Writing an outlook for the year ahead might be viewed as an exercise in damage limitation: don't stick your neck out and go with the consensus.
But Royal London Asset Management has never been a consensus asset manager. Last year, we highlighted three main concerns: geopolitical risk was probably not properly priced into markets; inflation was probably not transitory; and finally, asset prices were quite elevated while the conditions for a pullback had increased.
A simple prediction for 2023 would be that markets now do understand geopolitical risk properly, are fully aware of inflation and market falls mean that asset prices are better value. But markets are never quite that simple.
My basic belief for 2023 is that we see a degree of normalisation after a volatile 2022. I'm cognisant that economically things will, certainly from a data perspective, get worse before they get better. Markets have rallied in Q4 2022 in anticipation of a peak in the US interest rate cycle, but for example, if we saw an escalation in the war in Ukraine, further deterioration with China, or mismanagement of interest rate policy by the Fed, things would get worse before they get better. While all of these factors are possible, markets, as discounting mechanisms, are already reflecting quite a lot of bad news: whilst credit spreads are not back to previous crisis peaks and we have not seen a significant increase in default rates, interest rate increases and spread widening mean that yields in many fixed income asset classes are the most attractive they have been since the Global Financial Crisis.
If this sounds dangerously like ‘RLAM CIO predicts market turn', then I would say that calling turning points is difficult, and generally quite high risk - we've all seen the effect on 10-year investment returns if you missed the best 5/10 trading days. And we all recognise that markets do not move in a linear fashion.
Our job as investors of your capital is not to predict what will happen in 2023 - the events of the past three years alone have shown the futility of this (I didn't see many predicting a global pandemic, US insurrection and Russian invasion). Our job is to focus on the dozens of individual investment decisions we make each year on your behalf, and work on ways to tilt the odds in our favour, by marrying skilful investors with robust processes and strong support. Long-term investment success is based on identifying value and acquiring it, ensuring that we are getting the balance of risk and reward right for our clients. So what drives that risk/reward consideration for 2023?
Inflation is still top of the list
In economic terms, inflation has utterly dominated the agenda in 2022. First it was considered transitory, then simply a mathematical function of higher energy prices, but it is clearly more than that. Following a period of very low interest rates, quantitative easing (QE) and government intervention, it was naturally tempting to see the post-Covid period through the prism of the global financial crisis. That period also saw a large shock to economic growth, rates slashed by central banks, quantitative easing and massive government intervention, but little or no inflation. Of course, the main change this time is wages: after the GFC, wage growth was utterly anaemic; today it is not.
Writing this in the UK, on another strike day, I am all too aware that there is considerable upward pressure on wages. In every major economy in the west, public sector wage growth is constrained by a poor fiscal position, while private sector wage growth will struggle as profitability comes under pressure (more on that later): against this, workforces are facing significant cost of living increases and in some sectors, are looking at quite buoyant job markets.
However, it is worth noting that energy and commodities have been a large part of the recent rise in inflation. With oil now some 20% off its peak of around $110, London Metals Exchange inventories starting to rise and even grain exports easing, we have at least a partial fall in inflation already baked in.
Against this, we have had a strong deflationary trend pushing inflation lower for more than two decades - globalisation. Covid and Ukraine have showed us that the secure and free-flowing supply chains that are an essential foundation of that trend can no longer be counted on. For example, at the end of the third quarter, Ford had some 45,000 unfinished vehicles waiting on parts due to blockages in their global supply chain. Whilst it is too early to sound the death knell for globalisation we are already starting to see companies ‘reonshoring' production to reduce reliance on global supply chains, this will add to domestic labour demand.
Two stages of asset price decline
Bear markets usually go through two distinct phases. First, a de-rating where we see multiples fall, leading to somewhat counter-intuitive moves as companies announce decent earnings yet see their share price fall. This phase now largely feels complete. The second, as economic activity slows, driven by a fall or rebasing of earnings. We started to see earnings misses in the second half of 2022, and with economic growth slowing, earnings pressures are likely to persist in 2023.
One of the most important aspects of 2023 will be how companies - and investors - cope with high inflation. We have been in a low inflation environment for most of the last two decades, and many of today's business leaders are facing this for the first time. Companies that have pricing power and strong cost control could see significant earnings increases thanks to inflation-boosted revenues. More easily said than done of course, but this is the challenge all companies are facing and it will be interesting to see who can weather this particular storm.
Traditionally, an economic slowdown is a time to unload cyclicals and buy quality defensive growth and that may prove to be a good principle for 2023. As ever, understanding the underlying companies and what drives their earnings will be important. However, given the inflationary back drop and the rise in interest rates, the ability to grow and convert earnings in to free cashflow will be a critical focus and this may provide investment opportunities across industries. Just as the liquidity tide has lifted many corporate ‘boats' so, as it continues to go out in 2023, it will become clear who has sailed too close to the insolvency ‘rocks'. More than ever bottom up, research led active and engaged investment management will be critical for success in 2023.
A traditional and simple way to build a portfolio is to add a mix of equities and bonds. We think that investors wanting a true multi asset approach should also look at areas such as property and commodities but the reason that this approach has lasted as long as it has is because it often works. But not in 2022. The rise in bond yields not only dragged bond returns firmly into negative territory, but also those of equity markets - particularly the growth areas that are valued using long bond yields as a discount rate.
It's tempting to think that this means we need to look again at how to build portfolios. My own view is that we have to respect what happens in the bond and equity markets, and the interplay between them, but it is not a reason to rip up everything and start again.
Bond markets can obviously see more disruption, but yields are back at pre-GFC levels. Of course yields can go higher, but this is a much better starting level than we've seen in a decade. And with credit spreads wider, all-in yields are attractive and provide a better buffer for investors from default risk. For equity markets, the last couple of years have been as much about the change in the discount rate as corporate earnings and free cashflow generation. We believe that 2023 offers an excellent opportunity for bottom-up stock selection as the nuances of each business and their ability to manage and navigate the inflationary challenges they face need dedicated analysis rather than a macro-economic or cost of capital view.
An interesting lesson to take from 2022 was how quick and far markets can move. As a result, a strategy built on a point forecast is always subject to outlier events such as those seen this year. Looking to 2023, having a diverse asset allocation with a global lens should provide good opportunities to add value through tactical asset allocation. Given the themes I have noted, I believe it strengthens our underlying philosophy of being active managers and bottom up stock pickers: RLAM's investment teams will continue to make individual investment decisions that respect the macro backdrop, but do not defer to it.
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