Sunil Krishnan looks back at 2022, and outlines what multi-asset investors should look out for in 2023.
Read this article to understand:
- What to expect for bond markets, and the relationship between bonds and equities
- How to position portfolios for inflation
- The key themes that will affect global growth in 2023
Looking back at 2022, the big economic story was clearly inflation; a problem exacerbated by the Russian invasion of Ukraine, which eventually led to central banks having to admit defeat on the transitory inflation narrative.
2022 saw the worst equity and bond performance since modern indices began
But the real story of 2022 for investors was the worst equity and bond performance since modern indices began in the early 1970s, set against a backdrop of higher cash rates and inflation levels not seen for thirty years. This hamstrung portfolios throughout the year and raised five key questions on what investors should look out for in 2023.
Figure 1. Equities and bonds have not lost ground together in over 45 years (Annual US$ total return)
Source: Bloomberg. Data as of December 10, 2022
1. If inflation was the dominant theme in 2022, what does it mean for returns in 2023?
The good news: inflation should peak in the next few months, as evidenced by slowing goods price inflation and energy prices. In the United States, housing and housing services inflation are a key component of consumer price indices and are also slowing. Between now and the end of the first quarter, both year-on-year and monthly rates of inflation are likely to slow in most developed economies.
As this unfolds, investors and central banks will keep a close watch on the rest of the service sector, which is typically driven by labour costs. A key question is whether inflation will fall to levels that allow central banks to stabilise interest rates. Another is whether the ultimate path of rates slows the economy modestly or leads to a deeper recession, threatening company profits.
The bad news is that, on balance, investors may still be underestimating the risk inflation gets stuck on the way down, leading to renewed interest rate rises that could hamper company earnings. The key risks we are watching most closely are sticky components of inflation, particularly wages, and evidence of declines in earnings.
For markets, this means that, unless and until growth weakens to a point where central banks start reducing rates, there will still be episodes where equities and bonds move in tandem.
Over the next few quarters, we don't expect a return to the negative correlation between equities and bonds unless a deep economic downturn leads to much lower interest rates – a possibility in 2023 but not our base case.
2. Is high risk less risky than low risk?
For over a decade, bonds were the obvious choice for investors looking for liquid assets less volatile than equities. Not only did they deliver on their liquidity and low-volatility promises, they also saw huge capital gains once central bank quantitative easing began. This was an unexpected bonus but probably made investors complacent about prospective bond returns.
Bond markets will remain volatile, although we expect 2023 to be a better year
In contrast, 2022 was a poor year for bonds – one of the worst on record. Looking ahead, bond markets will remain volatile, although we expect 2023 to be a better year.
While there is still some two-way risk to bonds – for instance, if investors are disappointed that central banks fail to deliver rapid rate cuts – the asset class is now in a position of much better value. For example, the ten-year Treasury yield was 0.5 per cent in August 2020 and is now above 3.5 per cent.1 And one of the nice features of bonds is that, when prices drop, leading to a rise in yields, it mechanically leads to an increase in expected returns. We therefore expect a better outcome for bonds, and the fixed income element of cautious funds, in 2023 than we saw in 2022.
3. Is the 60/40 approach broken?
As we explained in July 2022, we still see a long-term structural role for bonds in multi-asset portfolios, even though it is important to avoid concentration risk (see ‘Multi-asset allocation views: Is this the end of the 60/40 strategy?’).2
Yet if your expectation is that bonds will rally every time equities wobble, smoothing even short-term volatility, then yes, the 60/40 model is broken. That past experience depended on central banks rushing to cut rates to cushion the stock market every time it fell. They no longer have the freedom to do this.
Our view is that bonds are likely to behave better in the coming years and be a source of steadier long-term returns. This means a 60/40 strategy will still comprise assets that are very liquid, generally inexpensive to get exposure to, not completely driven by the same factors, and therefore less than perfectly correlated. That brings useful diversification.
Equity valuations are still pricing in a relatively benign and shallow economic slowdown in 2023, which could be challenging for stocks in the first half. The asset class remains key to long-term wealth creation, but the associated noise could be high in the near term, so it will be important to be selective.
4. How do you protect against inflation in a multi-asset portfolio?
Not all inflation is the same. Different sources of inflation can arise against different backdrops in growth and interest rates; even within a single era of high inflation, the relationship between inflation, growth and rates can change. For example, the 1970s and 1980s can be viewed as one inflationary episode, but its first part was characterised by very low real interest rates, while in the 1980s, interest rates rose well above the rate of inflation, with a sharply braking effect on growth.
The need to be adaptable rather than setting a strategy and assuming it will work for all kinds of inflation
One lesson from this is the need to be adaptable rather than setting a strategy and assuming it will work for all kinds of inflation. Cash is valuable, despite its negative real interest rate, because it helps with the readjustment and reorientation of portfolios. In our tactical armoury, being able to put cash to work at the right time is a weapon we will use. It allows us to use higher cash balances to protect portfolios and deploy them when there are good opportunities, so clients can escape the burden of trying to time their investments.
Another lesson is that it is worth diversifying, not naively, but by taking exposure to assets better positioned for an inflationary and volatile period, such as absolute return funds. We also like parts of the equity market that enjoy good pricing and support for margins, which for us includes healthcare and energy.
5. What should investors expect for global growth next year?
As we head into 2023, the growth picture is differentiated across geographies.
From a UK and European perspective, it is not about whether a recession might emerge, but whether we are already in one. Confidence data in particular are consistent with an economic contraction already in effect; notable forecasters such as the Bank of England expect we will remain in this state for the whole of next year.
An earnings decline next year is still a reasonable probability, not yet reflected in consensus forecasts
In contrast, the US has proved surprisingly resilient, probably boosted by the fact households and companies came out of COVID-19 with stronger balance sheets than they went in. In 2023, the call on a US recession feels 50/50, although company earnings could be challenged whichever side the coin comes down. We think an earnings decline next year is still a reasonable probability, not yet reflected in consensus forecasts.
In China, investors seem to be constantly rethinking whether the government will remove its zero-COVID policy. Our base case remains that reopening will continue gradually and will have a noticeable effect on economic activity by the second quarter of 2023. That should provide support for demand globally and limit the scope for a deep downturn.
However, the way a reopening affects Chinese companies and emerging-market equities will not just be dictated by the zero-COVID policy, but also by the relationship the Chinese state wants to have with its companies. This still points towards rebalancing power away from large firms, which constitutes a headwind for the Chinese corporate sector.