Many investors will likely wish to forget 2022. They will mostly remember it for Russia’s invasion of Ukraine sending shockwaves around the world’s financial markets and the sharply rising interest rates that created major headwinds for equities and especially bonds. Will 2023 offer more of the same, or do better times lie ahead? Will the bad news lessen or cease to allow global markets to react more positively?
Inflation, and how far central banks would raise interest rates to tackle it, was the key question in 2022. Central banks will continue to walk a tightrope between doing too much or too little monetary tightening. But with interest rates likely peaking and even falling, 2023 is more likely to see investors focus on companies’ fundamentals, including earnings and financial strength.
We anticipate inflation will edge down in 2023 as the rolling base effects from Covid shutdowns, changes in consumer behaviour and the energy price shocks work through the system, with oil and gas prices having already fallen. This will enable central banks to ease off on rate hikes. While a slowdown in economic activity in 2023 is a broad worry, we believe that the global economy remains on a solid footing and the recession will be a ‘small r’ one rather than a protracted event.
Market prices have reset substantially in 2022, most notably in fixed income markets with government bond yields moving up from their rock bottom levels. The overarching theme in fixed income markets in 2022 was the extreme interest rate risk that condensed into a few weeks what could have been a multi-year grind upwards in yields from their very low base. Investors with the greatest weight in fixed income were the most impacted by these market moves, making low risk portfolios look temporarily high risk because of their interest rate sensitivity.
Yields available on both government and corporate debt are now around more normal, long-term levels and are significantly more rewarding than they have been in recent years. In particular, high yield (HY) bonds offer very attractive spreads versus government bonds that will provide a buffer against inflation and the risk of companies defaulting on their debts in an economic slowdown. Global HY spreads are presently around 500 basis points, which is comparable to levels seen in 2016 and the Covid pandemic. Yields-to-worst levels are just shy of 9%.
Such spreads are sufficiently rewarding to compensate for potentially higher default levels. There is more risk of bankruptcy in this market in 2023, especially if conditions worsen, which we believe means cautious and active managers are more suited to this environment.
We expect to see an uptick in defaults in credit markets in 2023. The longer we are in a recession, the greater the chance of defaults but the indications are that it will be reasonably contained. Some sectors are better placed to deal with a downturn. Energy companies, for example, are cash-rich but others, such as consumer discretionary stocks like Peloton, will be at risk.
We are at a point in time, however, when it is possible to buy even low-risk securities with attractive yields. It is the first time in a while that sovereign yields are close to long-term ‘normal’ levels and those of equities.
Equity markets look attractively valued now too following their selloffs this year and having priced in aggressive monetary tightening. The obvious risk in 2023 is further interest rate tightening, but if inflation subsides – and there has been growing evidence of this in the closing months of 2022 – then this risk will lessen.
After the astounding outperformance delivered by US technology growth stocks during the 2010s, we expect that in 2023 many assets will continue reverting to performances that are more in line with longer-term trends and fundamentals. Value has already recovered some ground, mainly in energy stocks, but there is still further to go.
Over time, for example, we would expect the strong economic growth trajectory, favourable demographics, governance improvements and risk premiums of emerging markets will bear fruit for the patient investor. We are also optimistic over the longer term that investors in small cap companies will be rewarded, given their nimbleness and growth profile. Emerging markets and small cap equities will be geared into any economic recovery in 2023.
The geopolitical risks to markets cannot be dismissed. The war in Ukraine has been a stark warning of this, together with the growing tensions between the US and China. The latter has its domestic issues too, as shown by the social unrest over its zero-Covid policy. While this had limited impact on markets, they are still sensitive to political risks, especially with regards to the consequences for supply chains and inflation.
Tail risks remain and while we do not envisage a raging bull market in 2023, we do anticipate equities will regain their powers, especially in emerging markets and small caps, and HY credit generally will do well. Bond yields are unlikely to fall significantly, despite a likely easing of inflation, given they are at fair value.
Trying to predict when asset classes will outperform is a hazardous pursuit. But being laser-focused on a handful of assets just because they might have done well in the past would be a mistake as well. We believe it is crucial to adopt a long-term view to investing and to spread risks via a broadly diversified investment portfolio to address market volatility and reap rewards from across the asset classes.
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