A Year-End Rally

Leo Wealth
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Harmen Overdijk, CFA

Nearly all financial assets generated strong returns in November. Two major developments explain the improvement in investor sentiment last month: first, tentative signs that inflation is peaking, and second, optimism that Beijing will relax Covid restrictions. Chinese stocks showed the highest returns in November. Chinese authorities are likely to respond to mass protests by expediting the relaxation of pandemic restrictions, which would be positive for the Chinese economic outlook.

Global equities more generally also benefited from preliminary signs that inflationary pressures are finally easing. While the Fed will slow the pace of rate hikes at its next meeting on December 14th, Chair Powell’s comments on Wednesday underscore that labor market conditions are still too tight for the central bank to start thinking about cutting rates.

The U.S. economy is likely to experience lower inflation over the next six months, while economic growth remains solid and it is likely that the Fed will at least slowdown its rate hikes in the coming months. This would mean that stock prices can rise further, while bond yields could drop, and the dollar will likely weaken.

Continued rate hikes in 2023 could challenge the equity rally later next year.

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Fed Policy: A Soft Landing or Recession

A soft landing is defined as the Fed achieving its policy goals of limiting inflation expectations by cooling the U.S. economy without creating a recession. The Fed’s long-term track record is not encouraging. Looking back in history, when the Fed embarked on a rate hiking cycle, it often led to a recession down the line. Can this time be any different?

Most investors still think a recession is going to be necessary to bring inflation under control. There are many indicators that are pointing towards a potential recession in the U.S. However, there are still different outcomes possible.

  1. What if the U.S. economy can actually deal with higher interest rates and the U.S avoids a recession altogether? Then we could see substantial upside in equity markets.
  2. It is also possible that the U.S. experiences a recession but a very mild one, which, to a large extent, is already priced in.
  3. Another option is that a recession does occur but at a different time than the market expects. Many market participants are forecasting a recession in 2023 but we could see a scenario where it would take longer than expected for the economy to go into recession.

All these scenarios will lead to a different outcome for risk assets and equity markets, and identifying the correct scenario is important for portfolio strategy.

In the early years of the 2009-2019 economic expansion, there was much concern among investors that cheap money and quantitative easing would cause massive financial speculation and potentially even hyperinflation.

It is now clear that monetary policy was much too easy last year, meaning that the risk of savings and capital misallocation is higher today than it was a decade ago. In this respect, the normalization of interest rates should be viewed positively as it has greatly reduced an economic imbalance.

We still believe that we will see headline inflation numbers come down over the next 6 months. This is partly because of the statistical effect that inflation is typically 12-month backward looking, and in the period October 2021 to March 2022 the monthly inflation numbers were very high. So, unless inflation accelerates from current levels, it is likely that Consumer Price Inflation will be closer to 4-5% year-over-year in April. That could mean that headline inflation could then be lower than the Fed Funds Rate, which was one of Jay Powell’s stated objectives.

Meanwhile, the U.S. economy remains strong as illustrated by strong jobs data. U.S. nonfarm payrolls increased by a greater-than-expected 263,000 jobs in November, following an upwardly revised 284,000 gain in October. Although the participation rate edged down to 62.1%, the unemployment rate was unchanged at 3.7%.

Given that Chair Powell highlighted in his recent speech that wage growth is the main driver of core services inflation. However,  several indicators of wage pressures such as the Atlanta Fed Wage Growth Tracker, and job openings have eased recently.

A combination of solid economic growth combined with falling inflation and a slightly less hawkish Fed, could be quite bullish for risk assets and supports our positive stance towards risk assets.

Political Gridlock

Last month’s U.S. midterm election saw Republicans underperform expectations of a ‘red wave’ with the Republican party gaining a very slim majority in the House or Representatives, while the Democrats keep control of the Senate. Both sides will have paper-thin majorities in the respective chambers, so the two ruling parties are evenly balanced and hence policy will be indecisive. This stalemate occurs in a context of historically elevated political polarization.

