Asset markets and investors experienced a tough year in 2022. Both global equities and bonds declined sharply, resulting in a passive 60/40 global equity/bond portfolio returning -18.1% in US dollars and having its worst year since 2008. The culprits where a combination of stretched starting valuations, major central banks moving to fight inflation and recessionary conditions in China.
Starting with China: 2 years ago, the Politburo, the principal policymaking committee of the Chinese Communist Party, talked about using 2021 as “a window of opportunity to address structural imbalances”, “anti-monopoly” and “curbing the disorderly expansion of capital”. This set the stage for the material macro policy tightening and regulatory reset experienced up until early 2022. Subsequently, policy pivoted towards incremental policy easing, and China’s regulatory cycle peaked. The lagged effects of tightening and then zero-Covid policies weighed heavily on the economy for the remainder of 2022 and more than offset any easing efforts. Heading into 2023, the Politburo has called for “significantly boosting market confidence”, “forceful monetary policy” and “reinforcing fiscal policy”. This doubling down on policy, coupled with a rapid unlocking of the economy post the abandonment of zero-covid polices and considerable pent-up household demand1, should drive a robust recovery in economic growth and corporate earnings over the next year. At the same time, equity valuations in China and Hong Kong are depressed, and investors generally remain pessimistic on the region. We continued to accumulate equity positions in these markets through the second half of 2022, and our portfolios are biased towards or overweight the region as a result of these dynamics.
Turning to developed markets (DMs), our central scenario is that the developed world will likely suffer the consequences of last year’s rapid and material tightening in monetary policy, as the lagged effects feed through into growth and earnings in 2023. We see a higher likelihood of a recession than is currently priced into asset markets. The much-anticipated “Fed pivot” seems unlikely in the near term. We don’t anticipate a change in policy until notable weakness in the economy has materialised – likely a precondition to sufficiently weaken the labour market and lower underlying inflation pressures. Our conviction comes from the fact that the Federal Reserve remains focused on addressing inflation and tightness in the labour market, with “the level of wage growth remaining inconsistent with inflation returning to 2%”, according to Fed chair Jerome Powell. Soft landings of the economy have also historically been associated with longer and shallower hiking cycles, while the pace and magnitude of this hiking cycle has historically been associated with a deeper recession. In our view, these expectations are yet to be priced into DM equities. Last year’s sell-off was a function of multiple derating as interest rates and bond yields rose, but there has yet to be much in the way of downward revisions in earnings. During a recession, earnings usually experience a 15-20%-plus decline. Consequently, we maintain a lower than average or underweight exposure to equities overall in portfolios, with the above noted bias towards China and Hong Kong.
Developed market government bond yields have risen sharply
Source: Bloomberg to 31 December 2022.
Another area where our central scenario for the developed world is yet to be priced is in DM government bonds. In US Treasuries and other select DM government bonds, real interest rates – a measure of value – are the highest they have been in 12 years. In particular, we see the best opportunities in high-grade government bonds in countries where housing markets and households are already feeling the effects of current hiking cycles. These nations include South Korea, Canada, Australia, New Zealand and Sweden. For example, South Korea has just entered its first phase of deleveraging since the Asian financial crisis, and the housing market in Sweden has already declined 17% from its peak. These nations face notable headwinds to growth and domestic inflation through 2023. We have established a higher than average or overweight position in defensive duration over the past 6 months, relative to a material underweight a year ago, with a strong bias towards these nations.
Turning to currencies, we entered 2022 with a notable long position in the US dollar versus Asian and European currencies. This reflected expectations of macro policy divergence; we expected the Fed to fight inflation and tighten policy swiftly, while the People’s Bank of China would move towards easing. Looking forward, we believe the US economy remains structurally more healthy than European countries and the above noted nations and will likely tolerate higher rates for longer. However, a reacceleration in Chinese growth and a tightening cycle from the Bank of Japan present notable headwinds to the US dollar through 2023. In our portfolios, the active currency overlay is currently structured to take advantage of the above noted country-level vulnerabilities. We remain defensive but more diversified than last year, being long the US dollar, Swiss franc and Japanese yen versus the Swedish krona, Canadian dollar, Australian dollar and New Zealand dollar.
All being said, 2023 will likely be a year where significant opportunity will be presented in DM equities and credit – just not yet.
1 Chinese households have accumulated excess savings of c.10% of GDP in recent years.