The Year Ahead 2023 Global Economic Outlook

Market turbulence dominated the economic environment in 2022. Geopolitical conflict, rising interest rates and record inflation heightened recessionary risks for many economies as financial conditions became increasingly constrained. As a result, we witnessed significant repricing in the fixed income and public equity markets. Real estate valuations have also started to cool.

While the current uncertain macroeconomic backdrop may imply continued market volatility entering 2023, at TD Asset Management Inc. (“TDAM”), we believe that underlying market fundamentals are sound as corporations, particularly in North America, remain generally well capitalized. We are also beginning to see signs that inflation levels may be moderating in some economic categories, such as used cars, shelter, and commodity prices, which may suggest less hawkish global central banks in the coming months.

In broad terms, earnings for North American companies have been relatively positive, though most sectors continue to face challenges and we anticipate overall softer demand in 2023. Within equity markets, current forward estimates for earnings and revenues will likely need to be revised lower in the coming quarters and this may put added pressure on stocks globally over the next year. If markets trend lower in the coming quarters, our perspective remains that market drawdowns can provide opportunities. Broad selloffs often create dislocations within equity markets, where quality companies begin trading at valuation discounts, making them attractive long-term investments.

While the environment for bonds has not been any rosier, as rapidly rising yields have driven bond prices down, today’s starting yields offer attractive entry points for those able to look beyond near-term volatility. Yields across fixed income sectors are well above the lows of the past decade and offer real potential for future returns. Additionally, we maintain a positive outlook for alternative assets which can provide long-term inflation protection and attractive absolute returns.

The Year Ahead

We expect below trend growth to carry into 2023, as tight monetary conditions restrict growth. Higher interest rates to combat the persistence of high inflation (particularly on the services side of the economy), increasing concerns around how severe a global recession could be, and the war in Ukraine, among other ongoing geopolitical turbulence, all remain risks to the market outlook through to next year.

Financial markets are always evolving as participants learn and innovate. We continue to have conviction in our adaptive portfolio allocation approach and in our principles. While recessions can be painful, they can be an effective mechanism for clearing out excesses in advance of the next period of growth.

Neutral Outlook for Equities

For most of 2022 we were overweight Canadian Equities. This was effective as the S&P/TSX Composite Index outperformed many global counterparts. However, today there are headwinds that may make continued outperformance more challenging as we enter 2023. For the Canadian Financials sector, while net interest margins may still have room to grow, we do not expect the magnitude of this tailwind to persist. Additionally, provisions for credit losses may need to be higher across the banks’ balance sheets which could act as a modest earnings headwind. Further, following significant outperformance by the Energy sector in 2022, we expect a more balanced energy market and moderate performance for the sector going forward.

Forward earnings estimates have been lowered in most sectors, but further deterioration in forecasts is expected. However, many blue-chip U.S. equities have seen sharp com- pression of valuation multiples and are trading close to long-term historical averages. Any further market weakness could be viewed as an opportunity to incrementally add to high quality compounders. We remain focused on quality in the market, specifically on companies with robust fundamentals, access to growth and sustainable free cash flow generation.

While inflationary pressures and geopolitical risks continue to cloud the outlook for global equities, we see some opportunity within international (European) markets as they appear inexpensive on a forward price-to-earnings basis relative to their history and in comparison to U.S. equities. A weakening U.S. dollar (USD) may also provide a tailwind for international stocks over the next 12-18 months.

In our view, China’s outlook remains weak, however, we are hopeful that 2023 could see a sentiment reversal in China triggered by the government’s possible easing of certain detrimental policies. These include the Zero-COVID-19 policy, the property-market crackdown, anti-trust campaigns over the Technology sector, and geopolitical tensions with the U.S. and Taiwan. Depressed valuations in select sectors may provide long term opportunity.

Emerging markets equities, similar to many global counterparts, are being challenged by persistently high inflation, concerns over global central bank monetary tightening, and the prospect of recession in many western economies. Our outlook for emerging markets remains cautious while recognizing that low valuations may provide a good entry point.

Fixed Income Attractive Entering 2023

North American central banks are beginning to slow the pace of policy rate hikes as inflation pressures show signs of easing at the margins. As a result, yields have stabilized at multi-year highs and government bonds remain appealing due to their potential to generate positive nominal returns over the longer term.

With a slowing global economic outlook, we prefer investing in higher quality corporate bonds. Credit fundamentals are robust and all-in yields are attractive, although there is limited upside from any further spread tightening in the near term. While their respective economies are more vulnerable to a down-turn, corporate bond opportunities in Canada and Europe are modestly more compelling than U.S. opportunities due to valuation.

Higher interest rates and a deteriorating economic backdrop will likely cause default rates for high yield bonds to rise from currently low levels. This could result in further volatility and downside risk for credit spreads despite the high potential return in the sector. Solid credit fundamentals should prevent high yield bonds from experiencing the extreme dislocations seen in some prior recessionary periods.

Investors are increasingly paying attention to the global economic slowdown narrative, so we are starting to see some reversal of the extreme bearish sentiment and positioning in the global bond market. As bond yields have risen considerably year-to-date, some markets now offer attractive incremental yields, net of currency hedges. Non-USD-denominated bonds may also benefit from a potentially weakening U.S. currency.

Positive Outlook for Alternatives in 2023

We maintain a modest overweight to commercial mortgages. Commercial mortgages continue to provide accretive income while insulating investor returns from the increased volatility in interest rates. Income collection via scheduled principal and interest payments remains resilient while demonstrating less volatility than observed in other corners of the fixed income markets.

We maintain a neutral weight to Canadian Real Estate. Aggressive interest rate hikes over the second half of 2022 are driving upward pressure on capitalization rates across property types. However, property fundamentals remain sound with supply/demand imbalances persisting within industrial and multi-family assets. This results in continued rental rate growth. High quality, transit-linked properties are exhibiting robust leasing activity.

We maintain a neutral weight to Global Real Estate. Rising inflation and interest rates remain the primary risks globally. Markets with strong institutional sponsorship, positive real estate fundamentals (i.e., low vacancy rates, rental rate growth), moderate development activity and conservative leverage ratios are long-term structural elements that may help support the broader real estate sector. We believe that being globally diversified within major cities and high quality assets should help navigate through economic turbulence.

We maintain a modest overweight to Infrastructure. We believe Infrastructure is well positioned to outperform relative to other asset classes through this interest rate cycle, even though rising interest rates will increase risk-free rates used to price private asset class- es. Increases in cash flow from higher than expected inflation is buffering the rising rates and we anticipate core-plus portfolios may be best positioned given the embedded growth in revenue from value-add and opportunistic assets.

Have a safe and prosperous 2023.

David Sykes is the Chief Investment Officer at TD Asset Management.