A volatile transition to a changing world

Chief Investment Officer's team
02 January 2023


  • 2022 has been terrible for investors with all major asset classes in the red, due to the return of inflation
  • This is a transition to a new regime with many uncertainties, but also opportunities for the long run.
  • We start 2023 with a reshuffled strategic asset allocation and an open tactical mind.

2022 has been awful: with both stocks and bonds deeply in the red, it is arguably the worst year for a portfolio combining the two major asset classes in a century. Equity indices lost around -20%, with a dramatic sector and style rotation punishing the former market darlings. The safest bonds were down -17% with no segment doing better than -13%. Gold and hedge funds limited losses but only cash delivered a positive return.

Apart from a collection of dramatic events, from the war in Ukraine to covid in China and including Europe’s energy crisis and a crypto crash, markets were dominated by one single factor: inflation in the West leading to the largest and most synchronized monetary tightening in 40 years. In essence, 2022 marks the transition from a deflationary era, combining ultra-low interest rates with the benefits of globalization, to an inflationary one: money is not free anymore, central banks do not support growth anymore, and international relations are materially fractured.

2023 starts with a rapid slowdown in global economy and a material risk of global recession. Market participants will focus on on only one magic moment: the pivot from central banks. When and why it will happen remain unknown: inflation normalizing or the economy crashing? Both? None of them?

We have reshuffled our strategic asset allocation to leverage on the valuation opportunities born from the 2022 debacle. Long-term expected returns are higher, which is the good news. With regards to our scenario and tactical stance, we keep an open mind and get prepared to being as nimble as ever. We will issue our global investment outlook later this month. We wish you a healthy, peaceful, happy and prosperous 2023.

Cross-asset Update

2022 has been a terrible year for financial markets. It wasn’t the worse for each of the major asset classes, but most of the pain came from the fact that all of them fell at the same time, with cash and gold the only exception.

This correlation shock was of course the result of an epic rise in Western inflation, to levels unseen in more than 40 years, which triggered a massive response from central banks. While the year started with interest rates close to zero everywhere, and with central banks keeping on expanding their balance-sheet through asset purchases, the trend brutally reverted with a series of jumbo interest rates hikes, an end to quantitative easing and the start of the reduction of the balance-sheets.

The rise in interest rates had a direct impact on bonds, down between -13% and -15% with a peak around -20%. It also affected cyclical assets through two factors: first, higher yields from risk-free assets command lower valuation multiples for risk assets. Second, the tightening of financial conditions by central banks explicitly aims at pressuring demand and slowing activity. This mechanically reduces future earnings prospects.

No surprise then that the usual benefits of diversification vanished in 2022. Active allocation was also penalized by the power of the inflation/tightening factor on all markets. As a result, our three profiles were deeply in the red in 2022, even if the fourth quarter was better, due to some correction of the excessive pessimism of the investors community. Our Cautious, Moderate and Aggressive profiles ended the year at respectively -14%, -15% and -16% (rounded). This was broadly in line with our international competitors.

We start 2023 with a reshuffled long-term Strategic Asset Allocation which is the optimal portfolio structure on which we base our tactical positioning by overweighting and underweighting asset classes, depending on the shorter-term opportunity set. The good news for the long-run is that the holistic turmoil of 2022 has lowered valuations everywhere, which enhances future long-term expectable returns. This is particularly true for money market, bonds and yield generating assets in general. Another positive is that with higher yields from fixed income, their diversifying power versus equity has improved. The classic negative correlation between bonds and stocks, which provides cushion from govies when equities are in trouble, should progressively come back.

Our new SAA will be presented in details in our Global Investment Outlook to be released later this month. In essence, the levels of cash have been lowered and redeployed towards fixed income and equity. Our key objective of minimizing the probability of capital loss at respectively 3,5 and 7 years has of course been maintained as the bedrock of our portfolio construction. We will transition our actual portfolio positioning closer to the new SAA this week.

Fixed Income Update

Many things have been said and written about 2022, from the worst performance of Government bonds in the last four decades to attractive valuations available toward the end of the year. There was also the surprise YCC move by the BoJ that caught the markets unawares. We had flagged this risk in our mid-year outlook. But, as a new year begins, so does a new story. If last year were all about inflation and central bank actions, this year it would be more about growth concerns. While inflation may not have come under control ultimately, analysts hope for it to moderate this year. What is worrying the analysts is the prospect of a slowdown this year.

