Tactical opportunities, but caution is the watchword

Q Typically, asset classes move in opposite directions. In 2022 everything has gone down. Will we see normality resume in 2023?

Certainly, markets have been highly correlated and the falls in bond markets have been more spectacular than equities. They have a common driver and that is the removal of cheap money, which has caused a re-pricing of all asset classes. Our sense is that we will see greater differentiation in asset class performance in 2023. We are likely to slide into a global recession and so we may see both interest rates starting to fall, and earnings too. Typically, the former should support bond markets, whereas the latter will potentially continue to undermine equity markets.

Q How have you navigated the challenging market environment?

We have tried to strike a balance between managing the downside but also looking for opportunities to generate returns. Our net equity exposure has been low, typically between high single-digits and mid-teens; and we had very little credit exposure, with high yield in the mid to low single-digits. Similarly, duration was kept tight, so interest rate risk was held to a year or so, for much of this year. That has helped, but with hindsight we could have held cash given how correlated everything has been.

Q What has the bond bear market meant for defensive investors?

It is important to try to understand what is driving markets and what is driving relationships between markets. The classic balanced portfolio has been reliant on two things: one is that bonds tend to have a negative correlation with equities and the other is that bonds generate positive returns. That combination has protected and supported the performance of balanced funds over the last 40 years. We are now potentially in a different environment and have to think about things differently. For instance, are we going to have permanently higher, positive correlations between bonds and equities? If inflation becomes more volatile that is definitely a risk because it affects the valuations of all asset classes. Also, are we going to have less of a tailwind or more of a headwind if interest rates tend to be higher in the future than they have been in the past?

The backdrop is continually evolving, necessitating a nimble approach to investing. We think there will be tactical opportunities to own bonds, but we are less convinced that it is a strategic allocation, particularly government bonds. Thus, investors need to explore other ways of providing protection. For us this means reducing exposure to risky assets, looking to run less net equity market exposure/less duration, as we have done this year, and then looking for opportunities to pick up cheap, resilient income generating securities that have been hit by the selloff, but which offer good cash flows, and good potential returns.

Q How will you approach 2023?

Initially, we are going to remain somewhat cautious in terms of overall risk. Our main concern is that all of the policy tightening will cause a recession in 2023, which will hit more cyclical asset classes and riskier asset classes like equities. It may also sow the seeds for a peak in the interest rate cycle and lower yields on more defensive assets, at least temporarily. But we have also seen a wholesale selloff in everything which typically means there are bargains to be had. These are assets that are cheap, that offer good income sources, with less uncertainty, and are potentially more defensive in an economic downturn. We think, for example, certain government bond markets, particularly those where recession risks may be under-priced such as Australia, Canada, New Zealand and some emerging market local government bonds, hedged back to hard currency, offer potential. In terms of emerging markets, many central banks are well ahead of developed markets in terms of the rates cycle.

Also, the quality end of the corporate bond market, where you are earning recessionary-type spreads already, but where they have strong balance sheets that are relatively healthy and where funding needs are not high. Then, within equities, there are definitely some businesses that are growing their earnings and passing on higher prices relatively successfully, particularly in some of the staples areas. We think they can continue to generate decent returns and are reasonably valued.