Last month we published the HWP Investor Insight 116, the year that was, reflecting on what shaped 2022, and whilst we were expecting volatility, we discussed how the level of volatility is what surprised us. This month we publish our outlook for 2023 and the year ahead.
We believe 2023 will be the year when “patience will be rewarded” as, despite some calling for an increase in risk-based exposure during 2022, that opportunity will come in 2023 but not for quite a few months yet. Increasing exposure gradually at the correct time will set portfolios up, underwriting returns for the decade ahead.
When we look back at the end of 2023, we believe investors who were well diversified amongst and within asset classes will have been rewarded, as we strongly believe it is going to be a bumpy ride.
Tactical Asset Allocation: Quarter 4 2022
We enter 2023 with the following asset allocation positions, adjusted in portfolios for appropriate risk profiles.
We come to this position through working with Heuristic Investment Systems and looking at probability or scenario analysis.
From the outset we wish to point out we sit in the middle of where many see markets in 2023.
There are those who are optimistic from this point and those who are very negative.
We see interest rate rises continuing in early 2023 before hitting the pause button. Corporate earnings will start to soften and that will provide downside to equity markets with a mild recession in the United States, more severe in the United Kingdom and Europe but we stand by our view that Australia may well escape a recession.
We forecast global GDP for 2023 at 1.5 per cent, the lowest since the GFC and down from the IMF projection for 2022 of 3.2 per cent (2021 was 6.0 per cent).
Inflation expectations long term will be anchored at around 2.5 per cent. If long term US bonds hold between 3.0 to 3.5 per cent, then the weaker equity market will provide an entry point, as we see equities eventually rallying once it is clear that interest rates are on hold, and we would expect to increase our weightings in risk-based assets.
Our view is based on interest rates being cut in Australia early in the second half in 2023 and we now see interest rate cuts earlier in the second half in the United States as the full effects of these interest rate increases result in slowdowns to economies globally.
The million-dollar question is where will inflation settle? Headline inflation in the US will fall over coming quarters as energy and food price increases drop out of the annual numbers. Capital Economics in London see this effect alone reducing their contribution from 4.0 per cent to 0.25 per cent, whilst shipping costs have plummeted by around 40 per cent on average assisting goods deflation however, on the other side is upward pressure on services-based inflation as wages increase in this part of the economy.
The relatively even probabilities of each outcome in the above scenario analysis illustrates that, looking ahead, we need to be prepared to pivot if necessary i.e. not get too attached to a particular view.
As Howard Marks the famous Wall Street investor told a recent forum we attended in Sydney, what we are experiencing is the side effects of central bank battles with excessive inflation, therefore monetary tightening and consequently, a slowing economy, but from this comes opportunity.
FIXED INCOME
Having spent most of the last few years underweight this asset class, with virtually no duration in our portfolios, we enter 2023 in a neutral position, and we are just starting to add duration (buying longer term bonds) as we enter the New Year.
Central banks have made it clear that there are more interest rate rises to come and that they are happy to risk their economies falling into recession to tame inflation. Yield curves will become more inverted as short-term bond yields rise but longer-term bond yields find support as growth stalls, provided longer term inflation expectations remain anchored at around 2.5%.
After warning last year that bonds would not provide the defensive characteristics that they have historically provided, in 2023 we believe they are more likely to revert to their defensive characteristics, as core inflation and growth fall. The market will remain volatile though, as we have seen by the reaction to the surprise move by the Bank of Japan at the end of 2022 to adjust their yield curve controls. If we are right about much of the world moving into recession, then watch also for the return of volatility in credit spreads.
CURRENCY
We are never comfortable forecasting a level for the Australian Dollar (AUD) as no one ever calls it correctly, but we will always be prepared to give it a direction.
As the AUD trended lower in the 2H 2022 we made a call to increase overall Developed Market hedging to approximately 65 per cent at around 0.62 against the USD.
We felt the AUD weakness was overdone, and if the AUD falls through this year’s lows, we will increase hedged exposure further.
We believe the trend for the AUD is to go above fair value at around 0.74 against the USD and would reverse these positions to at least 50 per cent when it goes above these levels.
The AUD is closing 2022 at around 0.67 against the USD. Commodity prices will see some weakness as economic demand softens globally, and short-term interest rate differentials may favour the USD especially as Australia starts to cut interest rates earlier in the second half of this calendar year ahead of the United States.
We see an upward trend for the AUD but believe at this stage it will struggle to reach our fair value level.
EQUITIES
We continue to advocate equities over fixed income when it comes to considering the longer term returns available from investing across asset classes.
We go into 2023 with a Neutral position to both Australian Equities and Emerging Market equities and a Significant Underweight in Developed Market Equities on the back of a negative view on the US equity market, which is above our assessment of fair value following the recent bear market rally.
Capital Economics view is that the “S&P 500 will make a new cyclical low by the spring of 2023 as a shallow recession gets underway in the US before rebounding to end next year higher than it is now. The buying opportunity for equities will therefore be with us in the first half of 2023. “.
