We run our client portfolios on the basis of long-term Strategic Asset Allocation (“SAA”) benchmarks, with adjustments for Tactical Asset Allocation (“TAA”) being made as the outlook for each asset class changes.
This has provided a very clear strategy for our clients and in 2022 our asset allocation consultant Heuristic Investment Services made eight TAA changes during the year. Whilst this provided a lot of work for us, Zenith Investment Partners, who provide attribution for us on our asset allocation benchmarks, have shown that Heuristic have provided value in six of the last seven years that we have used them. For 2022, this provided positive attribution of just over 2 per cent for a portfolio.
For the last six months we have been reminding our clients how important it is to have a plan in place. For existing portfolios, this plan is in place as per our TAA. For new cash, we have been stressing the need to have a constructive strategy, as we have said multiple times that we believe that investing at the opportune time will set portfolios up for a decade of outperformance.
Our only caveat is that we do not know when this time will come.
Whilst we do see a bumpy first half of 2023, the worst falls in both equities and bonds may well be behind us.
What we will be looking out for with Heuristic is fundamentals coming through. This will not be as easy as ringing a bell to signal the bottom, as nothing ever goes up or down in a straight line, but there will be a point where it is appropriate to start to deploy cash into risk-based assets, in stages.
The signal for this will be when Central Banks cease raising interest rates as the reality of the economic slowdown becomes clear and, in the case of the northern hemisphere, recession kicks in.
We added bonds to portfolios in December 2022 on this basis. We talk further about bonds later in this Insight, as we feel that many clients do not understand what government bonds are or why they are in portfolios.
Whilst US data is showing the resilience of their labour market, we believe that forward indicators show that there is a greater than 90 per cent chance the US will go into a mild recession. Households in the US are in good shape, which we think will ensure that the recession is not deep.
The uncertainty for 2023 for the US is the compromises made within the Republican Party to resolve the Congressional leadership. The debt ceiling will need to be lifted in the middle of this year. Will the political posturing by the Republicans over expenditure cuts to lift this ceiling create uncertainty and market volatility and is there a technical risk of a default in the US?
The US Federal Reserve says they will not cut interest rates this year, but we still believe that this posture will change. They are currently focussing on inflation but as data indicating an economic slowdown builds, their focus will shift to avoiding a severe recession.
With respect to Europe, we believe you will see a negative GDP print for Q4 2022 backed up by another negative print in Q1 2023. There will be a further 100 basis point increase in interest rates to 3.0 per cent before rates are put on hold there for approximately 12 months, as inflation weakens from over 9.0 per cent to 5-5.5 per cent.
The UK will see a more severe recession and one that will linger, as wage pressures and strikes need to be digested. Interest rates will also rise from 3.5 per cent to 4.5 per cent but we cannot see these falling during 2023.
China is the big surprise as the economy opens up at a rapid pace from its COVID lockdowns. This will see demand for energy and commodities pick up as they also become less aggressive on diplomatic posturing, especially towards Australia.
As we mentioned earlier, we increased bond exposure in late 2022.
We believe bonds could outperform equities during 2023, given the outlook for recessions in Europe and the US, as well as inflation having peaked earlier this year. Whilst we still need to watch services inflation, particularly wages, in many cases the signs in the US are that core goods are now experiencing disinflation.
We have allocated towards government bond funds only, with no credit exposure, as we believe that credit spreads will widen in a recessionary environment with the risk of defaults rising.
Many investors focus only on the yield provided by bonds but, whilst bonds are generally considered a “defensive” asset class, this ignores that fact that bond prices can be just as volatile as those of “risk” assets i.e. the capital value of the bond is also at risk. Yes, the regular coupon/income payments can be relied upon provided the bond issuer is of good credit quality – and there is no higher credit quality than that of the Government – nonetheless the price that these bonds trade in the market will fall as interest rates rise and vice versa. The rapid increases in interest rates witnessed in 2022 caused the biggest fall in bond prices in memory, with falls of fifteen per cent or more not uncommon.
The volatility of a bond’s price is greater the longer the maturity of the bond. This price sensitivity to moves in interest rates is referred to as “duration”.
As such, we avoided the worst of the bond market performance in 2022 by having virtually no duration in our portfolios. We are now adding duration back into portfolios, via government bond funds, as we believe we will see capital appreciation as it becomes clear that economic growth is slowing and central banks cease raising interest rates, eventually starting to cut interest rates in some countries.
In summary, we have stressed that volatility will continue in 2023 and as such it won’t be easy, but we believe this will be a better year for investment returns. When we sit back at the end of the year, we will have been provided an attractive entry point for risk assets, setting portfolios up well for the future.
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