Investment Outlook 2023

WELREX® Investment Director Stephen Ashworth and Director John Longo give their take on the prospects for the year to come

The headlines – We may be seeing peak uncertainty as we head into 2023

• Stocks will retest lows in 2023 and volatility will be high – be ready
• Bonds and cash can now offer some real yield opportunities
• Inflation will be stickier than expected as it falls back to more normal levels
• Interest rates may be close to their peak but will stay higher for longer
• Alternative strategies are key to positive returns in 2023

As we end a tumultuous year for investments, we can look forward to what 2023 might bring. There remains much uncertainty around the macro environment and how asset prices might respond. With uncertainty comes risk but also opportunity. This year has seen the worst collective performance for bond and equity portfolios since the 1930s. Traditional 60/40 portfolios have failed to deliver, and whilst bonds are now at arguably more attractive levels, it is far from clear that bond pricing will exhibit any real decorrelation from equities. Overall, uncertainties mean higher volatility and alternative thinking is more likely to deliver positive risk-adjusted returns.

Alternative thinking means seeking out investments whose returns are properly decorrelated from each other. Traditionally investors might look to private assets, which can on paper deliver some decorrelation in returns, but there is a huge valuation gap between publicly traded and private assets right now and this gap will have to correct – so private assets should be off limits for a while.

WELREX prefers alternative strategies using listed instruments, hedged, trend-following, and systematic strategies that are designed to deliver absolute returns. These should make up a larger allocation in portfolios than usual.

One of the key drivers of asset prices in 2022 was the rapid and material adjustment in the expectations for interest rates. Implied returns on inflation-linked bonds jumped up into positive territory driving a negative knock-on effect for valuations. Fundamentally, the rate adjustment upwards and away from the artificially low rates post the global financial crisis was always going to happen. Post-Covid supply chain problems and geopolitical tensions following the conflict in Ukraine created the catalyst for a return to inflation, necessitating the start of higher interest rates. Whilst rates and inflation may have peaked, there remains real uncertainty around both for 2023.

Alternatives – increasing allocations to trend-following, systematic, and hedged strategies

With so much macro uncertainty the challenging investment environment will continue. With ever-changing forecasts for key investment variables like interest rates and inflation, it is critical to monitor the trends within forecasts as much as the reported numbers. Investment markets will follow these trends, and this will tend to drive positive returns from trend-following strategies. 2023 should be a strong environment for trend-following strategies.

Value vs Growth – expect Value to continue to outperform Growth, but don’t overlook solid Growth names that now trade as Value. Stock selection and active management are key as volatility will remain elevated

Investment returns from equities have for the most part been very negative in 2022. Only the energy sector has escaped.

The aggressive rises in rates – with the Fed leading the way, +4.5% over the calendar year – have reset valuation points. Companies without earnings or those with uncertain future earnings or growth have been disproportionally punished.  In the US the Russell 1000 Growth index (“Growth”) has fallen 20%, and the Russell 1000 Value index (“Value”) is down 5%. Interestingly the value sector looks like it has some juice left in it to outperform growth.

Some names which were growth names – Meta, Alphabet, and PayPal for example – are now value names. Companies like this, which have sustainable earnings, present opportunities for stock selection and inclusion in portfolios. As and when markets have periods of risk-off price action, these names should fall less and rebound more.

Key to equities performance is earnings and the big risk to earnings in 2023 will be a recession. In the US, UK and Europe recession is certainly the consensus view, as indicated by the US yield curve which is heavily inverted. The key uncertainty is around the length, depth, and overall impact of the recession. It can be argued that the 2022 equity price adjustments have already priced in the higher rate environment but not the impact on earnings. It is certainly the case that US earnings have held up so far and shown some resilience to economic pressures. At the S&P 500 index level earnings expectations have not been reduced significantly; indeed for 2023 industry forecasts still show some expected growth. We will need to watch consumer behaviour – so far consumers have not reduced spending significantly, perhaps linked to high savings from lockdown and an ongoing tight labour market. Any downward trend in expected or realised earnings will likely see some significant weakness in stock prices.

It is usually the case that recession is seen to occur after tightening has completed. Equity markets do not bottom until the rate cycle has really peaked and this time inflation is also sufficiently high that it will take time to fall and may well be sticky on the way down, given the ongoing tightness in the labour market which is itself sustained by an ageing population. This increases the risk of rates going higher and certainly indicates they may be held higher for longer than the market currently thinks.

Inflation rate linked to employment

Fundamentally, inflation can’t be expected to fall back to acceptable levels without employment falling. This outcome is tied directly to earnings which won’t fall unless companies fear falling profits and, as a result, lay off staff. This may have already started with recent layoffs in the tech and finance sectors by the likes of Meta, Amazon, and Goldman Sachs.

