For investors, 2022 will not be missed. The year presented a series of firsts and worsts.
For investors, 2022 will not be missed. The year presented a series of firsts and worsts.
The tragic war in Ukraine hugely distorted global food and energy supply chains, further emphasized the divide between the US and China – see A greater separation between East and West: G2 polarization intensifies – and accelerated the onshoring of critical business infrastructure. The Fed instigated its fastest set of interest rate increases ever. In doing so, it responded to the inflation it caused by adding excessive liquidity to counteract the effects of the pandemic. As the safehaven US dollar strengthened, goods almost everywhere else became more expensive, adding to global central bank tightening pressures. These are all sources of instability. In this environment, equities and bonds declined in tandem by the most ever in 2023, with joint losses of about 20% at the low point. Cash outperformed almost every asset class. As we look ahead, however, we need to remember that markets lead economies. The poor market returns of 2022 anticipates the economic weakness we expect in 2023 – see Roadmap to recovery: Markets lead, the economy follows.
We believe that the Fed’s rate hikes and shrinking bond portfolio have been stringent enough to cause an economic contraction within 2023. And if the Fed does not pause rate hikes until it sees the contraction, a deeper recession may ensue. The most recent inflation data and Fed minutes suggest that the Fed is aware of these risks. Yet Fed policymakers’ tendency toward excess gives us pause as we plan for 2023.
With perfect hindsight, sitting out 2022 would have been worthwhile. But to think that way is dangerous for wealth preservation and creation. One year is just a “moment” in the lifetime of a portfolio. Sidestepping the pandemic and war-laden past three years would have been a major mistake for equity investors. Between December 2019 and November 2022, the S&P 500 Index rose 25% and the MSCI World 15.4%. For 2023, we reiterate the fundamental wisdom of keeping fully invested portfolios – see for example, It is time to put excess cash to work.
Remember, the world economy is highly adaptive and resilient. So too are markets.
Over the past 100 years, no bear market associated with a recession has bottomed before the recession has even begun
Markets in 2023 will lead the economic recovery we foresee for 2024. Therefore, we expect that 2023 may ultimately provide a series of meaningful opportunities for investors who are guided by relevant market precedents.
First, though, we need to get through a recession in the US that has not started yet. We believe that the Fed’s current and expected tightening willreduce nominal spending growth by more than half, raise US unemployment above 5% and cause a 10% decline in corporate earnings. The Fed will likely reduce the demand for labor sufficiently to slow services inflation just as high inventories are already curtailing goods inflation.
The relative health of corporate and personal balance sheets has delayed an economic downturn, for now. Household borrowing is sustaining growth presently, but this dissaving is likely unsustainable, especially given financial market and real estate price deflation. Also, when short-term rates are higher, there is a natural bias to deferring purchases.
We remind investors that over the past 100 years, no bear market associated with a recession has bottomed before the recession has even begun. (Of course, there is a first time for everything.) We believe that the current bear market rally is based on premature hopes that the recession will not occur – a so-called “soft landing” – and that there will not be a meaningful decline in corporate earnings.
Second, we need to get through a deeper recession in Europe as it struggles through a winter of energy scarcity and inflation. We also need to see a sustained economic recovery in China, whose prior regulatory policies and current COVID policies curtail domestic growth.
Third, we need to see the Fed truly pivot. Ironically, when the Fed does finally reduce rates for the first time in 2023 – an event that we expect after several negative employment reports – it will do so at a time when the economy is already weakening. We think this will mark a turning point that will portent the beginning of a sustained economic recovery in the US and beyond over the coming year.
After the big drop in valuations in 2022, our 10-year return forecasts – or “strategic return estimates” (SREs) – have risen. A year ago, our strategic asset allocation methodology pointed to annualized returns for Global Equities over the coming decade of 6.1%. Today, that stands at 10%. SREs for Private Equity and Real Estate are higher still. Likewise, the Global Fixed Income SRE has climbed from 3.7% to 5.1%. Even Cash now has an SRE of 3.4%, up from 1.5% – see Better long-term returns ahead.1
While no one can know the precise timing and sequence for selecting investments globally at a time of significant uncertainty, we think that there are numerous data points to suggest that a potential set of opportunities will arise in 2023.