However, gridlock is not necessarily positive or negative – it can be cooperative or competitive depending on circumstances. Ideally the two sides would recognize their limits and compromise on legislative bills, enabling a period of stability. The positive side for companies is that it is unlikely that the Republican house will approve any tax increases in the next two years.


The European economy is facing stronger near-term headwinds than the U.S. economy. Both the German manufacturing and services sectors are set to slow further in the coming few months, beset by a large decline in European real wages due to high inflation. The decline in real wages means that euro area consumption will likely be quite weak over the coming few months.

That said, Europe may have scope to grow faster than the U.S. beyond the next two quarters. The key driver for this is that there is still meaningful pent-up consumer demand in Europe. Stabilization of the European energy market is essential for euro area durable goods consumption to improve. European economies are switching their energy mix away from natural gas toward coal and oil, which are less expensive. We expect French nuclear electricity generation to improve next year, which will also diminish the need for expensive fossil fuels.

The fiscal policy backdrop is also supportive of economic growth in the coming quarters. The various government support programs implemented in recent months across Europe to deal with the energy situation amount to nearly €500bn. This spending does not completely undo the pain caused by higher energy prices, but it goes a long way toward mitigating its impact. These programs protect private sector balance sheets and therefore will allow lower inflation and higher real income to increase consumer spending next year.

Aside from the impact of a renewed escalation in the Russian-Ukrainian war on Europe’s energy market, China’s economy remains the wildcard for European economic activity, given the interdependent nature of those economies.  We do expect to see stronger than expected economic growth in China in 2023, which may bode well for Europe as well.

As a final point, the war in Ukraine has significantly accelerated the pace of renewable investment in Europe, which could eventually improve euro area productivity growth and lead to beneficial technological developments in the renewable energy space. But these potential gains are only likely to be realized over the long term.


The Chinese economy could be a bright spot in 2023. China’s zero-covid policy has probably passed the point of no-return. Bejing will either voluntarily phase out the current policy or be forced to do so by protests and the reality of a larger outbreak. An end to the covid-restrictions combined with economic stimulus should result in a cyclical upturn in the Chinese economy.

Combined with an equity market that has been under pressure since early 2021 and that hit 2005 levels last month, we were not surprised to see a strong rally developing in November, which we think has further to go. Chinese stocks rallied strongly off depressed levels. The three key factors that have weighed on the market since early 2021 are the crackdown on internet companies, the credit crunch on property developers and the zero-covid lockdowns. All have shown signs of loosening. At the same time, President Xi Jinping’s meeting with President Biden and other leaders at the G20 meeting shows that China is willing to engage more actively in diplomacy again.


Even in a year when inflation has been soaring globally, markets are not especially worried about inflation returning to Japan. Such complacency is probably misguided. Structural deflationary forces in Japan are weakening, setting the stage for inflation to make a comeback next year.

What will drive a resurgence of inflation in Japan? Corporate releveraging, a stabilization in land prices, a fundamentally more supportive fiscal policy, and finally, rising real wages – all support an improvement in aggregate demand.

Higher inflation will force the Bank of Japan to turn more hawkish, especially when Chairman Kuroda steps down in April. This will be an opportunity for the Bank of Japan to change its policy. Higher Japanese bond yields will lift the yen, which is extremely undervalued. A stronger yen will also help the Japanese equity market to outperform other equity markets, especially since Japanese stocks are trading at low valuations relative to historical levels.

Bonds: The return of the 60/40 portfolio

For years bond yields have been very low and thus the returns on traditional fixed income have been low. The traditional role of fixed income, other than providing income, is to act as a defensive part of the portfolio. Typically, when a recession hits and equity markets sell off, bonds go up in value and mitigate the downside of the portfolio.

