A uniquely complex financial and geopolitical backdrop still saw markets deliver positive returns for the first quarter of 2023. Luck and good timing will still be needed for the rest of the year but there remain compelling opportunities in bonds, equities and currency, for today’s patient investor.
A confluence of events and, yes, some good luck, left investment returns for the first quarter of 2023 better than most investors dared hope. In the face of two further US rate rises and bank failures on both sides of the Atlantic markets were, in the event, impressively calm. Government bonds, credit, equities and gold all delivered positive returns – and this was true even when measured in sterling (the best performing currency in the G10 this year).
The most unexpected move though, was a late surge in the Nasdaq as investors focused on two new themes: aggressive cost cutting (from the likes of Meta and Amazon) and a perceived ‘safe-haven’ status for the cash-rich technology giants seen as most likely to benefit from the nascent boom in ‘generative artificial intelligence (AI)’ (including Alphabet and Microsoft).
As luck would have it
Investors were lucky too. First, just as lockdown rules were scrapped in China (in January this year), US growth was itself starting to slow. Importantly, this meant that the return of Asian buyers only had a muted impact on energy and commodity prices, and thus headline inflation rates. Second, there looks to be some silver lining in last month’s bank failures: the credit shock they created has ironically done much of the US Federal Reserve’s (Fed’s) policy tightening for them.
In comments after the March meeting, Chairman Jerome Powell stated that the tighter credit conditions are already a substitute for one or more interest rate rises. In other words, no matter how uncomfortable the banking shock felt, the tighter lending standards it has triggered will probably slow the US economy and ease labour market pressures, at just the point needed. Evidence of this is already starting to build, with US job openings falling well below expectations last month. Put these events together and you can see why markets rallied and equity volatility fell. In short: over the last quarter, we were lucky.
Central banks are still sailing between Scylla and Charybdis
Looking forward to the rest of 2023, policymakers will, once again, need skill and not a little luck. Central bankers will have to navigate deftly between the Scylla of recession and bank failures, and the Charybdis of stubbornly high core inflation. The risk of policy error is high. So how should investors react?
The first step is to toughen portfolios and improve resilience. For us this means reviewing all our key equity holdings, watching for companies with higher borrowings or re-financings, while minimising our exposure to sectors that are historically vulnerable to rate rises. Commercial real estate and utilities are two examples; these also face significant and expensive environmental challenges. In addition, it means looking for hidden leverage or financing risk across more illiquid alternative assets, especially in more complex infrastructure funds and green energy generators.
Second, US growth is clearly slowing. The well-regarded ISM services survey for March was notably weaker and we now expect a recession – albeit a shallow one – in the second half of 2023. For us this means moving to a less cyclical portfolio with additions to healthcare (across our ageing theme) and defensive consumer staples (in our evolving consumption theme). A particular challenge remains our holdings of European industrial companies. We remain positive about the opportunity for long-term climate expenditure, but we are concerned that slower growth in the short term will constrain earnings. Therefore, we are reducing position sizes.
Third, it means focusing on assets in areas where monetary support can materially lower risk. Today this is true of selected bank bonds, issued by the stronger global franchises. In this regard, the support offered by the Fed this month is particularly generous. It means banks are now able to pledge treasuries, agency debt and mortgage-backed securities as collateral to the central bank. Importantly, these assets will be valued at par, effectively eliminating any institution’s need to sell any securities quickly in times of stress. My colleague Subitha Subramaniam focuses on the detailed implications of this overleaf. In a nutshell, it is supportive of bank debt and adds to liquidity globally.
Fourth, managers still face a world of heightened geopolitical flashpoints. These include escalating nuclear threats from Russia and increasingly bellicose behaviour from North Korea, alongside the now dire state of Sino-US relations. To give some protection against these ‘known-unknowns,’ we will continue to use portfolio insurance to hedge equity exposure for portfolios where we have permission. With equity volatility falling this month, costs are not unreasonable. Alternatively, for those accounts that cannot use derivatives, we will lower equity content below neutral, and compensate with higher corporate bond exposure.
Opportunities closer to home
Where else, then, can investors look for returns, in areas not overly impacted by tighter money? Our view is that there are opportunities in currency markets, and in particular sterling. As we have illustrated in our Six Minute Strategy reports, the UK currency has a long history of falling sharply in the aftermath of political crises, only to rally back slowly over the years that follow (see below). This occurred post the exchange rate mechanism (ERM) debacle in September 1992, after the Global Financial Crisis of 2008 and most recently in the aftermath of the Brexit referendum of June 2016. This time, while recovery is underway, we anticipate there is more of a rebound yet to come – and the reasons are not hard to find. The lack of credibility of the Boris Johnson government (including his stand-off with Europe), followed by the absurd Truss/Kwarteng budget of September last year meant, in effect, that many UK assets were simply off-limits to global investors.
However, the picture has been transformed by the Sunak government in a remarkably short period of time. The Windsor Accord with Europe was signed with a crushing parliamentary majority, fiscal policy credibility has been transformed with a prudent budget, while the Prime Minister has laid out sensible, and largely deliverable, mid-term policy targets. The political alternatives also seem less alarming: Sir Keir Starmer’s fiscal policy is little different to Sunak’s, while even the threat of Scottish independence will surely be limited by the quiet implosion of the Scottish National Party (SNP). While there are still risks – particularly in settling very genuine public sector pay disputes – there is already evidence that UK markets are starting to regain investor flows.
On our model, the pound should trade at around U$1.32-35 to reach fair value, hence our steady increase in sterling exposure (via forward contracts) over the last few months.
The market challenges for the remainder of 2023 are clear: if central banks ease too soon, they will fail to contain core inflation, but tighten too much and they risk a deeper recession and potentially more financial failures. For this reason, we remain a little cautious. We are targeting less cyclical equity exposure and lower leverage across all our assets, as well as deploying portfolio insurance to hedge against elevated geopolitical risks.
But despite these challenges, the world is not short of investment opportunities. Very generous central bank support argues for bank bonds issued by the strongest franchises, while defensive equities that are still geared to the powerful long-term themes of climate change and emerging consumer demand, are attractive too. Within all of this there are also currency opportunities, particularly in a renaissance of sterling. So yes, we do need a little luck, but defensive portfolios with the right currency overlay could still deliver robust returns for the remainder of 2023.
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