Investment opportunities are returning this year as global markets bounce back from the paradigm shifts of 2022, says Pictet in its 2023 investment outlook.
Last year, the combination of unrelenting inflation, the delayed reaction of central banks — most notably the US Federal Reserve — and the war in Ukraine caused global markets much pain. The typically negative correlation between bonds and equities began to trend the other way, and 2022 created an historic moment as US government bonds and US equities both delivered negative performances.
According to Pictet’s research, this had only happened two other times in history: first in 1931, at the depths of the Great Depression; and in 1969, at the start of the relatively mild recession that year and the next. Investors with the traditional balanced portfolio of 60% equities and 40% fixed income would have found little joy last year as both asset classes suffered.
Now, the 60/40 portfolio could be back with a vengeance in 2023, says Pictet, as the correlation between treasuries and equities turns negative again. “The traditional buffer was badly missed last year, but should come back in play this year,” says Hugues Rialan, Pictet Asia’s chief investment officer and head of discretionary portfolio management, at a recent briefing.
What could continue from 2022, however, is heightened volatility across asset classes. Aside from a “revival” in the fortunes of 60/40, he believes interest in bonds will continue to grow, as well as a renewed recognition of the value of multi-asset strategies.
As the world continues to grapple with severe political and geopolitical tensions, as well as high and persistent inflation, among other uncertainties, Rialan expects market volatility to remain elevated. The pick-up in volatility in currencies, fixed income and commodities has been particularly noticeable, he says.
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By treating volatility as an asset class in its own right, Rialan says it also provides opportunities, offering the chance to deploy derivatives to monetise high volatility and mitigate portfolio risk. “We think that volatility in all asset classes on average will be significantly higher than in the past decade. That has consequences of unexpected returns, for instance, on the use of leverage,” he says.
Says Rialan: “As we move into a new year, markets are sending different messages. On the one hand, future prices of commodities like copper and trends in overnight lending rates point to a recession. On the other, the US equity risk premium has been coming down and high-yield spreads are still below recessionary levels, indicating the ‘soft landing’ narrative is gaining traction.”
Fixed income repriced, equities on the comeback
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According to Rialan, the rise in real yields is offering a new range of possibilities in fixed income as bonds come back “selectively”. He believes long-dated US Treasuries will increasingly come into their own as inflation moderates, regaining their “safe haven” status in case of recession. Pictet is forecasting 10-year US Treasury yields to hover between 3.2% and 4.2% this year and to end 2023 at around 3.5%.
A potential climb in the default rate and the rise of floating-rate debt in the high-yield space are among the reasons why Pictet prefers investment-grade bonds, which offer attractive coupons without having to take on too much duration or credit risk, says Rialan. In emerging market credit, his preference continues to be for Asian investment-grade bonds in US dollars, which falls under Pictet’s “safe carry” classification, while he remains neutral and highly selective in emerging market sovereign bonds in local currencies.
Rialan believes that fixed income will be an “interesting” play throughout 2023. In contrast, equities will be “more volatile” during the first half of 2023 and will stage a “comeback” in the latter half, making the whole of 2023 still a better year “overall” for investors.
“2022 was one of the worst years on record for [the 60/40 portfolio strategy], but as we know, trends should not be extrapolated,” he says. “And in this case, that is good news.”
Taking into account differences in equity risk premiums, Rialan expects markets with lower valuations to perform better than US large caps. Rialan believes the “convergence” of risk premium that started in 2022 has “further to run”, and is expecting negative 6% returns on the S&P 500 in 2023. “The valuation difference between risk assets is still too wide, and there is too much dispersion in these valuation metrics,” he explains.
He adds: “In 2022, what we saw was risk premiums for fixed income and equities starting to converge brutally. The bonds were overvalued and the repricing of bonds led to a repricing of equities. Still today, we think that US large caps in particular are too expensive relative to other assets.”
Rialan believes developed market equities could achieve low single-digit growth in revenues this year, but increasing pressure on margins will eat into earnings per share growth, which could turn slightly negative, as pressure on US equity valuations could continue this year. With fixed income “more or less” repriced, Rialan sees US small caps as more attractive than their large-cap counterparts, while Japanese and Chinese equities could also prove interesting.
