View From The Top: We ain’t done yet

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: The path forward will be extremely fraught and volatile but even against this backdrop, we believe it is possible to create a constructive view on 2023’s prospects. Fundamentals should start to reassert themselves as the year develops. Although this process will not be linear, asset prices could rebound as Central Banks start to slow and eventually cease their monetary tightening campaigns. Fear of recession is likely to replace that of inflation, but the worst falls in equities and fixed income may already have occurred. Plan for the worst, but hope for the best and do not forget the power of mean reversion. Nonetheless, even if starting points are lower than a year ago, the returns enjoyed over the past decade are unlikely to be repeated going forward. Protecting against potential future investment losses should form a crucial part of asset allocation strategy. Our counsel is to deploy dry powder judiciously and unemotionally and to embrace a diverse range of investment styles.

Asset Allocation:

• Equities: Investors would need to go back to the 2000-2002 period to find a time in which global equities fell for two consecutive years. We believe that an aggressively hawkish Federal Reserve may have front-loaded the equity sell-off in this cycle. Even if there may be more downside to earnings estimates in some segments of the market, particularly as a recession becomes more developed, multiples have already started to contract and estimates to fall. While quality may outperform in a recessionary environment, our counsel is to seek exposure to a broad range of styles (growth and value, cyclical and defensive). Should financial conditions ease – even on a relative basis – as 2023 evolves, then early cyclicals (and small caps) may benefit.
• Fixed Income/Credit: Consensus seems to be building around the notion that bonds could outperform in 2023, both in absolute terms and relative to equities. Beyond mean reversion after the major drawdown witnessed in 2022, peak inflation and a looming recession would argue for lower yields. An increasingly disinflationary environment would also be supportive. It’s still important to retain a high-quality bias, however, within the credit space. Spreads have not widened as much as would typically be expected in this hiking cycle. Defaults could also accelerate in a more challenged macro environment.
• Currencies: The US Dollar is unlikely to be the same one-way bet in 2023 that it was for most investors in 2022. The currency has already witnessed a c10% fall from its 20-year high (reached in September) and more may follow, even if it’s hard to identify a clear challenger to the Dollar over the longer-term. Consider diversifying exposure.  
• Gold/Commodities: Beyond its defensive qualities and diversification characteristics, gold should benefit from Dollar depreciation and lower real yields. Commodities share some of these attractions and pullbacks create opportunities. Should the Chinese economy reopen in 2023, then this would also benefit the commodity space.
• Alternative Assets:  The collateral-backed cashflows available for this asset class can act both as a portfolio diversifier and an inflation hedge. We favour business models with strong balance sheets, but recommend thorough due diligence.
• Cash: Although we see a continued logic in deploying cash tactically and unemotionally, we also recognise the current attractiveness of cash as a bona fide asset class for the first time in decades.

2022 is a year that most investors will want to forget. Beyond an unexpected war in Europe, globally, inflation and subsequent policy responses both massively exceeded expectations. As a result, rarely were things as bloody in so many asset classes at once. There were few places to hide. Consider that at its lowest point in 2022, more than $10tr of value had been erased from the S&P 500 Index. Equities had their worst year since the Great Financial Crisis, while fixed income (as measured by the move in US Treasuries) saw the poorest returns in over fifty years. Elsewhere, assets from Bitcoin to US housing recorded severe declines. Even in such an environment, investors who had allocated to gold witnessed just flat returns in 2022, while commodities rose only against a war-inspired backdrop.

As we enter 2023, it may therefore be justifiable to contemplate how much more pain lies ahead. A lot has changed relative to 12 months ago. For sure, there is less investor complacency, but more importantly, there has been a shift in sentiment. With the era of cheap money long behind us, the FOMO (fear of missing out) mindset has been replaced with one centred around protecting investment losses. Plan for the worst, but hope for the best.

The good news is that the worst falls in equities and bonds may already have occurred. A guarded mood among investors with buyers generally hesitant does create opportunities. Do not forget the power of mean reversion. Further, given the low(er) starting points for most asset classes, the long-term return potential looks more compelling relative to a year prior, even if a mix of poor growth and more stubborn inflation may constrain returns relative to history. Have no doubt, 2023 will not be an ‘easy’ year for investing, but it should be relatively less bad than 2022, in our view.