It is important to make the most of any downside, despite any negative noise, as Capital Economics go on to say that with the US 10-year Treasury yield likely to stay low and fall further in 2024, this should reinforce a “fairly strong rebound in the S&P 500 from mid-2023 onwards”.
We believe the Australian and US equity markets will test the lows they reached earlier this year (3400 on the S&P500) before rallying when interest rate expectations eventually improve.
We anticipate large sector divergence during 2023, like what we witnessed in 2022, where Energy was the standout winner and sectors such as communications, real estate, consumer discretionary and technology performed the worst. Unpredictable events such as Russia’s invasion of Ukraine have the potential to unhinge these predictions and remaining nimble and prepared to pivot will be critical during 2023.
PROPERTY
Our property market view varies between listed and unlisted property, with the former having already adjusted to higher interest rates and factoring in a tougher economic climate in 2023. Unlisted property has largely escaped these price adjustments in 2022 because of a lack of transactions and subsequent price discovery.
Towards the end of 2022 we witnessed global property groups like Blackstone and several domestic groups withdraw or limit redemption facilities for unlisted property funds. We expect this to continue into 2023 until unlisted markets find a more realistic equilibrium, where transaction volumes increase, and prices adjust. It is at this point that we anticipate allocating to more opportunistic unlisted property funds, with this most likely occurring sometime in FY24.
Excluding the COVID market drawdown in early 2020, valuations in the REIT sector are more attractive than they have been in over a decade on a price to book value metric, with the sector now trading below 1 times price to book. Valuations should not be viewed in isolation, as tight policy and liquidity conditions, an uncertain macroeconomic backdrop and negative momentum is preventing us from moving overweight REITs. We will look to add an overweight REIT position prior to the anticipation by markets of interest rate cuts in the second half of 2023.
ALTERNATIVE ASSETS
Allocations have remained steady over the last twelve months, and we look for selective opportunities in 2023 for those portfolios whose allocations are not yet at a satisfactory level.
We believe that distressed opportunities could present themselves in Property, Diversified Credit and Private Equity. We will be keen to research these opportunities as possible investments for our portfolios.
We need to ensure that sequencing risk is reduced by providing a spread of vintages during portfolio construction. We also have several investments in the harvest stage therefore both these occurrences will see us selectively make investments further across portfolios.
We also need to ensure that risk within this asset class is managed, by providing diversification within sub-asset classes and amongst both assets and vintages.
We do believe our portfolios will continue to see respectable returns from this part of the market in 2023.
Alternative assets reduced volatility and enhanced returns over 2022, and we are very encouraged by the prudent revaluations that have occurred. In some cases, valuations were not positive but nonetheless provided a high degree of transparency within areas that are often criticised for being opaque.
There is a clear benefit from including private assets in the areas of Property, Diversified Credit, Private Equity, and Infrastructure, where appropriate for a client’s risk appetite.
Over the years we have attempted to maximise Alternative strategies in client portfolios, and this has been a strong emphasis since mid-2018. Illiquidity can be an issue for some of these strategies but, provided the weighting is suitably conservative and in line with a client’s risk profile, these can also provide clients with attractive returns uncorrelated to traditional markets.
FINALLY
It is a mixed market out there at the moment. Whilst many have called the bottom and believe the relief rally is the start of the next upward stage, there are many seeing the end of the world.
We are somewhere in the middle. We believe that core inflation, economic growth and corporate earnings will slow. We will see a further decline in equities and, eventually, in longer term bond yields. This will provide an opportunity to add to risk assets but the timing is unclear. There are still many unknowns, including if/when central banks pause their hiking cycle and where inflation settles. We have only briefly mentioned geopolitics but these risks remain elevated. The Ukraine war is not going away any time soon. The outlook for China will improve as they remove their zero-COVID policy but again recovery there will be bumpy.
As a wealth manager we always concentrate on fundamentals, which is why we have taken the position we have, but we are optimists.
Please remember human beings often get anchored to the circumstances we are in – or how the latest market performance affects us.
There is a point of balance to bear in mind.
We believe risk will be rewarded over the medium to long term but through a conservative lens, as inflation will be with us for the years ahead.
Successful investors never forget risk as a component of strategy and the need for prudent risk management. Looking towards 2023, we are attempting to expose portfolios to risk exposure and to increase this at some point during the year through both equities and alternative assets.
We reiterate our strongly held view that the opportunity to increase risk-based exposure will come in 2023 and is still many months away, but increasing exposure gradually at the correct time, will set portfolios up, underwriting returns for the decade ahead.
At HWP, we will always position client portfolios for a full market cycle, and we will not be distracted by short term “noise”. Underlying asset valuations and credit quality are always considered, but asset allocation is the key and investors who are bold when markets are out of line with valuations will achieve the best results.
We do believe such an opportunity could present itself during 2023.
The combination therefore of manager selection combined with diversification through asset allocation, discipline and patience should ensure portfolio outperformance is delivered.
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