19 January 2023
2022 was a tough year for most asset classes. Inflation soared to levels we haven’t seen since the 1970s, and global central banks raised interest rates at a record pace to combat inflation. Central bank tightening, along with an energy crisis caused by Russia’s invasion of Ukraine, caused global stocks and bonds to fall into bear market territory.
So, what lies ahead in 2023, and how should investors position their portfolios?
In our market outlook webinar, Freddy and Stephanie discuss our portfolio performance in 2022 and share where they see investment opportunities emerging in 2023.
Our models show that inflation, particularly in the US, has likely peaked and will continue to moderate over the next few months. Our investment framework, ERAA®, signalled a shift from inflationary growth to stagflation in December 2022. In other words, we’re now in a new economic regime, where inflation is high (but starting to decline) and growth is contracting.
As major central banks’ interest rate hikes work their way through the economy, investors will shift their focus from inflation to growth – given the increasing likelihood of a recession in developed market economies in 2023. As of now, views diverge: a gauge developed by the New York Fed puts the probability of a US recession within the next 12 months at 47%, while Wall Street predictions are mixed.
Leading economic data like the US ISM Manufacturing Index suggest the world’s biggest economy is slowing significantly - with the gauge falling below the 50 mark that separates expansion from contraction toward the end of 2022. Similarly, economic data for other major economies have also softened considerably in recent months.
That’s consistent with the sharp downward trend in ERAA®’s growth tracker, which incorporates a number of forward-looking economic indicators to help us read the state of the US economy in real time. Put together, this data reinforces the view that a significant economic slowdown could be in the cards in the coming months – particularly for developed markets.
After aggressive interest rate increases in 2022, global central banks are continuing to tighten policy into 2023 – though some central banks, like the Fed, have started to tap on the brakes. (Read more in our November 2022 CIO Insights: Could Rate Hikes Be Approaching a Peak?)
But apart from raising rates, central banks have also begun to tighten monetary policy by selling assets such as government bonds – a process known as quantitative tightening (QT).
The Fed and Bank of England have already started to shrink their balance sheets, while the European Central Bank is expected to begin reducing its bond holdings in March.
This means that three of the world’s major central banks will be removing liquidity from the financial system at a relatively rapid pace. And QT at this scale could put upward pressure on borrowing costs and be an additional source of market volatility this year.
The slowdown in growth, coupled with high but peaking inflation, presents a new set of challenges for markets, but it also opens up opportunities in various asset classes. Let’s break it down:
Interest rate and inflation expectations drive bond prices – when inflation and interest rates fall, bond prices tend to rise, and vice versa. As we approach the end of the Fed’s rate hike cycle, inflation expectations are easing as investors shift their attention to slowing growth. So we can expect bonds to stage a recovery this year as interest rates stabilise and inflation moderates.
Short-duration bonds already look attractive, given their combination of higher yields compared with the start of the year and relatively lower risk. For example, US 3-month Treasury Bills currently yield about 4.5% p.a., and are a good option for investors looking to generate income in an uncertain environment.
Longer-duration bonds are more sensitive to interest rate changes, and their prices fell significantly as the Fed hiked rates in 2022. But with the Fed’s rate hike cycle likely nearing its end, that creates price appreciation opportunities for longer-dated bonds.
What’s more, real yields (ie. the bond yield minus inflation) of longer-duration bonds are now positive. This means that investors are compensated with income that beats inflation, which increases bonds’ relative attractiveness versus other asset classes.
During periods of economic contraction, we can expect to see company earnings fall – leading to lower stock prices. Should we enter a recessionary environment, defensive equity sectors such as healthcare and consumer staples could outperform cyclical sectors such as energy and industrials.
We expect economic growth between developed markets (DMs) and emerging markets (EMs) to diverge in 2023. EMs, led by China, were weighed down in 2022 by Covid-19 lockdowns and a strong USD, among other challenges. As these constraints now appear to be easing, EMs are starting to show signs of economic recovery. On the other hand, the World Bank expects growth in developed economies to slow from 2.5% in 2022 to 0.5% in 2023.
Also, as growth in the US slows, the dominance of the USD versus other currencies that characterised much of 2022 could continue to fade in 2023. Instead of broad-based USD strength, we could see more divergent currency performance depending on each country’s central bank decisions and pace of economic growth. (Read more in our October 2022 CIO Insights: What's Going On in Global Currency Markets?)
We continue to favour Gold as a balancing asset in diversified portfolios, given its low correlation to stock and bond prices and its status as a “safe-haven” asset. Gold prices are also generally inversely related to the US dollar. This means that the metal could continue to be resilient in the months ahead should the USD weaken as the Fed slows down its pace of rate hikes.
Given the breadth of opportunities that investing in 2023 could bring, the best course of action is to continue allocating into a well-diversified portfolio. While market drawdowns may be uncomfortable, they have historically provided the best opportunities for investors to dollar cost average into the market and put spare cash to good use. Asset prices have always gone up in the long term – so taking a big-picture approach, being true to your risk appetite, and sticking to a sensible investing strategy could keep you on track to reaching your financial goals.
If you’re invested with us, the good news is that your portfolios are already well-placed to navigate the new economic landscape. In our December reoptimisation, ERAA® positioned your portfolios with a higher exposure to bonds, defensive equity sectors, and emerging markets, and maintained its allocation to Gold.
As ERAA® continues to monitor the latest macroeconomic data, it’ll ensure that your portfolios have the optimal asset allocation for your risk profile, while maximising your long-term returns through each stage of the economic cycle.
Our BlackRock-powered portfolios are managed with the investment guidance of BlackRock – read more about their December 2022 reoptimisation here.