This year it has been completely different. We did not experience a global recession, and yet the global equity market sold off almost 30%. However, as bond yields rose sharply this year, fixed income sold off as well. In fact, 2022 is the worst year for bond portfolios ever. In other words, bonds did not offer any form of diversification to the equity part of the portfolio this year, which is quite a unique situation. This is one of the main reasons why several investors have declared “the death of the 60/40 portfolio.” A 60/40 portfolio stands for a combination of equity and fixed income or also known as a balanced portfolio.

A balanced portfolio clearly did not deliver this year and as bond prices fell almost as much as stocks. However, at the moment the world looks different. The Fed and other central banks have normalized interest rates and for the first time in a decade we are seeing normal bond yields again of 4 to 5%.

This means that fixed income can play a defensive role again in portfolios. If we experience a recession next year, then it is likely that bond yields will fall. And even if bond yields move higher, the performance will be cushioned by the 5% interest income yield. In other words, for the first time in almost 10 years we think it is worth considering increasing the allocation to fixed income as part of a diversified portfolio strategy.

Alternative Investments

As part of a diversified portfolio strategy in a period with higher interest rates and higher inflation, we believe alternative investment will play a bigger role in the coming years in balancing portfolio risks. Alternative investments cover a wide range of non-traditional investments like stocks and bonds. These include real estate, commodities, precious metals but also hedge funds, private equity and private credit. Each of these have their own characteristics but we believe that depending on your personal investment objectives, investors should consider diversifying their portfolios by allocating part of the portfolio to alternative investments. 

One of the traditional portfolio diversifiers in times of inflation is Gold. Gold failed to benefit from higher inflation this year and could paradoxically rally as inflation subsides in 2023. Real yields and the US dollar should decline as the Fed’s focus shifts from fighting inflation to fighting a recession. These trends could bode well for precious metals.

Crypto Currencies and the FTX Implosion

The downfall of FTX resembles Enron’s collapse much more than Lehman’s. Thus, the macroeconomic consequences should be limited as the digital asset exchanges are not affecting the global financial system. If anything, they enhance the trust in traditional financial institutions.

There is, however, one macro consequence that has been largely overlooked, which is pertinent to the question of why inflation rose so much last year. At the height of the crypto bubble, the total market cap of cryptocurrencies stood at about $3 trillion. About a third of that, or $1 trillion, was held by U.S. residents. As a point of comparison, there was about $2 trillion in U.S. currency in circulation in 2021, slightly less than half of which was held by non-residents. Hence, US residents held about as much cryptocurrency as US dollar notes and coins last year. That amount is a lot lower now after the sell-off in the crypto market. In both directions, there is a wealth effect. If every additional dollar of crypto wealth generates four additional cents of demand for domestically-produced goods and services – which is close to the estimate for stocks – the crypto boom would have boosted US aggregate demand by $60-to-$80 billion. While this is not a huge amount for a $23 trillion economy, it could have been enough to stoke inflation. So, the sell-off could actually contribute to lower inflation going forward.

The fact that Bitcoin and Ethereum remained relatively stable throughout the FTX debacle makes us more positive on crypto currencies again. With crypto currencies there is a high correlation with general market sentiment, and as we expect equity markets to stay supported, risk assets like crypto could profit as well.

Portfolio Positioning

Our core portfolios were well positioned to profit from the recent rebound in equity markets and the weakening US dollar. The positions in Chinese and Japanese equity markets helped performance in the past month.

Overall we maintain a balanced approach in portfolios with a slight tilt to growth and international stocks as we think these will profit more from cooling inflation pressures.

For our GBP and EUR denominated clients, increasing the size of currency hedges in those core portfolios improved returns as the USD weakened and nearly all major international currencies strengthened.

Last but not least, we rebalanced many of our single stock portfolios during the month, taking advantage of a change in sentiment to replace low-scoring stocks with higher-scoring ones, improving portfolio valuation, quality, safety, technical and sentiment characteristics.


The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to the accuracy, completeness, or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. 

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies

Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

 Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses.  They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.

Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency.

Rebalancing/Reallocating can entail transaction costs and tax consequences that should be considered when determining a rebalancing/reallocation strategy.

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