Chris Ford, Fund Manager, Sanlam Global Artificial Intelligence Fund:
After a year to forget for both bond and equity investors, attention inevitably turns to 2023 and there are some key trends that we can discern already.
The first is that the layoffs we have seen recently in the technology space are unlikely to be finished – from where we sit, the outlook in IT services (and particularly software) is not rosy.
The second is that the equity market has turned more positive on some of the early cyclicals. Expectations have been reset and the market tentatively hopes revised levels of guidance could be met in 2023. At any rate, early cycle bellwethers, for example, in the semiconductor space (such as Advantest) are no longer trading anywhere near trough valuation multiples.
The third is that the relationship between the US and China continues to deteriorate, with Activision Blizzard severing ties with NetEase; another example of the West abandoning its commercial links to China. Increasingly we expect China to forge its own (separate) path in years to come, even if that means duplicating technology manufacturing systems.
Monetary policy operates with a lag and as a result 2023 might be a challenging one as far as the ‘real’ economy is concerned; inflation should begin to roll over but for consumers and businesses there will be the chastening experience of having to re-finance debt at materially higher ‘risk-free’ rates.
For AI as a theme, we remain highly constructive on the short-, medium- and long-term outlook. We have always regarded AI as a transformational investment theme and, even with the turmoil in markets this year, there has been nothing we have seen in 2022 that has led us to question the durability or relevance of AI. More and more companies are engaging with AI and we are rapidly approaching the point where the vast majority company management teams will have a basic responsibility to consider the impact of AI and automation in order to be regarded as responsible and credible custodians of their shareholders’ capital.
We also continue to think that the world faces profound economic, social and environmental challenges, and that waiting for significant changes in human nature to alleviate some of the worst problems is perhaps unrealistic – climate change conferences like COP27 have been long on rhetoric but short on delivery and it is clear to us that time is beginning to run out. Like DeepMind’s co-founder Demis Hassabis, we think it makes sense to focus on the quantum leap that can provided by AI, rather than waiting for exponential improvements in human behaviour that in reality may never transpire, even with politicians’ best efforts.
Lastly, AI continues to make inroads in the most unexpected areas – humans have been the only art creators on Earth for tens of thousands of years, but AI art produced by the likes of Stable Diffusion and DALL-E 2 has started to change to change the parameters of what is possible in the art world. If you have ever wanted a picture of a slightly depressed cat in a mountain landscape in the style of JMW Turner, there is an AI out there that can cater for your needs: Incoherent, creepy and gorgeous: we asked six leading artists to make work using AI – and here are the results.
Peter Doherty, Fund Manager, Sanlam Hybrid Capital Bond Fund:
We believe the start of 2023 offers an attractive entry point for selective parts of the credit markets. Total returns should be robust: Returns were abysmal for credit in 2022, with interest rate moves the largest factor. Starting levels are much more attractive from a yield standpoint and provide room for error, whether it is spread widening in a recession or a rise in downgrades and defaults.
We are however expecting a higher frequency of defaults and idiosyncratic risks in Corporate Bonds and Leveraged Finance. The leading trade credit insurer Allianz Trade anticipates significant increases in insolvencies around the world from the US, to Europe and China. The three main reasons for the expected increase in insolvencies it gives are: 1. The major profitability shock for European firms due to the energy crisis, 2. the interest rate shock and higher wage bill due to a sharp increase in inflation, and 3. the limited intervention expected from governments.
For US High Yield amid a challenging macro environment, risk assets will face further pressure next year, though spreads should peak in the first half and we expect them to recover somewhat by year-end resulting in total returns of 4.0-5.0% (not guaranteed).
Though they have remained near historically low levels post-COVID, there are many factors pointing to higher default rates within high yield and loans next year. We think around 5-6% on an issuer-weighted basis.
Corporate fundamentals will be challenged by slowing growth globally, with a recession in the developed economies. This will create a tough operating environment for corporates. Furthermore, US non-financial revenue growth is more correlated to European GDP now than pre-GFC. We believe that corporate fundamentals will continue to deteriorate in an adverse operating environment.
We plan to remain invested in high quality, investment grade companies which can sell assets, reduce headcount, and raise equity long before asking bondholders to share losses; and also to pick up additional yield by investing down the capital structure into Tier 1 / Tier 2 Bank and Insurance Hybrid Capital.
US, EU and UK Bank and Insurance company balance sheets will come under some pressure as asset quality and values deteriorate but current excess capital and robust risk management offer a substantial cushion. With insolvencies set to increase next year in a potential recession, European banks are likely to experience an increase in impairments. Higher impairments should be broadly manageable for most banks, provided the unemployment rate does not spike up dramatically. This is due to banks having decent starting capital positions, strong asset quality metrics and some existing impairment overlays put in place for the COVID pandemic.
Pieter Fourie, Fund Manager, Sanlam Global High Quality Fund:
High inflation and rising bond yields were responsible for the 2022 equity bear market, however in our opinion, both factors may reverse next year. And while equity bears argue that leading economic indicators point to rising odds of the U.S. and European economies heading into recession, we believe that there are some mitigating factors which may help the global economy including: a weakening dollar; falling inflation expectations and interest rates peaking by the second quarter of 2023.