In December, the hawkishness from the FED and the BoJ policy move significantly impacted the yields. The 10-year treasury yield increased by 39 bps to end the year at 3.87% after hitting a 52-week low of 3.42% on 7th December. The impact of the BoJ move has yet to be fully baked in, so we expect yields to rise a bit from current levels and settle down before growth concerns pull them back. If inflation is not the more significant concern, but growth is, then the tailwind for the yields to rip much higher is not present. Unlike last year, long-duration government bonds would provide a cushion against market gyrations in 2023.

Investment Grade Credit valuation though better than other segments (70 percentile), is still below the High Vol period (characterized by Move Index > 95) average by 11% and recession-era spreads by 38%. The current spread is higher than the average spread by 9%. IG yields look attractive, and inflows should remain strong while supply would pick up as other sectors join Financials which dominated the issuance in 2022. We expect the spreads to widen slightly to match the High Vol period, and this sector remains our preferred investment vehicle for the year.

On the other hand, both EM and HY spreads look tight compared to historical levels. Both the spreads hover around the 60 percentile. HY especially seems pretty tight. Supply should remain tight as the market would price out a few low-rated issuers. Demand for HY and EM issuers would be moderate, given the growth and slowdown concerns. Moreover, with DM IG offering decent yields, global asset allocators would be spoilt for choice this year. HY default rates are also expected to double from current levels. These indicate that selectivity would rule in these two sub-sectors, and high-quality concentrated bets would pay off more than beta exposure.

GCC bonds look the tightest on paper, trading around the ten percentile range. However, the composition of the GCC Debt market has changed significantly, and its short history makes it challenging to find a meaningful correlation. Nevertheless, the regression model taking Global PMI, Oil price, and US 10-year real yield as independent parameters currently gives an output of 182 bps which is around Non-recession era spreads. Assuming stable Oil prices and slightly lower PMI we would estimate the range to be between 175 -200 bps

Equity Update

In 2022 equity markets were defined by volatility with a first 3 quarters with negative returns as worries grew around corporate margins and profit growth a result of higher rates, wages and raw materials. Though the world reopened, and supply chain pressures dissipated, inflation numbers remained close to double digits in the developed markets. Q4 was positive with a rally in October and November, with inflation trending lower, Central Bank softening but still hawkish, the USD losing some of its strength and China reopening. December, however, was broadly negative for regions and sectors barring China, which continued its November rally. 2022 saw global equities down 18% with developed markets slightly better than emerging markets. Value as a factor performed better. The only positive sector was energy +35% with communication services the worst performing sector an exact mirror image of energy at -35%.10 year US Treasury yields are below their peak but the outlook of long duration growth sectors such as technology is still in question. The UAE, Dubai and Abu Dhabi equity indices were the world’s second best performing region in USD. India and UK were up in local currency but not USD.

In Q4 2022, China reopening and rates looking to peak near term (a central bank pivot on the horizon) were positive catalysts for equity markets. In early 2023, Q4 earnings and guidance are key for equity performance along with monetary policy direction, inflation, unemployment data, geopolitics and supply chain issues. Inflation is showing signs of peaking with energy prices lower, but above Central Bank targets, with Europe more impacted by oil shortage. Whist equity performance in 2022 was largely a function of valuation derating with the US S&P 500 trading down from a trailing P/E multiple at the start of 2022 of 26X to 18.5X at the end of the year, earnings growth also saw a pull back from 47% y/y in 2021 to an estimated 5% for 2022. Earning estimates for 2023 have been revised down for most developed markets, with margins a concern.

Our fair value estimates for 2023 predicate low single digit upside for US equities with earnings to stay flat for the S&P 500 and a PE multiple of 18.2X by the end of the year. We expect European equities to perform in line with economic growth, that is small negative returns. We expect more upside i.e mid teens, from emerging markets which are at low valuations and relatively high growth. We like the UAE and India, tactically and strategically. New listings in both regions will aid performance and India domestic demand remains resilient. On China we are tactically overweight as a part of our EM Asia overweight, though COVID cases continue to rise. Longer term we are wary of US tech sanctions and China’s own onerous policies on data and on monopolistic tech and payment companies.

We recommend income strategies as the best hedge against the lower growth and the likely recession outlook and recommend buying stocks of companies with resilient income, serviceable debt and sustainable dividends. Many healthcare and energy companies generate over 3% dividend. Our regional preference within DM are the US and Japan and within EM, India and the UAE.

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