, some fund managers are upbeat, pointing out that as the stock market is forward-looking, the recession has already been priced into the market. In this camp is Ian Lance, co-manager of Temple Bar (LSE:TMPL) investment trust. Appearing last month in our On The Money podcast, Lance said: “I think [a recession] is already being priced into the market. If you look at the performance of different sectors year-to-date, the best-performing sectors are the most defensive ones, things such as tobacco and consumer staples.

“The worst-performing sectors year-to-date are autos, housebuilders, and retailers. Some of those sectors have halved year-to-date. This certainly suggests that a recession is being priced in.”

Also looking on the bright side is Richard Buxton, fund manager of the Jupiter UK Alpha fund. Buxton points out that “this recession is going to be different from previous ones”, as it is “likely to be shallow but lengthy rather than deep”. He expects employment to remain high, pointing out that “many small businesses are struggling to fill vacancies”.

Another reason to be optimistic, according to Buxton, is that UK shares are so cheap that “further material declines are unlikely”. He notes that the UK equity market “has materially underperformed other equity markets in recent years – a result of Brexit, a value bias to unpopular sectors and persistent net selling”.  Buxton adds: “In a historical context, UK equities look very attractively valued.”

However, the bearish viewpoint is that company earnings forecasts heading into a recession are too optimistic, and will be cut. In response, the market will likely take a dim view of this and re-price accordingly. 

Duncan MacInnes, fund manager of Ruffer Investment Company (LSE:RICA), says the stock market moved lower in 2022 “because of interest rates going up”. He added: “It's not come down because of corporate earnings being reduced. The S&P 500 is still forecast to grow earnings 8% next year. We think that's way too optimistic. In recessions, earnings usually fall 10% to 20%, so earnings could still fall.”

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Central to how markets fare in a recessionary environment is whether interest rate rises have the desired impact in reducing red-hot inflation.

Johanna Kyrklund, chief investment officer and co-head of investment at Schroders, says: “Inflation is the key to market performance in 2023. Provided inflation does come down, we could start to see a more benign environment for markets. But if inflation persists, then we've got a problem on our hands. Rates might then have to go even higher, and markets would have to reassess valuations once again.”

Taking in late December 2022, MacInnes’ was of the view that inflation will fall in 2023, but be volatile over the next decade.

“The last decade had 2% inflation with very little volatility around that. The next decade might have 3% or 4% inflation on average, but with 10% inflation like today and some periods of lower inflation, zero inflation or deflation.

“I think as we move into next year - we are at peak inflation now - we head into that sort of disinflationary part of the inflation-volatility journey. So, lower inflation [in 2023] would be our guess.”

Consumer-facing shares: time to buy or avoid?

Consumer discretionary companies – those that provide products and services not viewed by consumers as being essential – face a challenging backdrop if, as expected, UK consumers tighten their belts during a recession.

However, as ever, there will be both winners and losers, meaning there are opportunities in the economic malaise. Neil Hermon, fund manager of Henderson Smaller Companies (LSE:HSL) investment trust, picked out four shares he thinks look well placed to weather the storm of a decline in consumer spending: Hollywood Bowl (LSE:BOWL), Young & Co's Brewery (LSE:YNGA), DFS Furniture (LSE:DFS), and Team17 (LSE:TM17), a developer of computer games.

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Feeling more cautious about the consumer is Gervais Williams, fund manager of Diverse Income Trust (LSE:DIVI). He says that he “doesn’t think the consumer will necessarily be as buoyant as people hope”.

Williams added: “I think it's going to be quite a long period where we get through the cost-of-living crisis. Companies themselves may have some setbacks. There may be more profit warnings, and it may be that governments continue to run out of money and have to keep raising taxes.”

One company that he thinks will buck the trend is AO World (LSE:AO.), the online electricals firm. Williams’ view is that the firm is in a better position than rivals to grow market share by “improving efficiencies”.

Is China a buying opportunity or is there too much political risk?

Investor sentiment towards China is very low, due to policy tightening and stringent regulation by its government in a number of sectors, notably technology and property.

In addition, there are concerns that its strict zero-Covid policies, which are now being eased, have come at the cost of economic growth. There are also separate fears over debt levels in China’s property market. All these headwinds led China’s stock market to fall around 15% in 2022.

A big concern going forwards, which has led some fund managers to completely sell out of China, is that further regulatory crackdowns could be made, which would stifle the growth of successful companies and potentially limit their share price upside.

Professional investors with sizeable exposure to China argue that political risk is nothing new, and that it is a price worth paying. Moreover, as the world’s second-largest economy and home to some of the world’s most-exciting entrepreneurial businesses, China is difficult for investors to neglect in their portfolio.

Looking ahead Nicholas Yeo, co-manager of abrdn China Investment (LSE:ACIC), gave two reasons why he is optimistic China that will have a better year in 2023.

“First, stimulus measures have been working their way through the system in the second half of this year.

“Second, recent direction – including steps taken to kickstart the gradual loosening of the zero-Covid policy and support for the property sector – indicate that the central government is aware of the economic headwinds China is facing and is prepared to intervene to protect growth.

Yeo added that with valuations so low and investment sentiment so poor, the Chinese market “does not need too many catalysts to recover”.

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Dale Nicholls, fund manager of Fidelity China Special Situations (LSE:FCSS), argues that the sell-off “has been overdone”.

“We believe that government policy will move to address factors related to zero-Covid and the property sector, along with further easing for both the monetary and fiscal side,” he said. 

Addressing political risk, Nicholls said that “the peak of new regulatory reforms, particularly in China’s internet space, is now behind us.”

He adds that valuations are also now very attractive versus both history and other markets.

However, political risk has been viewed by other investors as a price not worth paying. Among the fund managers who have completely exited China are Jason Pidcock, manager of Jupiter Asian Income fund, and Simon Edelsten, manager of Mid Wynd International Investment Trust (LSE:MWY).

Pidcock notes that “while some market participants are now expecting a rebound in the Chinese economy, we are not as optimistic, instead believing that its economy is on a downwards trajectory over the longer term”.

This is reflected by the fund not having any exposure to China after selling out of its remaining positions in the summer of 2022.

Pidcock explained that his negative stance towards China is due to becoming “increasingly concerned about China’s political nature, both domestically and in relation to other countries, and we think it is likely to be a low-growth command economy going forward due to a combination of state intervention and demographics”.

He added: “At China’s 20th Party Congress in October, President Xi Jinping was confirmed for a third term as party leader, further consolidating power with a leadership shake-up. While Xi remains in power, we do not anticipate re-investing in China.

“We do still have exposure to China’s economy though, through successful companies located elsewhere in the region that sell to it.”