As we look into 2023, the headwinds from slowing growth and higher rates that have been plaguing investors will remain key market drivers. But while the cyclical outlook remains a major challenge, we are starting to see a silver lining on the rate front.

Let’s look at the bad news first. Global economic momentum continues to slow, with the Eurozone and UK in recession, US growth well below normal, and China’s 2023 recovery likely to be shallow. This cyclical headwind largely determines how we feel about stocks. We expect consensus earnings growth to slow further, so we are underweight on global equities, with a defensive sector bias and a focus on quality stocks with strong market positions. Geographically, the relative resilience of the US leads us to prefer US stocks over European stocks. In Asia, we have upgraded Chinese stocks because policy measures are easing COVID and housing related risks. Asia’s reopening is supportive of economic activity but the tech cycle is slow.

On the rate front, markets have tried several times to anticipate peak rates, but so far fallen back each time. The lower-than-expected US inflation print for October, however, signals that we are getting closer to peak rates, even if we’re not quite there yet. Commodity price inflation, transportation costs and supply chain issues are all easing. Rents are still rising but should plateau in coming months, as they tend to follow house prices, which have been falling.

As the Fed approaches peak rates, USD’s impressive bull run should come to a halt. We therefore adopt a neutral view on the greenback. And with bond markets already pricing a 5% Fed funds rate for Q1 2023, we feel comfortable with the yield level of short-to-medium dated and highly rated bonds, which we overweight. Adjusted for their relative risk levels, bonds have sold off more than equities this year, making them look cheap. We also like bonds for diversification purposes, because their correlation with equities typically drops in times of slowing economic growth. We further diversify portfolios through our overweight in hedge funds, which benefit from high volatility, the diverging fundamentals of different countries, and the rising income hedge funds receive on their cash balances.

While our confidence in short-to-medium dated bonds, our upgrade of Chinese stocks and downgrade of USD are signs that we see a silver lining, we will keep monitoring important milestones that could make us add more risk. When the peak in core inflation and Fed rates is eventually confirmed, we may well increase our rate exposure through increased duration and add back to our tech exposure. Good news on the rate front may help stocks too, but before we see a sustained equity rally, the cyclical outlook first needs to stabilise. That will have to wait, as rate hikes have a lagged effect on economic growth. But once the cycle is more stable, we could get more positive on stocks and lower rated credit. Stronger global risk appetite would eventually also lead us to take a bearish view on USD.

Those are potential reasons for future optimism, but for now, we remain cautious and see four priorities for investors. First, we rebalance portfolios towards high rated bonds. Secondly, we build recession resistant portfolios by focusing on quality stocks and partial inflation hedges. Third, we enhance the diversification from bonds by adding hedge funds and a core allocation to private assets and real estate. And finally, we position in structural trends, noting that many companies that are well placed for such trends now often trade at cheap valuations.

One case in point is sustainability. Some governments have allowed more oil and gas drilling to secure energy supplies, but this does not put into question the long term investment case for climate mitigation and adaptation solutions. In fact, the same governments have also invested in renewable energy and nuclear, while households and businesses have invested in solar and increased insulation, and are making production processes more efficient to save on high energy bills. So the short- term cost incentive is adding to the long- term sustainability driver, compressing the green premium and advancing new green solutions and technologies.

At the end of a difficult year, investors face an important balancing act. On the one hand, there is great uncertainty around geopolitics and the timing of the turn in the rate, inflation and growth cycles. On the other hand, almost all assets have repriced since the start of 2022. The good news is that even quality assets are now much cheaper and investors can build resilient portfolios with respectable expected returns, and wait for better fundamentals to take riskier positions.

Source: HCBC - 23 Nov 2022