|By Georgina Taylor, Head of Multi-Asset, and Sebastian MacKay, Multi-Asset fund manager, Invesco|
Central to the poor performance of both equities and bonds in 2022 was the scale and the persistence of the inflation shock and the resulting abrupt switch in monetary policy.
The need for central banks to withdraw liquidity to combat inflation removed a key pillar of support that we had all become so comfortably accustomed to.
The behaviour of Central Banks, investors, consumers and corporates is going to be a key determinant of the outcome for financial markets in 2023. The change in behaviour required, in our view, will take time given the seismic shift in investment regime in 2022. Some participants will remain anchored in the past for quite some time, others will adjust more rapidly. It is this push-pull dynamic that will underpin ongoing volatility for markets in 2023 and beyond.
Looking ahead, the prospects for inflation have started to improve – pipeline price pressures are easing, supply chains blockages are clearing and demand is weakening. As a result, the pressure on central banks to tighten policy is, gradually, beginning to ease. Does this mean that 2023 will be a bumper year for equities and bonds? Or perhaps just bumpy?
Unfortunately, it’s more likely to be the latter. Monetary policy operates with long lags, meaning that tighter policy in 2022 will still be influencing the economy and asset prices in 2023. After a long period of extremely low interest rates, overall levels of debt remain high, despite some deleveraging in the household sector. As shown by the UK pensions crisis in the autumn of 2022, the jump in interest rates has potential to cause ongoing disruption.
Another concern is that even after double digit declines in 2022, equity prices remain underpinned by earnings forecasts that are unlikely to be achieved in a recessionary environment. If growth does disappoint in a meaningful way, then equities could see another leg lower before the bottom.
Moreover, the outperformance of financial assets over the economy since the GFC was arguably driven by central bank accommodation. A structural removal of central bank support suggests that the gap between economic and financial asset performance may start to close.
Figure 1: The great reset is under way between economic growth and financial assets
Source: Bloomberg as at 31 December 2022.
What does it all mean for investors?
Previous playbooks may not offer the answers to how the next phase will unfold for economies and asset prices due to the unusual confluence of events over the last few decades and the changing nature going forward.
There were a couple of false starts in 2022 when market participants started to believe that less restrictive monetary policy would fuel a sustained equity market recovery. This is the ‘anchoring’ of investors to the previous investment regime that will take time to pick apart and is a behavioural aspect of investing that we all must be aware of.
2023 may see the grieving process play out for that previous market regime followed by a reluctant acceptance. The first part of the year could see ongoing disappointment that financial markets are not reverting to type and reflecting performance and correlations that market participants understand and can process.
There are numerous knock-on effects of this shift in regime. Investors may need to be more tactical in riding the waves in sentiment around which investment regime ultimately takes hold. In addition, how one approaches portfolio construction is subject to change. A fundamental area which we all need to be aware of is that risk models are very explicitly and directly being challenged.
Don’t Keep Calm and Carry On
We start 2023 with a high level of macro uncertainty, but amidst that uncertainty investment opportunities are emerging. It may not be the one-way trade in the S&P 500 that investors have come to enjoy, but the good news is that there are still good return opportunities across markets for macro investors with flexibility.
Now that interest rates have risen, the concept of TINA ‘there is no alternative’ seems a less valid justification for a positive view on equities. Higher yields available across cash, bonds, and credit are leaving equities lagging some way behind and are leading investors to believe that ‘there are reasonable alternatives’ (enter TARA stage left). This doesn’t mean equities will stay on the side lines forever, but it does mean the hurdle rate for investing just got higher.
Within our portfolios, we maintain a cautious and selective stance on equities near term and prefer credit instead as our risk asset of choice. Yields on credit are now very attractive and whilst we believe the earnings downgrade cycle is still to come, balance sheets remain strong meaning that defaults should remain relatively contained.
Duration has been painful in 2022 but as we transition to a world of slower policy tightening and increased recession risks, the traditional inverse equity/bond correlation can be restored. Selectivity is once again key though. Areas of the rates market such as Australia where there is a stronger feed through mechanism from higher interest rates to economic growth look particularly attractive.
Outside of more traditional asset classes, multi asset portfolios with a wider and more flexible “toolkit” are best positioned to benefit from material anomalies that have emerged in 2022. Being long the Japanese yen for instance is one such example after one of the most brutal years for the currency in history. Relative value trades or in some cases, even selling certain parts of the equity market look like an interesting diversifying tool in this environment.