The managers of the AIMS Target Return strategy explain why investors should be prepared for more turbulence in 2023.
Read this article to understand:
- Why the breakdown in the historic bond-equity correlation is likely to persist in 2023
- Why many investors could be overoptimistic on early interest rate cuts
- How relative-value trades offer an alternative means of generating returns in more challenging market conditions
2022 was one of the toughest years in living memory for investors. Bonds, equities and pretty much every other asset class other than commodities suffered heavy losses as soaring inflation led central banks to tighten monetary policy forcefully for the first time since the global financial crisis.
Peter Fitzgerald (PF) and Ian Pizer (IP), managers of our AIMS Target Return strategy, tell us how they have been navigating this environment, discuss their expectations for 2023, and give some insight into how their portfolio is positioned to cope with higher interest rates and lower returns than investors have become accustomed to.
Can you briefly recap on how the strategy performed in 2022?
PF: Towards the end of 2021 we identified within equities that we wanted to be overweight energy and commodity stocks. We also wanted to be overweight value versus growth stocks. Both decisions were helpful.
We also saw US interest rates rising by more than was being priced into markets. We didn't necessarily know to what level, but we kept revising our targets higher as we saw the risks to the upside.
This in turn meant the correlation between equities and bonds was probably going to be different than normal. That suggested the risk to running long equity positions was going to be offset by being short rather than long bonds, as would have been the case in the past.
IP: We thought inflation would be sticky, but we didn't expect it to rise as far as it has. The key has been to avoid being a slave to historic correlations. Even if your risk model suggested you were not building a diversified portfolio, it helped to override it by taking more of a scenario-based approach.
Looking at the prospects for 2023, with labour markets tight, equities seem to be pricing in no worse than a fairly shallow recession, at least in the US. Are they too optimistic?
IP: The falls we have seen in equities can be fully attributed to rising interest rates. I don’t think the market is priced for falling earnings, which suggests there is further downside if there is a recession. So we remain cautious on equities.
Central banks are no longer providing markets with a backstop
This is the first slowdown since the financial crisis that is effectively being sanctioned by central banks. They are aiming to get economic growth well below trend. They're hoping not to go negative, but whereas before they were likely to back off at any sign of slowdown, they are no longer providing markets with a backstop. Equities are suddenly having to cope with a very different environment.
PF: The recent rebound in equities, coupled with signs inflation may have peaked, is causing some to call the end of the equity bear market. I think that is premature.
Most investors have only experienced short, sharp bear markets in equities. Even if you look at the 2008 financial crisis, there was a very sharp fall, but the recovery took hold relatively quickly as well. But as we saw at the turn of the century, you don't need a deep recession to have a prolonged bear market in equities. Even if you believe we’re going to get a relatively soft landing from an economic perspective, that doesn’t mean equities are not going to be in for a tricky period.
With equities having delivered double-digit annual returns since 2009, there is a suggestion markets have borrowed future returns, and going forward sub-par returns are now likely for an extended period. What’s your view?
IP: Central banks have effectively brought forward asset price returns to buoy the consumer via the wealth effect. Having done this, it is natural to expect there will be a payback.
That doesn’t necessarily imply negative returns, but we certainly wouldn't expect to see consistent double-digit returns over the coming years.
A lot of the outsized returns have been generated by one market – the US
PF: A lot of the outsized returns have been generated by one market – the US – and within that market a small group of high-growth tech companies. It is going to be more difficult for equities to deliver the sort of returns we’ve grown accustomed to, especially with US Treasuries offering a risk-free return of as much as four per cent. There may be sectors within the market, such as value stocks, which continue to do well, but overall indices will struggle.
The prolonged era of ultra-cheap money appears to be over, yet markets seem to be reluctant to accept this. For instance, US rates are expected to peak at around five per cent before being cut quite aggressively to around 2.8 per cent over the next three years. Does this make sense?
IP: Even if rates peak at five per cent and then trough at 2.8 per cent, the market is pricing the end of cheap money. That is fundamentally different to what we have had, which is rates at zero, briefly climbing towards say three per cent, and then quickly coming back down.
It seems like we may be returning to the kind of regime we saw before 2008
That said, it is still unclear as to whether five per cent is going to be enough, or the extent to which you may have to stay at five per cent for a more extended period. Before the financial crisis, when the Fed hiked, rates tended to spend more time towards the top end of the range than the bottom. Since then, they have only briefly risen above zero. It seems like we may be returning to the kind of regime we saw before 2008.
