Turning the page on 2022

Key takeaways

• We review the performance of our convictions for 2022, and look ahead to 2023
• Our favouring of cash, high-grade bonds, value and cyclical stocks, together with our views on the US dollar’s strength and gold’s underperformance, all proved helpful
• However, we did not foresee the impact of the Ukraine war on equity markets, or such a sharp rise in interest rates. China’s slow growth was also a disappointment, and affected Asian credit markets
• We favour a cautious investment stance as we head into 2023, and expect to see opportunities to increase risk exposure once US real rates peak.

‘Permacrisis’ is Collins Dictionary’s word of the year. It was an exceptionally difficult 12 months on many levels. From record inflation, rising rates and the cost of living, to the Ukraine war and subsequent energy crisis, it’s worth remembering how unusual the year was for investors. Just three years in the last hundred, 1931, 1969 and now 2022 have posted negative returns in both fixed income and equity markets.

We believe that it is useful to review our investment convictions of just over a year ago, what we got right, and where our expectations missed the mark. In mid-November 2021, we looked ahead to a complex economic recovery from the pandemic as governments and central banks normalised fiscal and monetary policies. That included central banks raising interest rates to counter increasingly persistent inflation. The persistence and impact of inflationary pressures was deeper than we anticipated, and will probably take US interest rates as high as 5% in 2023 as the Federal Reserve tips the economy into recession, weakening the housing and labour markets to bring down prices. We believe this monetary strategy is working and should drop US inflation to around 3%, or slightly less, a year from now.

While the US economy looks increasingly to be moving in the right direction, Europe’s path remains less clear. Russia’s invasion of Ukraine on 24 February 2022, was widely considered improbable, right up until the event itself. The war’s scale, and Ukraine’s recent successes, were tough to anticipate. Away from the battlefield, the energy crisis that followed has proven painful for the European economy and consumers. Yet over the longer term, it also offers the prospect of a much-accelerated transition to cleaner energy as European governments invest to develop alternatives to Russian sources at scale, such as nuclear and sustainable power.

While the rest of the world dropped its Covid masks as vaccination campaigns rolled out, China remained mired in intermittent lockdowns. China is now on a path to reopen, even if it will inevitably be a bumpy road. The late reopening has acted as a brake on the domestic and global economy, while driving inflation elsewhere upwards as the shortages from its factories slowed supplies and limited inventories.

As you can see below, in 2022 we got a clear seven out of ten investments convictions correct, although we did not foresee the year’s geopolitical catalysts. Please do not confuse this exercise in humility with our latest convictions for 2023, which can be found here.
 

1. Start rebuilding cash buffers in portfolios ✔

We advocated a cash buffer to seize investment opportunities in the event of sell-offs, likely triggered by slowing growth and elevated valuations. In the event, fixed income volatility was even higher than we anticipated, and cash outperformed most asset classes in 2022. We remain overweight cash as we start 2023, for the same reasons, as investment opportunities will arise as conditions improve.

2. Further reduce exposure to high-grade bonds ✔

Anticipating rising rates in response to inflation in the first months of 2022 proved prescient and made both government bonds and investment grade credits unattractive. This was the basis of our large underweight position in early 2022. Much has changed since, and as we move through 2023, with rates expected to stabilise and spreads become more attractive, we believe that investment grade credit will be an attractive source of carry to weather a likely recession. We will also look for opportunities to increase portfolios’ duration.

3. Sound earnings continue to make equities attractive ✖

We expected that strong corporate earnings - at a time when consumption was rebounding - would translate into positive performance in equity markets in 2022 despite elevated valuations. While earnings did remain solid, the sharper-than-expected rise in interest rates and the war in Ukraine meant lower valuations and decelerating earnings, for a negative, rather than positive, outcome. With valuations at current levels, and the S&P 500 now trading around 4,000 points, our expectation is that in 12 months we will see a broadly flat index along with a lot of volatility. This is because we expect to see earnings contract as recessions bite in early 2023, before a recovery takes hold. Factoring in the degree of economic uncertainties and geopolitical risks, we consider bearish and bullish scenarios closer to 3,200 and 4,500, respectively.

4. Keep a bias towards value and cyclical stocks ✔ 

This conviction proved fruitful, with value indices outperforming strongly; and in particular those biases towards investments in the energy sector, mining and financial firms. While we still prefer value, as the challenges of high inflation and high rates decline, equity valuation multiples for growth segments could benefit, leading to fortunes that are more balanced. Once real rates have peaked, and growth deterioration starts normalising, we expect to see opportunities to add to cyclical and growth names.

5. Tilt emerging-hard-currency overweight towards Asia ✔

While Asian credit did outperform within the universe of emerging market hard currency debt in 2022, it did not do so significantly, nor was it driven, as we expected, by China’s more speculative segments. Built around our conviction that China would maintain its focus on economic growth, we were disappointed to see the country’s slow pivot on Covid management and timid support of the real estate sector. Both factors weighed on Asian credit. In the wake of much popular discontent with the government’s zero-Covid policy, in recent weeks the public health situation has rapidly changed. While the path to a fully opened economy will prove testing as the number of Covid cases increases in a poorly vaccinated country, we expect China to achieve GDP growth of 4% in 2023, thanks to monetary support and structural government spending.

6. Factor-in a stronger dollar and a weaker euro ✔ 

Our overweight exposure worked well for much of 2022 as the US currency strengthened strongly against both major developed and emerging currencies. We now expect the dollar to remain strong as monetary conditions continue to tighten and the interest rate advantage remains favourable, effectively increasing demand for the currency. Looking beyond this nearer term, we think a USD peak is forming, that demand will tail off, and that during the first half of 2023 it will be timely to diversify exposure towards the Japanese yen, and some other developed market currencies.