Q 2022 has been challenging for most asset classes. Is there light at the end of the tunnel?
When it comes to developed markets, 2022 has seen a reset in valuations. We have seen a rise in cash rates and bond yields, as central banks have moved to fight inflation, which has placed material downward pressure on equity prices. At the same time, earnings in the developed world have remained quite strong and reasonably robust.
In Asia, market weakness has been driven by earnings weakness and multiple compression, which happens when stock prices fall faster than earnings. This followed the tightening implemented by the People's Bank of China (PBoC) a year before developed market central banks began similar tightening.
Whether there is light at the end of the tunnel for developed market equities depends on the eventual economic impact of this year’s tightening, because it has a six to 12 month lag on it. Ultimately we believe the odds are stacked against a soft landing in developed market economies because historically, when hiking cycles take place at such speed and magnitude, they tend to be followed by a harder landing for economies. In this case, companies are likely to see earnings weaken with economic growth and the equity market could suffer, particularly if the Fed maintains tight policy to maintain inflation at the same time.
Q Was a reset necessary for certain asset classes?
Yes. It was obvious early this year that the liquidity provided by central banks through the COVID shock, coupled with the fiscal stimulus, led to a serious compression of the risk frontier, or the efficient frontier, where government bond yields were exceptionally low and multiples in equity markets were very high, so expected returns had been flattened across the curve. In effect, we borrowed some returns from the future. But with bond yields rising and equity multiples having compressed, the risk premium within markets is returning to more sensible levels.
Q What are the main themes of 2023?
Given the speed and magnitude of the hiking cycles in the developed world, we expect to see a pretty solid slowdown and most likely a recession over the next 6-12 months.
China has its own challenges and there is negative price action in Asia linked to the extension of zero-COVID policies, coupled with the consolidation of power by President Xi. However, after the tightening in 2021, policy loosened this year to stabilise the economy. The government has embarked on a new credit cycle, it is taking steps to stabilise the real estate market and has gone quiet on regulation as it seeks to rebuild confidence in the economy. We think China will see economic recovery in 2023.
When we think about the bigger implications for asset markets, 2022 was all about lower equities; higher bond yields and the US dollar’s notable strength. In 2023, we think we’ll see bond yields begin to peak on emerging economic weakness. We believe we are already seeing this in some peripheral economies within the developed world. We’ll likely see equity markets bottom out, as it becomes obvious that the slowdown has taken place. We think the US dollar will probably peak next year, when the US Federal Reserve (Fed) signals that inflation is heading towards its goal.
Q Using your countercyclical approach, where do you see opportunities in 2023, and what will be the best way to access them?
Opportunities have already begun to emerge. For example, we are taking on risk in selected government bonds. Usually when you move into a period of negative growth with negative inflation impulses - which we anticipate in the first half of 2023 – it is a signal to start taking on risk in government bonds. We are doing that in areas where there is notable vulnerability due to higher interest rates, and one of the main areas globally is in housing markets where considerable leverage has been taken on in the last decade. This includes countries like Australia, Canada, New Zealand, South Korea, as well as some of the Scandinavian economies. Their housing markets are already turning down as a function of higher interest rates, and so we are buying long in bonds in those markets.
When we get the signal that the US is beginning to slow down, we will expand our exposure to those markets, given that they are influenced by Treasury yields too. Beyond rates markets into currencies, we have
benefited from a long dollar view and if we see growth slowing and the Fed looking like it will pivot at some point – we see a big opportunity, potentially, in the Japanese yen, which has been materially beaten up this
year. If we start to see policy convergence at some point, maybe later next year, then the yen will be a standout opportunity. I think in general, over the
next 12 months, we will be looking to allocate capital into risk assets. So, as pricing moves in line with our central scenario of a weaker economic backdrop, we will be allocating a notable amount of capital, we believe next year, into risk assets.
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Specific risks. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Emerging and Frontier market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.