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Positive developments, such as the full reopening of China and some degree of resolution in Ukraine, could benefit comparatively cheaply valued emerging market equities as the year develops. Nonetheless, defensive emerging market equities could make “more sense” before moving into more cyclical ones, he reasons.
Asian prospects more promising
While Rialan expects to see a gradual recovery in the West while China progressively reopens, he believes rate hikes still have some way to go, and that the US and Europe will tip into a mild recession in the early part of 2023 before global gross domestic product (GDP) growth rebounds in the second half of this year.
He expects inflation in advanced economies to ease to 3.2% in 2023 from 6.9% in 2022, but notes that high consumer inflation expectations and relatively sticky wage growth could make the Fed wary about letting down its guard too early for fear that price increments re-accelerate.
Rialan expects the Fed funds rate (FFR) to stabilise at a terminal rate of 5.05% to 5.25%, which could be reached by March, and does not see Fed rate cuts as likely before early 2024.
Global GDP, according to Pictet, will grow 2.5% this year, down from 3% last year. The deceleration is likely to come from major developed economies such as the US and Europe, says Dong Chen, Pictet’s head of Asia macroeconomic research.
According to Chen, although US consumption was in good financial shape in 2022, sticky inflation and tightening financial conditions mean real consumption growth will probably be close to flat this year. Meanwhile, the euro area grew significantly in the first half of 2022, but the energy shock, record inflation prints and tightening of financial conditions have since weighed on that economic zone.
Chen expects US GDP to decline by 0.2% in 2023 from its 1.9% growth last year, while forward-looking indicators in Europe still point to a mild recession in the first half of this year, and is also forecasting euro area economic growth to decline by 0.2% in 2023 from its 3.3% increase in 2022.
Asia’s prospects this year, in contrast, are “broadly better”. Chen expects China’s GDP to grow 4.5% in 2023, a “moderate rebound” from its 2.8% growth last year on Beijing’s policy shift.
“Given very weak growth momentum, a set of new measures aimed at providing credit support to property developers was issued in mid-November 2022. In our view, these measures are the strongest policy support since the property crisis started in late 2021 and may help stabilise the housing sector in the coming months, although a massive rebound is unlikely for structural reasons,” says Chen.
Chinese authorities’ recent switch to a rapid reopening of the economy has seen a significant spike in Covid-19 infections and hospitalisations, adding further downside risks in the near term. However, Chen says this will likely be followed by a rebound in activities when the Covid-19 situation improves.
Japan is expected to maintain the same level of “moderate expansion” it showed in 2022 into this year, as private consumption could benefit from the economic reopening and households start to spend a significant amount of excess savings, while capital expenditure picks up in manufacturing. For 2023, Chen expects Japan to match the 1.5% GDP growth it showed last year. “For Japan, this is actually fairly decent growth, especially compared to the expected negative growth that we’re going to see in both the US and Europe,” he says.
Chen says that with waning global demand and domestic monetary policy continuing to weigh on North Asian exporting markets like Taiwan and South Korea, these economies could see slower growth in 2023.
On the other hand, India, which has a notably smaller external sector, will likely be less affected by declining global growth, as it continues to become an increasingly attractive destination for manufacturing multi-nationals seeking to diversify their supply chains. Chen expects India’s economy to grow by 6% in 2023 — lower than Pictet’s 7% forecast for 2022 but still easily placing India atop the growth league of major economies.
Similar to India, Asean economies are enjoy- ing the structural tailwinds of “demographic dividends” and could continue to benefit from global supply-chain relocations. Vietnam continues to be a top choice for foreign manufacturers, although in the near term it faces a property slump. Thailand may see a stronger recovery in 2023, thanks to a rebound in tourism.
While many countries and markets lament being caught between the US and China, Singapore has been a “big winner” in the region, says Rialan. The financial system here continues to attract large-scale inflows of capital and with that, the talent managing these funds. The increased waits for family offices registering for tax exemptions in Singapore have been a clear indication of this trend. This could, however, also mean that inflation continues to run hot in the country, he notes.
