Ten investment convictions for 2023

2023 may divide into two distinct phases. The effects of tighter monetary policy, high inflation and slowing growth will carry into 2023, demanding prudent portfolio positioning. However, once real interest rates peak, the economic cycle will pivot, creating opportunities to raise allocations to risk assets.

That will only happen once the US Federal Reserve halts its interest rate hikes. The central bank is entering a new phase in its monetary cycle by slowing the pace of tightening as inflation declines slowly from four-decade highs. A higher peak in interest rates will accompany a probable recession late in 2022 and into 2023. The resilience of the American job market will be key to the shifting pace of monetary policy.

In Europe, consumer prices remain largely driven by energy. The continent’s decoupling from Russian sources is having deep economic and geopolitical consequences. Much now depends on the severity of the northern hemisphere’s winter, but gas inventories have been replenished.

China is a potential source of growth in 2023. Its exports remain an essential component of global supply chains and we see the authorities gradually shifting their Covid strategy to re-open the economy. The recovery of the Chinese real estate sector will be another precondition for economic expansion. However, international trade patterns continue to evolve in a more fragmented world, as corporations make their supply chains more resilient through ‘friend-shoring.’

The main risks for global growth remain overly restrictive monetary policies, which would worsen the affordability of housing in developed economies. The war in Ukraine retains the potential to inflict further damage on energy markets and on Europe in particular. Any further delay in re-opening the Chinese economy would weigh on global growth, and we cannot rule out further geopolitical tensions over Taiwan.

We maintain a cautious stance as we enter the first phase of 2023. We favour quality across asset classes. In equities, we like companies with low earnings volatility and better ability to maintain margins. In fixed income, we prefer investment grade over high yield debt, and in currencies, we prefer havens from risk, such as the US dollar and Swiss franc. We are overweight cash, which enables us to stay nimble and seize investment opportunities as conditions improve.

A peak in real interest rates and a trough in economic activity are two key signposts for a different set of investment opportunities. We look at these two distinct phases as demanding distinct responses for portfolios. In this publication, we set out these two approaches for the year ahead.

1. A pivot year: look for the inflection point

Monetary policy tightening in the western world, amid a global downturn in economic activity, translates into an unfavourable setup for risk assets. Recession and further cuts to corporate earnings expectations are the main downside risks for both equities and bonds. Peak real rates should provide a turning point in markets. To get there, the Fed will need to pause its interest rate hiking cycle as inflation slows and unemployment rises. As this inflection point approaches, we will gradually increase risk levels in portfolios by adding duration in government bonds and to gold, as well as some equities and credit.

Phase One, pre-pivot: until real rates peak, we remain moderately cautious

2. Underweight risk assets for now

Macroeconomic conditions warrant an underweight exposure to risk assets, focussing instead on assets that can better withstand the impact of weaker growth or higher rates. Specifically, this means holding quality stocks, government bonds, and investment grade credit. It also implies overweight cash positions to be able to invest as soon as we see opportunities.

3. Prefer quality and diversification across asset classes

In the months ahead, we expect new equity market lows as high borrowing costs limit firms’ multiple expansion, and earnings estimates keep adjusting to recessions. In this context, we look for quality companies with low earnings volatility and better ability to defend their margins. Such stocks tend to outperform in recessions or when profits decline. In terms of quality sectors, we prefer healthcare as it enjoys high margins, some insulation from inflation, due to high pricing power, and attractive shareholder returns. Valuations also remain historically undemanding compared with other defensive growth sectors.

4. Asymmetric return profiles

Options strategies, such as put spreads on equity indices, can shield portfolios from drawdowns. We have implemented hedges to portfolios throughout 2022, and we will continue to manage them tactically in line with market conditions.

5. Seek diversification through alternatives

As market conditions will remain relatively challenging, we continue to favour resilient hedge fund strategies such as global macro, discretionary and quantitative. These should provide diversification, as they tend to benefit from performance dispersion across asset classes and regions. Their typically convex profiles, designed to perform in more extreme periods, should profit from the volatile environment with limited correlation to underlying markets. Some relative value strategies should also provide attractive returns once rates stabilise.

6. USD strength to continue

The US dollar’s strength should persist through the ‘pre-pivot’ phase, supported by rate differentials, liquidity tightening and America’s terms of trade. Other currencies supported by this environment include the Swiss franc and, potentially, the Japanese yen. The euro and sterling should lag, since they are suffering more structural problems related to the energy shock. The Chinese yuan should also underperform as the country’s robust balance of payments begins to weaken. Post pivot, the dollar should weaken.

Phase two, once real rates have peaked; we add risk to portfolios, adopting a moderately optimistic stance

7. Gold’s appeal to increase

For much of 2022, gold prices were caught between support from geopolitical and recession risks, and the downward pressures of real rates and a strong dollar. With lower rates, a weaker US dollar, and a reopening China, gold prices should rise. In October we sold put options on gold, as a potential means of bringing our position to neutral. Selling out-of-the-money put options allows us to potentially monetise the gold market’s current high volatility, while offering clients greater exposure should prices fall.