From a bigger picture macro perspective, the siren calls for recession are mounting, especially as Central Banks press on in their fight against inflation. Fear of inflation has migrated to fear of recession. While some are still daring to dream of a soft landing, the risks around a harder landing for the economy appear to be growing. The Eurozone and the UK are probably already in recession and the US may well enter a state of economic contraction in 2023. Both the IMF and OECD have sounded cautious notes on global growth prospects. 2023 will likely see the slowest rate of global GDP expansion since 2003, when the financial crisis and pandemic years stripped out.

Most macro data that we observe (composite manufacturing and service activity indices, retail sales, housing market trends) point to economic deterioration. Bad news is coming to be seen as unequivocally bad, indicative of an economy weakening faster and worse than expected. If inflation was the economic ‘shock’ for most investors in 2022, what might be the odds of rising unemployment having a similar impact in 2023? As recession bites, this will impact consumer sentiment too. The US savings rate is the lowest it has been in almost sixty years. Accumulated savings may dry up just as the full effect of the Fed’s hikes hit economy activity. As Jerome Powell, the Fed Chair, notes, “monetary policy works with uncertain lags.”   

Against this background, investors continue to be surprised by the hawkish stance adopted by the Federal Reserve. The disconnect is that the market still expects the Fed to start easing in 2023, while the US Central Bank has given no indication to this effect. CPI inflation in the US may have been ‘only’ 7.1% last month relative to 7.7% in the prior period, but it remains a long way from its stated 2% target. Eurozone inflation is even further from this objective, at 10.1% last reported. No surprise then that Jerome Powell says “there is more work to be done.” We all know that forecasting inflation is hard, but the jury is still out on how inflation comes under control.

There is no logic for the Fed to sound less bearish while inflation levels and expectations are still high. For now the Fed wants to maintain optionality, not ease policy. Put another way, why undermine hard-fought credibility and engender reputational risk? History shows that easing too early would likely be a terrible mistake. Before the Fed can become more dovish, in our view, it would need to see cooling in the labour market and material slack in the economy. Obviously the Central Bank has a dual mandate and if both inflation and growth start to fall, then its calculus may change. If investors surely have learned anything, then it is simply don’t fight the Fed. Hawkishness is necessarily in the eye of the beholder.

However, we believe it is possible to be constructive on 2023’s prospects, even in light of a likely recession. Sure, the path forward will be extremely volatile and fraught with risk, but rebounds can happen very quickly, especially since equity markets tend to bottom long before either the real economy or earnings estimates do. As fast as inflation rose, it may fall back, particularly if exogenous pandemic-inspired effects drove the initial surge. Inflation could be replaced by disinflation in 2023.  More importantly, there is little point in trying to get the timing exactly right. With lots of cash on the sidelines and risk aversion levels high, our counsel is for steady and emotionless deployment.  

Our thesis is that more bullish market fundamentals should start to assert themselves as 2023 develops, and particularly in the latter part of the year. It is possible to envisage a scenario of asset price rebounds as Central Banks slow and eventually cease their monetary tightening campaigns. Sure, any recession and subsequent recovery will be non-linear, implying that markets may well be as erratic in 2023 as they were in 2022. Corporate earnings estimates are clearly at risk – not every business has seen a possible recession fully discounted in its forward estimates – but this may be to miss the point. Multiples could expand simply from monetary policy becoming relatively less tight.  

The last twelve months have, of course, shown the dangers in trying to make (too accurate) predictions, especially if these can be undermined by exogenous factors. Any investment outlook also probably needs to take into account the still elevated levels of geopolitical risk. Several taboos in 2022 were also broken in terms of how trade was used as a weapon – think of US policy action towards Russia. This sets 2023 up to be a year in which countries may test new ways to weaponise their economic advantages. China also remains a major wildcard. While almost every other major economy globally is still tightening monetary policy in the face of slowing economic growth, China appears to be out of sync in this respect and may benefit should its economy reopen (post zero-COVID). In this scenario, other emerging markets may also prosper.

What does seem certain is that we are not going back to the ‘easy’ era of low inflation and interest rates from the 2010s any time soon. Viewed in a broader historic context, this period may come to be seen as the exception rather than the rule. From our perspective, the new normal will be to accept no consistency of leadership in terms of investment style. Volatility should not be seen as a risk when buying assets on a long-term view. Embrace a diversified approach and remain nimble.

Alex Gunz, Fund Manager, Heptagon Capital