The general direction of a weakening U.S. dollar should alleviate pressure on emerging markets and so we retain our overweight position. Emerging market equities were down by 42% by late October 2022 from their peak in February 2021. We have been adding to our emerging market exposure over the last 18 months in anticipation of a better environment for this region in 2023.
Our optimism for Asian equities is based on our belief that equities are forward looking and typically turn 6-9 months before the economy. As the Chinese economy gradually starts to accelerate this should ease concerns that the economy will remain in a state of paralysis. Policy reflation in China could be more effective as zero-Covid restrictions are gradually phased out. We like companies like Yum China and Samsung Electronics, due to very long-term sustainable growth dynamics within the industries they operate in.
Within the U.S. in 2022 there has been a rush to stable, predictable businesses with mostly dollar earnings like healthcare insurance business Elevance. Due to very expensive valuation levels (after strong outperformance) we sold Elevance and our attention is now on faster growing U.S. based companies and select Asian names.
At the beginning of 2022 multinational growth stocks were under pressure due to their expensive equity valuations: a strong dollar leading to negative earnings revisions and the lasting impact of travel restrictions on revenue acceleration and staff shortages. A weakening dollar, fewer travel restrictions and valuation multiples back to relatively attractive levels means we are positive on companies like Edwards Lifesciences, Thermo Fisher and Visa. As valuation levels stabilise we also believe new positions like Intuit and London Stock Exchange Group should demonstrate the benefits of being in predictable industries with strong recurring revenues.
Mark Whitehead, Fund Manager, Sanlam Sustainable Global Dividend Fund:
In 2023 we expect more criticism of companies’ sustainability efforts and expect more funds changing their sustainability claims and accreditation. It’s likely that regulators will tighten up on their scrutiny of all things sustainability related. Strong reporting processes do not necessarily mean strong sustainability credentials, and strong sustainability credentials can be masked by poor reporting processes. Nothing beats looking under the bonnet and doing your own due diligence.
2022, like 2021, was a good year for dividend investors. Gross dividends are likely to have grown over 10% again as the recovery following a weak 2020, continues. Strong free cash flow growth and strong balance sheets are key to the delivery of sustainable dividend growth. In 2023 we expect free cash flow growth to be harder to come by. Profitability is likely to suffer at the hands of recessionary or slow growth environments. Higher interest rates mean debt is more expensive. Continuing supply chain blockages will likely mean higher levels of inventories and elevated inflation will mean inventories held are more highly priced. These factors are all headwinds for free cash flow growth. In 2023 dividend growth may not match that of 2022 and 2021.
In 2023 our focus, as always, will be on ensuring our portfolio holdings have a combination of strong dividend and sustainability credentials and all that entails. At the start of 2022 the MSCI World Index was at an historic high and has since declined. This has been in part due to the starting valuations; the declining macro and geopolitical environment; and to higher discount rates. Factors which are interlinked. How these factors play out in 2023 will be key to the direction of travel of equity markets.
Guillaume Desqueyroux, Fund Manager, Sanlam Credit Fund:
While the recession is already/nearly here in the UK/Europe, it still seems premature in my opinion to extend into too much duration. Nor do you want to fight the Fed too early. While I’m cognisant that the front end of the yield curve will keep bearing the pressure of the remaining hikes, the strong pick-up you can achieve into the short part of the curve justifies the risk. There are two ways to consider the credit markets for next year, each with its own compelling arguments.
The glass half empty view sees the UK Budget in November as having confirmed the astronomical level of Gilts to be issued by the UK government despite various fiscal measures, plus the move to quantitative tightening (QT), with the BoE selling corporate bonds. The former pushing risk-free rate higher, the latter widening the spread. And a similar pattern can be defined for the ECB and its various governments, where central bankers will gradually test the markets for its QT.
If you see the glass half full, you will point out the current valuations reflecting the already higher rates and spreads represent a great opportunity to lock in impressive yields while reallocating your portfolio from riskier/uncertain assets. The flow dynamics will have to adjust to the new risk appetite given the now sizeable carry from bonds.
When focusing on fundamental research, it is important to assess the key features of the company that will come through this tough environment with all its “doubts” and even benefit from it. Some will be companies with a strong balance sheet and most importantly, multiple entry points in the value chain. For the companies which didn’t fix issues in previous years, the problems may build up. 2023 is expected to be a year of more normalised default rate given the perfect recipe of recessionary environment and higher refinancing costs for companies. It will clear the “doubts”.
At sector level, I also think that the fundamentals for the financials are very appealing. While I am comfortable with their capital strength and the tailwind of higher rates, naturally comes the question of the development of non-performing loans for UK and continental banks. The big squeeze has been more obvious in the UK given the structure of the mortgage market. With borrowers exposed to floating rate (after a fixed period of 2-to-5 years), the rate hike will impact a third of borrowers year after year on average.
Finally, financial rigour is the new motto and governments are not expected to be as interventionist as during the pandemic. Having said that, it would not be impossible to reconsider the fiscal measures to protect consumers, borrowers, workers and companies in time of stress. I believe that 2023 will present a nice set of features (and “doubts”) to generate unique investment ideas as we travel through 2023.