We would like to take the opportunity to thank you for entrusting your capital with us this year and look forward to another year of partnership.
2022 in rear-view
In hindsight 2022 was one of the strangest years in recent history. After a brief respite from the previous covid-induced turmoil, markets were rattled by a Russian invasion of Ukraine, a global energy crisis, a surge in inflation not seen for nearly 50 years, an aggressive central bank hiking program that sent global stocks plunging, a rapid cooling of global property markets, an ill-timed UK budget error, a Chinese covid-zero policy with serious knock-on effects, and the implosion of FTX which thrust an already troubled crypto world into crisis. Stress events are certainly not rare, but what is rare is the simultaneous sell-off across so many asset classes. Most crucially, equities and bonds both recorded heavy losses, something which has only happened 11 times previously in the last 150 years, while the total return on US treasuries was the worst in 150 years.
Whilst an extremely rare phenomenon, the cause-and-effect dynamics are clear, and the starting point was not the invasion of Ukraine; that was merely a catalyst. One can make a strong argument that inflation would have surged in any event, just not as rapidly and aggressively. The reason goes back to the massive policy errors made at the onset of the pandemic. At the start of 2020 the world had settled into a groove that many thought was not possible long-term: Low interest rates, abundant liquidity, low but positive inflation, healthy labour market conditions and fairly consistent GDP growth. The covid-crisis itself was so short-lived from a financial point of view that it barely registered.
The consequences of the world’s management of covid are, however, extremely far reaching and were only starting to be felt in 2022. One thing one does not do to an extremely complex, delicately balanced global monetary system that depends on infinitely low inflation, is flood it with highly inflationary liquidity, yet we did just that. Concurrently, also due to covid, the world was deglobalized and supply chains were significantly disrupted. These 2 factors were the entire reason why the incredibly erroneous “transitory inflation” narrative ever emerged in the first place. Perhaps there was a medium-term path out of that tight corner, but the war in Ukraine was the final nail in the coffin. Everything that followed was quite predictable, from the surges in interest rates, to the sell-off in equities and bonds, to the cooling of property markets.
Looking ahead to 2023
It is important to recap the above progression as it underlines the most central issue investors face in 2023, and for many years beyond that: The era of cheap and abundant liquidity is over. This is a paradigm shift, the era that succeeds the one we have been accustomed to since 2008. As a result, the way we think about investing and allocating portfolios must change. Many of the effects of the above quagmire are yet to play out. For example, we have not seen a major impact on consumer spending, corporate profitability, or delinquencies. It is dangerous to draw a solid black line under 2022 and position for a “rebound year” in 2023. Certainly, longer-term opportunities are starting to emerge (not least in higher quality credit which is seeing the highest yields in more than 10 years), but it is quite possible that 2023 will be a year of halves, in more ways than one.
Firstly, it is quite likely that we will see the re-emergence of some of the volatility seen during 2022 in the first couple of months of the year. We may get some false starts on inflation data. We are likely to see a few more twists and turns in the war, and we are yet to see solid bottoming signals for both equities and bonds. Tempting as it is to pile back into tech mega caps whose valuations are so intrinsically linked to long-term discount rates, it is quite possible that we will see further declines until we have actually reached terminal interest rates. It is also likely to be a year of two halves geographically, given the huge disparities between inflation timing and energy dependency between east and west, and even between the US and Europe. Europe and the UK will almost certainly see peak inflation well after the US, and it is no coincidence that the Fed is further along its hiking cycle, and also no coincidence that US equities have been significantly harder hit (they have already priced in a lot of the pain). The adage “fools rush in” comes to mind; the simple resetting of the Gregorian calendar should not lull us into a safe sense of security just yet.
Rather, we should be focused on fundamental market data and signals. These include:
- A tangible slowdown of the rate of tightening by the Fed in response to a clearer downward trend in inflation
- A significant decrease in earnings estimates (Q1 is likely to be underwhelming in terms of earnings) which will reinforce that equity markets have bottomed. It is normal for this slow-down to lag tightening conditions, so potential decreases could happen later in 2023
- Recession: Incredibly more than half of market participants still believe a soft landing is possible in the US, but either way we are likely to have some form of recession in the UK and parts of Europe, just perhaps not on aggregate globally, which is purely down to many Asian economies still growing (albeit more slowly)
- The direction of travel for post-pandemic-era QE programs. The impact of the Fed and other central banks reversing direction has had a huge impact on risk assets, yet is a much less central narrative than the increase in rates.
