By now many of you would have seen several outlook reports for 2023 from the sell-side or large buy-side firms. Most start with a set of forecasts on growth, inflation, and interest rates to drive their asset class and sector return estimates. The challenge with this approach is that human beings cannot see the future. Even if we could accurately estimate the earnings on a company or an index, the valuation multiple could vary wildly depending on risk perceptions and discount rates. Put another way, the price determination mechanism is considerably more complex than a linear model of earnings and valuation.
From our perch, this is a key reason why it is important to focus on what is probably wrong, rather than to attempt to forecast what might go right. Stated differently, we assess where there is a large skew in valuation, risk compensation, positioning, and consensus beliefs rather than attempt to back an asset based purely on a forecast or view. In addition to a large valuation anomaly, our definition of a behavioural episode is when price has been driven by emotional sources of volatility, rather than fundamentals. The final element is the focus on a single story (the Financial Times Cover).
While there has been considerable (warranted) focus on the geopolitical risk premium in 2022, the critical story for markets has been inflation and the interest rate response to that episode. There is also a broader question (that we identified this time last year) on whether there has been a potential secular shift in the post-2008 regime from permanently lower growth, inflation, and interest rates to a less stable and higher volatility regime.
Our sense is that it is still too early to tell whether market conditions this year were driven by cyclical or structural factors. However, the fact that cross asset risk (volatility) premiums were under-priced this time last year was clearly notable and guided some of our key non-predictions for 2022.
More importantly, for our portfolios it steered our decision to avoid expensive long duration equity and fixed income all together. To be fair, it was also probably a missed opportunity (or opportunity cost) not to make more on the short side of profitless tech and fixed income. On the positive side, our preference for equities with inexpensive valuation, strong free cash flow, balance sheet strength and growth were important.
Looking forward, we have a few key observations on the potential asymmetry for returns in 2023. The good news, as we have noted recently, is that the magnitude and speed of the rise in policy rates has increased the funds rate close to the terminal rate for this cycle. Clearly there is room for rates to rise further but the destination is now well appreciated and priced. The opportunity for cross asset investors, therefore, is in the 2-year part of the curve. At 4.4% (at the time of writing) the outright return on the 2-year Treasury is attractive relative to the downside risk of yields pushing higher from here. The yield on the 2-year note is also attractive relative to risk assets (credit or equities). Put another way, the risk-adjusted return on 2-year yields is probably superior to US equities or high yield credit in most scenarios apart from a soft landing or growth re-acceleration.
A widely held prevailing bias for 2023, is the potential for a hard-landing or recession. While that appears to be the consensus belief in the Bank of America Fund Manager Survey and other measures of sentiment (for example, the CEO Confidence Survey) it is probably not fully discounted in equities or credit. Economic and earnings growth is anticipated to be below trend next year, but far from recessionary conditions. Moreover, the valuation multiple on the global risk proxy (S&P500) remains close to the historic average, despite de-rating materially over the year.
As we noted recently, the high yield credit risk premium also remains below the long-term average (440 versus 500 basis points) and a long way from priced for a recession or distressed episode. In contrast, equities and high yield credit in Asia are already priced for a profit recession or distress. The key point here is that the asymmetry or odds for prospective returns are much better in this region, even if the US experiences a hard landing next year. In contrast, if a recession is avoided, Asia and emerging market assets would likely perform well.
Within equities, our sense is that macro conditions will still probably favour companies with strong free cash flow and balance sheet strength. We find it difficult to imagine a return to the low rate, super abundant liquidity regime before an earnings recession has even commenced. Although there has been a material 70% decline from peak in profitless growth companies, we would still caution investors on attempting to bottom-pick in this type of equity. In this region, we also remain cautious on consumer discretionary in Australia, where retail spending is 50% above trend and higher interest rates and debt are likely to constrain future consumption. In addition, the companies still trade at 18.3 times peak earnings. In contrast, our long equity exposure trades at 9 times depressed earnings (on average).
While all forecasting is difficult, foreign exchange markets are arguably the most challenging because: a) currencies are used as a policy tool; b) some large participants are motivated by non-economic factors; c) currencies can diverge from long run underlying fundamentals such as inflation, interest rates and external balances for extended periods; and d) currency trends can persist or extend further than many market participants expect. It is an obvious point, but currencies are always a relative price. Therefore, any judgment about fundamentals needs to be viewed in that context.
For Asia and emerging markets, the US dollar index remains important as the world’s reserve currency. Looking into 2023, it would probably be helpful if the dollar depreciated as that would ease financial and funding market conditions. That may or may not happen, but an interesting cross currency pair is the Korean Won against the Taiwan dollar. The current spot rate is back close to 1997 levels. While the cross-correlation is high at around 0.7, the Korean Won is the more risk-sensitive of the pair which is reflected in above-average 5.3% carry or risk compensation. In a cyclical recovery, the Korean Won probably has greater upside, in a risk event, the currencies are correlated, and the relative price is already at trough levels.
In that context, we have outlined the non-predictions for 2023. More detail will be provided in a presentation to follow.
1. The 2-Year Treasury Yield will not under-perform equities in risk-adjusted terms in 2023
2. Asian equities will not underperform US equities in 2023
3. US high yield credit will not outperform investment grade in H1 2023
4. The RBA cash rate will not peak below the Fed Funds Rate
5. Consumer Discretionary stocks will not outperform Value/Quality in 2023
6. The Korean Won will not underperform the Taiwan Dollar in 2023
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.