Ahead of the expected recession, we are committed to selectivity and quality. This begins with fixed income, which we believe offers genuine portfolio value now for the first time in several years. Short-duration US Treasuries present a compelling alternative to holding cash. For US investors, municipal bonds also seek better risk-adjusted after-tax returns. Broader investment-grade bonds offer a range of higher yields at every maturity. And loans in private markets – think private equity lending – offer larger yield premiums with lower loan-to-value ratios than at any time since 2008-09.
If the economy does go into a mild recession, the US yield curve will initially invert more deeply. We can imagine thus that longer duration bonds may perform well at the stage. After this stage, we would look to redeploy assets more widely.
Higher interest rates have caused a repricing of private assets amid much higher borrowing costs.
In the near term, we believe equities in companies with strong balance sheets and healthy cash flows will provide investors with greater portfolio resilience – see Why dividend grower “tortoises” may be core holdings.
We expect that as 2023 progresses, opportunities to increase portfolio risk will evolve. Once interest rates peak, we will likely shift toward non-cyclical growth equities. These have already repriced lower, and we expect them to begin performing once more before cyclicals. Among non-cyclical growth equities are many exposed to our Unstoppable Trends – see Deepening digitization. Subsequently, early in the recovery period, we will also seek a reentry opportunity in cyclical growth industries, as value equities may prosper when supply pipelines are unable to meet revived demand. The dollar could continue rallying for longer than fundamentals justify. Overshoots have been a characteristic of prior periods of dollar strength. Around a durable dollar peak, we will look to add more non-US equities and bonds.
In our view, 2023 will potentially be a great vintage for alternative investments. Higher interest rates have caused a repricing of private assets amid much higher borrowing costs. As such, specialist managers will be able to deploy capital into areas of distress and illiquidity – see Alternative investments may enhance cash yields. Across the venture capital industry, capital is now being deployed more judiciously and at more favorable valuations for investors – see Digitization and the growth in alternative investments.
For real estate, a higher bar is now in place for new investment across almost all markets and property types. We see this as a favorable backdrop for real estate investors in 2023 – see How unstoppable trends are redefining real estate. Our strategic return estimates in these areas are now materially higher than they were just a year ago when interest rates were much lower, indicative of how much value may be earned over time by taking illiquidity risk when others are less willing to do so.
Over the past six months, we have written about the “little fires” burning across the globe.2 No one knows how or when the war in Ukraine will end. We cannot be sure of China’s trajectory given its election of like-minded leadership. And we certainly do not know what political events will unfold in response to the recession itself, as governments will lack the resources needed to support individuals and companies as they did through the pandemic. In short, markets today are assuming that none of these little fires grow bigger or come together in an untimely way – see Expect the unexpected: How we might be wrong. That itself means that investors need to think of “sequencing” as a useful investing discipline.
As we look ahead to 2023, it is a time for pragmatism and practicality. There has been no economic period like this one, buffeted by the collective impact of a pandemic, a war and a highly reactive Fed. That said, we maintain our realistic view that the world will see businesses improve the lives of customers across the world. For example, we believe that the climate challenges will ultimately be addressed and provide fuel for profits along the way – see Energy security is vital. We believe that the post-pandemic period will accelerate the development of new treatments for disease and new tools to prevent future calamities – see Seeking to boost portfolio immunity with healthcare. We believe that new global macro realities will present opportunities to reshape supply chains and alliances. And we also believe that a return to a “new normal” is the likeliest outcome for the global economy – though not the only one.
It has been a great honor to work with a highly capable team in our Office of the CIO these last years as we provide you, our valued clients, with insights designed to make your lives better as we make your portfolios more resilient.
Wishing us all a better, healthier and peaceful 2023.
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