Key investment themes for 2023

AS we move into a new year, we believe the heightened volatility across asset classes that was a feature last year could continue. But with volatility comes opportunities for active management. 

We believe we will see interest in bonds continue to grow, a revival in the fortunes of 60/40 portfolio strategies, and renewed recognition of the value of multi-asset strategies. The rise in real yields is offering a new range of possibilities in government bonds and credits alike. As for equities, taking into account differences in equity risk premia, we expect markets with lower valuations will perform better than US large caps.

Private assets will remain an integral part of a multi-asset strategy. The relative drop in valuations means the next couple of years could be good “vintages” for early investors with long investment horizons.

Global economy: ‘healthy’ recession and easing inflation

A gradual recovery in the West and progressive reopening of the Chinese economy should mean global GDP growth is likely to rebound in the second half of this year. Our forecast for global GDP growth for 2023 is 2.5 per cent, down from 3 per cent in 2022.

Meanwhile, price pressures continue to ease. Weaker demand, easing bottlenecks and favourable base effects should ensure global inflation returns towards the more normal levels of recent years. We expect inflation in advanced economies to ease to 3.2 per cent in 2023 from 6.9 per cent in 2022.

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 rises re-accelerate. We expect the Fed funds rate to stabilise at a terminal rate of 5 to 5.25 per cent, which could be reached by March 2023. Fed rate cuts are unlikely before early 2024, in our view.

What to watch out for

• Revenge of the 60/40 portfolio

In 2022, positive correlations between bonds and equities meant that investors with 60/40 portfolios (60 per cent equities and 40 per cent fixed income) found little solace. But we expect that correlations will turn negative again, with government bonds and equities moving less in tandem. As rate rises tail off and recession looms, we believe core government bonds will come into their own again. High-quality investment-grade bonds of low duration in US dollars and euros could well prove their resilience in a time of more subdued growth and inflation, and should continue to offer yields higher than equity dividends.

2. From deglobalisation to friend-shoring

The pandemic, the war in Ukraine and growing geopolitical tensions with China have led to the weaponisation of assets, from microchips to natural gas and national currencies. A period of offshoring by western firms when globalisation was at its height has given way to one of re-shoring or friend-shoring (siting activities in friendly countries), as deglobalisation gains hold.

Countries’ scramble to source energy supplies in increasingly uncertain times allows us to be positive on commodities and commodity-linked themes. The need to transition to renewable energy, lent even greater urgency by last year’s energy crisis, will also have its beneficiaries. Efforts to improve productive capacity as part of re-shoring entail increased capital expenditure, from which firms in the industrial sector should benefit.

Fragmentation and dispersion across economies and asset classes are ideal conditions for macro hedge fund strategies, which are set to capitalise on continued volatility in rates and currency markets. Hedge fund strategies focused on trading commodities futures is also a particular area of interest.

3. Convergence of risk premia

In light of the rise in interest rates, higher volatility and significant political and economic uncertainties, we see investors demanding higher risk premia across all asset classes. In 2022, we saw a decline in the US equity risk premium as the rise in bond yields reduced the excess return investors earn over risk-free government bonds. But we think the convergence of risk premia will continue to progressively shake up the opportunity set within equities, with valuation extremes converging.

Regional selection is key. In a scenario where risk premia converge, we think global and US small caps and Japanese equities could again look interesting. The former offer diversification potential and are an area where active managers can shine. Global small caps have typically outperformed when they reach the low relative valuation levels we have recently seen. We may also see greater interest in the Japanese market, where price-earnings ratios have come down substantially and the domestic economic outlook has been slowly improving.

4. Bond vigilantes are back

The era of free money and of “quantitative easing”, begun in reaction to the Global Financial Crisis and prolonged by the pandemic, is now over. This can be seen in the rapid disappearance of negative interest rates throughout most developed countries. The tightening of financial conditions and the general upsurge in bond volatility mean fixed income investors need to pay more attention than ever to credit quality. A complex, volatile environment in which we are bound to have more credit events (defaults) calls for vigilance and an active approach to corporate credit.

We continue to avoid non-investment grade bonds and leveraged-loans borrowers facing rising debt-servicing bills, preferring top-rated investment-grade credits instead. This includes the bonds of disciplined hard-currency Asian investment-grade issuers that continue to offer attractive carry in return for limited credit risk.

5: 2023–2024 vintages in private assets

Amid much volatility and relatively subdued prospects in many public markets, we view private assets as more essential than ever for alpha generation, portfolio volatility reduction and long-term diversification. While not immune from the same short-term challenges as public assets, we continue to see significant potential for private investments in tech, health and the environment. The recent drop in valuations offers a particularly interesting entry point for those with a long-term investment horizon.

The drop in valuations suggests that 2023 and 2024 are good vintages (the year in which private-equity funds make their initial investments) for funds with investment horizons of five to seven years. The same is true of private real estate. As economic conditions deteriorate, special situations and distressed assets will also be a growing focus for private investments.

6: Volatility as an asset class

As the world continues to grapple with severe political and geopolitical tensions, high and persistent inflation and other unknowns, we expect market volatility to remain elevated. The pick-up in volatility in currency, fixed-income and commodity markets has been particularly noticeable. But volatility, which we continue to treat as an asset class in its own right, also provides opportunities, offering the chance to deploy derivatives to monetise high volatility and mitigate portfolio risk.

For example, solutions can be found to enhance yield via commodity derivatives. Various option strategies, including equity hedges and capital-protected notes, have also come into their own as a way of mitigating portfolio risk, and will remain a valid way to approach uncertain markets.

The writer is Asia chief investment officer and head of discretionary portfolio management, Pictet Wealth Management.