2022 was a year marked by tumult, uncertainty, and fundamental shifts in the geopolitical, social, and investing landscape. Amid the fallout of the pandemic, the world continues working to establish a new status quo. Investors, consumers, businesses, and the international community have had to continually rethink the way they engage with one another. The world has had to digest the first major act of aggression by a global superpower since WWII, and the most legitimate threat of nuclear war in nearly as long. Europe was divorced from its primary source of oil and gas. China’s unrelenting Covid protocols led to further disruptions in global supply chains and the most salient political unrest the country has seen in decades. The second-order effects of these events prompted tremendous fiscal response from global central banks, leading to the highest levels of inflation in nearly half a century and necessitating further fiscal intervention that has left much of the world at risk of recession.
Central banks like the Fed pivoted into aggressive tightening cycles just as economies had begun to stabilize, leading to slowed growth in the US and China and negative growth in Europe. The world has been forced to accept and respond to the vulnerability of its international supply chains and other systems linked to the proliferation of globalism.
Faced with disruption on this scale, markets corrected their Covid booms across the board. Both bond and equity markets are positioned to end the year near pre-pandemic levels, with some market intersections down as much as 50%. For the first time in over 30 years, bond and equity markets were highly correlated, leaving investors with no real long term safe havens. (The commodities/energy sectors may be the sole exception, a direct result of the war in Ukraine and efforts to account for a consistent lack of investment in infrastructure over the last ten years.) In our portfolios, the other major source of returns has been volatility strategies that have capitalized on the consistent uncertainty and change.
As we look toward the new year, the outlook for inflation and central bank monetary policy remains at the forefront of investors’ minds. Currently, central banks appear ready to slow the pace of their rate hikes, and interest rate differentials have begun to narrow in most parts of the world. While the dollar has begun to depreciate, our research suggests this is mostly the result of the short-term removal of speculative positions. (Growth differentials inevitably impact currency rates, and the US continues to dominate, relatively speaking.) Investors must now rethink how to capture returns in a world of low growth and persistent inflation, where governments and central banks have largely exhausted their arsenals.
“L’État, c’est moi”: the Importance of Jerome Powell’s New Regime
Led by the US Federal Reserve, the regime changes instituted by global central banks have predominantly driven the narrative of global markets for the last 8 months, and understanding their actions is essential to preparing for the investing landscape in 2023. Though inflation seems to have peaked—as indicated by recent prints from both the CPI and PPI—will the Fed continue to tighten above the 4.5% current level? And will they continue with additional hikes, even while the real rate currently stands at 1.5%? Nothing if not transparent, Jerome Powell remains committed to containing inflation and bringing it back down to a 2% target at all costs. Market expectations are that the Fed will continue hiking to 5.5% over the next year. This over-tightening will lead to a shallow recession and weigh down equities through 2023 and possibly 2024.
We anticipate that the Fed will stop hiking by the end of Q1 and settle at 4.75-5% once it processes two key data points: (1) a rapid decline in inflation as the impact of high rates on housing and manufacturing is rolled into data, and (2) household surveys, which imply there has been no meaningful job creation for the past 9 months. As the unemployment level jumps to reflect this reality, we believe the Fed will cease hiking and address its dual mandate.
Despite the fastest rate hike up from a trough since the Fed’s inception, the US consumer has remained resilient. Over 196.7 million shoppers went out shopping on Thanksgiving weekend as excess savings and a solid employment market continue to buttress the consumer. Online sales, on both Cyber Monday and Black Friday, increased by 5.8% and 2.3% YoY, respectively. However, housing markets are showing clear slowdowns as the increase in mortgage rates (which have doubled to 6.7%) led to a drop in housing starts from 1.8 to 1.4 million units over the last 6 months.
Outside the US, Europe and the UK have proven firmly committed to hiking rates at a similar pace as the Fed. Because inflation driven by energy supply chain disruption has been so much more severe in Europe than in the US, central banks in the region may be forced to continue hiking long after Jerome Powell has eased up on the breaks. However, the worst may largely be over: German producer prices have eased by -4.2% in October, and the PMI index increased only slightly to 46.4 and remains in contracting territory. In the UK, inflation reached a high at 11% earlier in the fall, but core inflation across the pond has come down to stabilize at 6.5%. Additionally, consumer confidence has begun to improve a bit, and the UK is anticipating a (relatively moderate) 1.5% decline in GDP for 2023.
As China continues to climb out of the grave dug by its own “Zero Covid” policy and ineffective vaccine rollouts, PMI in the PRC stands at 48.3% (though this is also contracting), while imports and retail sales are down -0.7% and -0.5% YoY. Following President Xi Jinping’s de facto coronation in October, it’s difficult to completely anticipate exactly what steps the nation will take to address these concerns, in addition to widespread social unrest and a real estate market left in shambles.