Inflation will be sticky as it falls too, so we might expect some discussions to evolve about adjusting the inflation target higher. This might be an explicitly higher rate target, or the target might be maintained at 2% with the central banks taking a more relaxed approach to missing it. It is worth remembering that originally the 2% target was chosen as a somewhat arbitrary target. The key question is what is the inflation rate that causes real problems with the public? Clearly right now inflation is causing a problem, but perhaps 3-4% can be lived with more easily. Critically, whatever the rate of inflation, it will need to be assimilated within asset prices via valuation multiples and return expectations. The ultimate negativity, for asset prices, to watch here is stagflation, where a recession is combined with inflation.

2023 will see some significant volatility across all asset classes. When you have an environment where the risk-free rate is uncertain and volatile, the risky rate will be even more volatile and when the risky rate experiences higher volatility, so do the asset prices that are driven by it.

Cash now pays a reasonable return with higher rates – keep dry powder, and when opportunities arise switch to the equity exposures that present themselves

Equity indices are likely to have some way to go before they bottom.  However, some sectors are also poised with stronger performance drivers, and these should feature in portfolios, with allocations increased into future price weakness.

The defence sector should benefit from increases in budgets in light of the Ukraine conflict, and more specifically with orders to replenish the ammunition stocks sent to Ukraine. The financial sector, and specifically the banks, should see some benefit from higher rates feeding through to margins – even with some expected uptick in provision for loan losses arising from a recession. Stocks linked to commodities stand poised to benefit generally as China changes tack on its zero Covid approach, and copper, in particular, should benefit from the huge demand for green energy and electric vehicle demand with restrictions in the supply and increased marginal cost of production. Finally, don’t overlook small-cap stocks which have seen and will likely continue to see disproportionate price pressure in sell-offs.

Real Assets – can provide some degree of protection from inflation that stays higher than expected

Real assets are a good diversifier and with inflation high, they can deliver returns that track real rates. Real estate is a classic example. Implied rebuild costs increase in line with labour and parts inflation.  Rental income returns are also often contractually linked to inflation and increase accordingly. Some care is needed with real estate as interest rate-driven valuation falls can erode any inflation-linked benefits. Recent news around redemption demand and liquidity restrictions in Blackstone’s large open-ended real estate income trust (BREIT) underscore the significant valuation gap between the listed and private sector for real estate. It should not be surprising that investors are selling BREIT to reinvest in listed real estate instruments (usually traded as closed-ended real estate investment trusts, better known as REITs) which can be bought at 30-40% discounts to the implied value of similar physical buildings. Commercial real estate does have some specific challenges, especially around getting staff back to offices, but for the right buildings demand in the form of rents paid remains strong. Understanding the valuation entry point is key to getting the right exposure at the right time. However bad the economy gets, the sector is less leveraged than it was in 2008 and the recession would have to be exceptionally painful for asset values to fall at an asset class level by 30-40%.

Crypto – cheaper but remember it’s a long game

The chasm of knowledge between those in the crypto industry and the central banks remains as wide as ever. At a recent conference the ECB speaker implied an understanding of the potential for blockchain but at the same time exhibited a lack of understanding of the nature of how crypto/digital assets can change the financial system – or at best, they do understand and are very scared of it. The jury is still out on whether to regulate and legitimize crypto or not regulate and hope it goes away. This debate will certainly continue in 2023 but it seems likely to us that regulation will be forthcoming.

2022 was certainly not a good year for Crypto. Weakness and volatility in prices drove business failures in centralized businesses involved with stablecoins, lending, and perhaps most spectacularly the FTX exchange run by Sam Bankman Fried, now facing fraud charges. For all the shocking losses at FTX, what is critical to be aware of is that these losses arose not from some fundamental flaw in blockchain, wallets, or hacking, but from simple basic good business practices not being followed.

The remaining centralized exchanges should stand to benefit from the failure of their peers and whilst the crypto asset class will likely continue to trade as a risk-on asset, the wider digital asset ecosystem will see more development and mainstream adoption. Any new regulation should ultimately be a positive for these ecosystems since it may result in greater confidence and legal protections. There may be some interesting conceptual parallels here with the Internet Bubble popping in 2000, ultimately rebounding of course. 

Finally – where might surprises come from?

• • Some form of resolution to the conflict in Ukraine

• • The impact of China’s change in approach to zero Covid

• • Breakthrough technologies such as ML/AI and nuclear fusion

• • Unexpected increases in credit defaults, perhaps as a consequence of a liquidity squeeze as private equity asset values reset downwards

• • Potential for long-end yield curve control by central banks as the pressures to reduce rates increase when the recession hits

• • Next Bull market might be already running, earnings growth at an index level maintained through resilience in the US economy and lower energy prices. Plus, there is a lot of cash on the sidelines.

Stephen Ashworth and John Longo, CFA

WELREX® Investment Team