CIO Lens Q1 2023: brighter days ahead?
After the gloom of 2022, Johanna Kyrklund and other leading investors around Schroders look at what might await in 2023, including the increased attraction of bonds and markets outside the US.
It’s a gloomy time of year in more ways than one at the moment. Even the excitement of my recent move to a new house can’t distract from the literal and figurative darkness of January 2023. The war in Ukraine is dragging on and the spectre of recession looms and rising unemployment large, to name but two dark clouds over us all.
Just as a new house brings a fresh start, a fresh calendar year is an opportunity for active investors to look to the future. And as we peer through the present gloom, we see some causes for optimism. Following the poor performance and significant falls in equity and bond markets in 2023, we now see some attractive valuations. And I’m reassured that whatever comes next, we have the processes and teams to cope.
Recessions are tough for everyone, but from an investment perspective, this is also when we can find fresh opportunities. Indeed, as I mentioned in my recent 2023 outlook, it’s important to remember that historically some of the best opportunities for equities – for example - occur in the midst of recessions. Markets always move ahead of economic news.
Investing in a new era
Over the last couple of years we’ve talked regularly about disruption and regime change, as we move into an era where both inflation and interest rates nestle into higher ranges. With this in mind, I’ve previously summarised our strategic view as "think about what you did over the last decade, and do the opposite". This still stands. So, what does that mean for markets in 2023?
Let's start with the epicentre of weakness in 2022 - fixed income. As I mentioned, we believe that inflation will be structurally higher over the next few years due to deglobalisation and decarbonisation. There will still be cycles in inflation, of course but we expect that central banks won't get back to the zero rate policies of the 2010s. This means that we can't assume that fixed income will be negatively correlated with equities over the medium term. However, with the repricing of yields in 2022 and the risk of recession in 2023, we think that fixed income offers an attractive source of yield and diversification.
We expect geopolitical tension to continue to run high, but as an investor these risks are impossible to time or predict given their binary nature. Our main defence is diversification and identifying exposures which might protect us from geopolitical news, but which we also like for other reasons. In this regard, we continue to believe that strategic allocations to commodities and commodity-related investments provide some protection from geopolitics as well as inflation risks.
Look beyond the US
The last decade was dominated by the outperformance of US assets - both equities and bonds. We now see benefits to greater regional diversification.
Within fixed income, a number of emerging markets are further along in the battle against inflation and have reasonably solid macroeconomic fundamentals. Given the high level of yields, particularly in local currency-denominated bonds, and the level of underinvestment in this asset class due to turbulence over the last decade, we see opportunities for 2023. Our emerging markets debt team has highlighted local currency bonds in Mexico, Brazil, Indonesia, South Africa and a number of dollar debt frontier markets such as Angola and Ivory Coast as being particularly appealing.
We are also starting to differentiate more within equities as regions outside of the US offer more compelling valuations. As Alex Tedder, Head of Global Equities points out, underlying US margins, after a prolonged period of strong execution, are at record levels. As we've seen with the tech sector, cost pressures in the US are now making themselves apparent at a time when revenue growth is clearly starting to slow. Negative operating leverage - where fixed costs comprise a greater portion of a company’s total cost structure while simultaneously sales decrease - is beginning to kick in. Yet Wall Street still expects 6-7% earnings growth for the S&P in 2023, which seems optimistic.
China on the rise again?
The rest of the world definitely looks more interesting, however, especially Asia. China is likely to accelerate quite strongly out of its extended period of strict Covid-19 lockdowns. Our Asian equities team expects a sharp recovery in consumer spending to kick in from the second quarter on, supporting domestic earnings in many sectors of the Chinese economy.
Lastly, a word on overall risk levels. While rate expectations are now more realistic and we expect interest rate volatility to stabilise, we expect liquidity to remain tight in the next few months. Combined with the risk of recession, we believe that more pro-cyclical positions need to be balanced with lower allocations to US equities. It will be prudent to keep some dry powder for the opportunities likely to appear.
Here in the UK the Winter solstice is behind us and the days are slowly getting lighter. Brighter days for investing surely await too.
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