A New Paradigm
Despite the high likelihood of slow growth and recessions in Europe, UK, and the US currently looming over the horizon, we see clear alpha opportunities in many areas heading into 2023. With the US rate hike cycle nearly completed, we believe investors will look to bonds while searching for dry land amid the ocean of uncertainty. Most companies’ balance sheets appear healthy, and while the recent correction in bonds was on par with levels during the GFC, the issues present then are now absent. We anticipate that investors will add to positions in investment-grade credit, sacrificing liquidity for the higher returns of private credit in investments where they are senior to equity and that are secured by hard assets, cash-flowing companies, or both. Our conviction is that significant Alpha can be generated in both areas.
Given the probability of recession, corporate credit spreads, which widened this year, may widen even more in 2023 in the high yield sector. Thus, we favor investment grate corporates, and still prefer the US to Europe and Emerging Markets. We also still favor a solid allocation to short duration treasuries.
With the slowdowns in growth of global economies, equities (which, as a broad asset class, are still trading at an overall level of 16-17x per the S&P), do not offer a great risk/return profile for 2023. However, select companies are trading well below that level and still show climbing growth in areas with accelerating demand. Many higher growth companies that are now trading at 19x (down from loftier levels of 30x at their post-pandemic peaks) have maintained YoY growth of around 30% and have preserved margins at roughly 20%. We believe investors seeking higher returns will come home to many of these companies, provided they demonstrate sustainable cash flows and solid business models. Reactionary sell-offs amid fears of a deep recession have created opportunities to invest for the medium to long term in these high-quality companies at attractive valuations. Significant Alpha can be found with active managers in these areas, despite a flat economy.
In response to both social unrest and concerns around its negative growth data, China has begun lifting some its “Zero Covid” protocols, relaxing testing requirements and travel restrictions and allowing people infected with mild cases of the virus to self-isolate and work from home, rather than in the centrally managed facilities that frequently left many businesses short-staffed. It will take a while for this change to positively affect markets, but over the course of the year, this engine of global growth will continue to return. This will impact markets globally and lead to a less negative outlook for global growth. Alpha can also be found in equities that may benefit from the gradual return of the Chinese consumer.
Across the international community, the world appears to have decided to address climate change aggressively. As a result, investment in energy infrastructure and in “responsible investing” themes will continue to accelerate and contribute significantly to growth across economies. We anticipate that Alpha will accelerate in energy infrastructure, commodities (as the transition away from fossil fuels lags behind consumer demand), and in the B2B technologies that emerge to support these burgeoning industries.
The Path Less Traveled
As the world returns to a more normal rate environment and abandons the “free money” paradigm that characterized the years leading up to and during the pandemic, volatility strategies have re-emerged as an investable asset class and a major return driver for portfolios.
It is important to remember that the GFC was a balance sheet recession. The private sector had to radically de-leverage across the board, and governments turned to constrained fiscal frugality and monetary policy to fill the gaps. These actions led to slowed economic growth but acceleration in financial asset growth. In addition, a demand deficiency driven by massive unemployment confronted excess supply caused by private sector activity. This resulted in a great 10 years for financial assets but meaningful difficulty for the rest of the economy, and widespread de-leveraging that pushed cap rates down.
As a result of this de-leveraging, individual consumers are now mostly safe, and countries will not be forced into austerity. In the present, while demand remains strong, supply shortages (of materials, parts, and labor) are virtually ubiquitous in some form or another. Labor and energy shortages led to higher real yields, driving inflation, and forcing the Fed to withdraw liquidity from markets before that inflation was cemented but also creating a major headwind for all financial asset classes—particularly where company balance sheets lack the brown fat needed to survive the winter. Under this new paradigm, central banks will need to keep rates higher and tolerate inflation for longer, and governments will need to spend more than they are used to.
Portfolio Construction Takeaways
Looking ahead, we do anticipate mild recessions due to supply/demand imbalances, first in Europe and the UK and possibly in US later in 2023. However, this will create meaningful opportunities for portfolios with solid cash positions, so while we remain defensive for the time being, we also are preparing to pivot within the next six months when markets grant the opportunity to capitalize on this.
The previous “free money” regime made it difficult for active managers to generate alpha as discerning stock selectors struggled to differentiate themselves from passive managers, and prudence was often punished. This is now changing. Managers with the experience and resources to conduct in-depth research, generate novel ideas, and carefully time their trades will thrive once again. Despite recession fears for the broader markets, we remain bullish for our own portfolios as we return to a more rational market with a close eye on risk, a recognition of real value, and a steadfast conviction in the value of intelligent investing.
We remain dedicated to our mission of delivering meaningful outperformance irrespective of market environment, grateful for your continued support, and excited for what 2023 has in store.
Happy Holidays and Happy New Year.
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