Point 4 potentially has the greatest impact as it is currently the hardest to predict. Inflation and rates increases have all but been baked in at this point. While recession risk has less consensus, it is at this point hardly capable of providing a significant shock. QT, however, or the potential of renewed QE at some stage could drastically change the overall picture. We need to remember that central banks currently favour a slowdown in housing and labour markets as it helps them with their inflation battle. They are probably willing to risk shallow recessions as well. What happens after inflation is no longer a threat, particularly if this coincides with recession, however, is still ambiguous. To reminds us how impactful QE has been compared to interest rates in recent years all we need to do is look at growth mega-caps. Post-covid to 2021 many of these market caps tripled and quadrupled. That was against a backdrop where interest rates were effectively unchanged. We seem to attribute much of the valuation decreases solely to interest rate increases (companies like Meta and Netflix being down 80% from the peak for example). By that rational a stabilisation, or at some stage perhaps a slight decrease in rates would cause these assets to rally significantly, and that is certainly a scenario that is being touted. But it does fail to take into account the liquidity angle. How is a massive rally meant to be sustained when trillions of dollars of liquidity are no longer fuelling it?
Major risks and opportunities next year
There is some room for cautious optimism. Simply stated, the recession fears we face in 2023 are likely less ominous and already more priced in than the toxic inflation impact that surprised markets in 2022. Having said that, a full “risk-on” approach is unwarranted in our opinion. Below are some of the risks and opportunities worth considering:
- The significant rise in interest rates means fixed-income yield is back. Given some of the above headwinds, however, it is crucial to be focused on high quality credits and average in as we approach terminal rates.
- The positive correlation between equities and bonds will ease in 2023, although the aforementioned paradigm shift implies that investing will not be a simple case of reverting back to classic 60/40 allocations in 2023. There is a scenario where both global equities and bonds are trading lower again in periodically in 2023, despite the sharp declines seen this year.
- We have high conviction that global property markets will come under serious pressure (this is something we have been calling for since the end of 2021). With patience this will lead to opportunities later in the year. We divested the last of our property funds and REITS in 2021 and are not re-opening those positions any time soon.
- The outlook for equities is less clear. Weak growth could drag stock markets even lower before we reach a bottom. Valuations have become more attractive and that provides a good medium to long-term opportunity. Our preference remains on quality companies with strong cash flows and balance sheets. Overall, we continue to position defensively in equities, particularly in the first half of the year. Value is primed to outperform growth, particularly as a number of high-quality companies have essentially fallen into the value bucket. Tech mega caps that are dependent on abundant liquidity are likely to run out of steam at some point in 2023.
- Private equity risk has not been discounted enough. While we are in a slowly down-trending environment there have been no significant moves. During the last investment cycle a lot of leverage has moved into PE (not too dissimilar to leverage in the housing market in 2008), yet PE is not mark-to-marketed, and managers are notoriously bad at marking their assets down.
- The US Dollar will almost certainly perform very poorly compared to 2022, particularly in the first half of the year. The main reason for this is that 2023 is highly likely to be less “risk-off” than 2022. The Fed is also more likely to adopt a dovish pivot sooner than other central banks.
Summary
There is a high likelihood that 2023 will be a less challenging year than 2022, as we are unlikely to see the same measure of shocks again. The prevailing narrative is likely to be the tug-of-war between reducing inflation and risking recession. Risk assets are now cheaper than they were at the start of 2022, but they haven’t crashed in the order they did in 2008 for example (the SP500 is down 20% in 2022, it halved in 2008). Some challenges remain. Most notably many are predicting soft landings and the avoidance of recessions, while we are not. It is possible that further discounts will be priced in if recession becomes the central scenario. A full “risk-on” approach is not warranted as we do not anticipate a 2009-style rebound. Given the resilience of many major economies, particularly the US, and the overall strength of labour markets, it is likely that recessions have delayed onsets.
Overall, our approach will thus not be too dissimilar to that taken in 2022, which was correct in hindsight: Defensive positioning, avoidance of high beta plays, and sacrificing large potential upsides in order to protect against downside risks. In contrast to 2022, however, we will gradually re-enter fixed income (high quality credits and diversified funds) and take slightly more directional equity exposure (skewed towards value). We will also actively reduce exposure to the dollar, which we believe will almost certainly struggle particularly in the first half of 2023. Duration will be kept reasonably short as we are likely to see further interest rate hikes globally, and secondary market liquidity will continue to be prioritised in order to remain nimble in the event that base case scenarios shift materially.