PF: Even if rates come down next year, the trough of the next cycle is almost like the peak of the previous one. I see an exceptionally low probability of rates returning to zero. If you cast your mind back a few years, people were talking about how deeply negative rates could go, with some even questioning whether there was a lower bound. Those days are over.
Rising rates have had a knock-on effect on fiscal policy as we saw in the UK this autumn. Does this imply all governments are going to have to take steps to get deficits under control, even the US?
IP: I don’t think markets are too concerned about the size of deficits. What they didn’t like in the UK was the inconsistency between a central bank that was tightening policy to restrict growth and a government saying it was going to use fiscal policy to try to boost growth.
I think markets are still fairly tolerant of high deficits. At some point that may change, but I don't think we have seen evidence of that yet.
While there are signs inflation may be close to peaking, there are reasons to believe we may be in a new higher inflation environment. If so, what are the options for investors wishing to hedge this risk?
IP: We are getting to a point where inflation-linked bonds could be of interest for someone whose primary concern is inflation.
Shortages are going to be quite acute in parts of the commodity market
Beyond that, if we are in a higher inflation environment, what is the scarcity that's causing it and where can you be invested? You would still be looking at parts of the commodity market where shortages are going to be quite acute given the energy transition over the next decade.
PF: It will be very difficult to get higher inflation without higher commodity prices. Better still, for those looking to invest in commodities, many commodity curves are in backwardation, meaning you are not paying a lot of money to hold positions, whereas historically there has been a sizeable negative carry working against you.
Can you talk us through how your portfolio is positioned and the main ways in which you are trying to deliver returns?
PF: Within both bonds and equities we are mainly taking relative-value positions rather than outright directional ones. Within equities, we prefer value to growth, and we like the resources and commodity sectors.
IP: Interms of bonds, while it seems we may be in a higher inflation environment, we don’t want to be particularly short US Treasuries. The market looks reasonably priced given uncertainty as to precisely what this new inflation and interest rate regime will look like.
European countries are spending a lot of money to shield their economies from rising energy bills
We like UK bonds relative to European peers. This is firstly because we think the UK has probably priced in a little bit too much monetary tightening given the country’s mortgage market is especially sensitive to changes in interest rates, since most loans are floating or fixed for shorter periods.
From a fiscal perspective, European countries are spending a lot of money to shield their economies from rising energy bills, whereas UK fiscal policy looks to be heading in the other direction.
Is China becoming uninvestable given rising political and economic risks?
PF: Not yet. There will be opportunities to trade in some Chinese assets, particularly as the economy re-opens, but the risks are high, and you need to bear that in mind prior to allocating capital.
IP: It is clear the Chinese government does not believe in the capitalist system and does not want the market to freely allocate capital. Beijing appears to have no concern for ensuring the returns on offer to the providers of capital are commensurate with the risk. Faced with this new reality, investors are going to demand a much bigger risk premium.
An abnormally high correlation between equities and bonds has been a headache for managers this year. Is this likely to persist?
PF: That correlation is going to be more unstable than it has been historically with a bias to it being positive. History suggests higher inflation regimes lead to a positive correlation.
History suggests higher inflation regimes lead to a positive correlation
But while this is a problem for traditional multi-asset funds, it arguably is of benefit for a multi-strategy, absolute return, manager such as ourselves that can take long and short positions. Central banks’ suppression of interest rates and volatility since 2008 has made it hard to make money from relative-value opportunities. We see that changing.
What are the main market themes you anticipate in 2023?
PF: We made money by being short equity volatility in 2022. I think we will get opportunities to be short volatility again in 2023 as people search in vain for risk-off strategies by going back to the traditional playbook of buying volatility.
The big theme will be continued outperformance of value relative to growth
But for me, the big theme will be continued outperformance of value relative to growth, a continued de-rating of high-growth sectors and probably underperformance of US equities relative to the rest of the world. They’ve got to a point where they are over 60 per cent of the MSCI World. I would be surprised if you generated a positive return in US equities this year.
The other thing we expect is resources will continue to be in demand. That was going to happen even without the war in Ukraine given the material underinvestment in the supply of major commodities.
Central banks will be determined to stay the course and won’t turn a blind eye to their inflation target
IP: I expect continued repricing in government bond markets. Central banks, in particular the Fed, will be determined to stay the course and won’t turn a blind eye to their inflation target.
We will get to a point where markets will reprice for that; you will get an opportunity to own government debt at attractive yields and for a while it will serve as that traditional diversifier. But it is hard to see us getting to this point until markets stop pricing in early rate cuts. At present, rate cuts are simply anticipated too soon.
