Regifting 2022: Another 2023 Road Map

What if 2023 is a drawn-out repeat of 2022? It would be the bad regift to end all regifts.

From the perspective of most investors, 2022 was one of unrelenting grimness. But even grimmer news may be on the horizon. What if 2023 is a drawn-out repeat of 2022? It would be the bad regift to end all regifts. We face very similar concerns to the start of 2022 – investors must manage rising correlations between asset classes, and account for the Federal Reserve’s hiking cycle which is driving returns across most markets. Desperate to find a Fed pivot and end to inflation, investors are likely to remain hooked on Jerome Powell’s every word and glued to every data point.

What if everything that went wrong in 2022 continues to go wrong in 2023 – in exactly the same way.

Instead, if we consider the theme of 2023 as 2022 but on repeat, it might make sense for investors to start with what the worst-case scenario might look like. In essence, what if everything that went wrong in 2022 continues to go wrong in 2023 – in exactly the same way (Figure 2)? That would leave equities 38% lower than they were at the end of 2021, rates in ten-year bonds at 6.3%, crude soaring back over 115, and bitcoin around 5000 down 87.5% in two years. Although given the volatility cryptocurrency investors have already seen, this last option might almost seem normal.

Coming into 2022, both bonds and equities were especially expensive in historical terms.

The driving force behind the moves was inflation, which affected asset prices in two ways. Firstly, higher inflation, all things equal, tends to drive rates higher. This, in turn, decreases the theoretical price of assets in a discounted cash flow model. Coming into 2022, both bond and equities were exceptionally expensive in historical terms (Figure 4). As such, the bond/equity correlation sharply increased as both asset classes fell.

Investors seem to be assuming inflation falling to 5-6% may be enough, but that seems to miss Powell’s message of higher for longer.

It is notable that over a long history, negative correlation is most associated with a period in which inflation was persistently falling and reached unprecedently low levels. Inflation is almost certainly likely to moderate in 2023, largely due to base effects. However, given all the issues in supply chains, wage inflation and other factors such heavily weighted items such as energy and food in the CPI calculation, it is difficult to imagine that inflation falls back under the 2% target used by the Fed, the European Central Bank (‘ECB’) and the Bank of England (‘BoE’). Investors seem to be assuming inflation falling to 5-6% may be enough, but that seems to miss Powell’s message of higher for longer. An inflation move below 2% may be only the result of a jobs recession and an extremely hard landing — which will improve correlations but destroy portfolios. If the Fed followed the Taylor Rule, the Fed funds rate might end up much higher than even the wildest of predictions, which might mean more 50-75 bp hikes in 2023 (Figure 5).

With positive bond-equity correlation, portfolio volatility will remain uncomfortably high.

The net effect, we believe, is that investors need to be very active about managing the use of bonds in their portfolios as correlations change. With positive bond-equity correlation, high bond and even just moderately high equity volatility, portfolio volatility may remain uncomfortably high and returns in both assets may remain negative going well beyond the good old days of negative correlations. In our view, managing this correlation, will be key to navigating 2023.

Positive correlations are not just limited to stocks and bonds (Figure 6). Indeed, cross-asset correlations are at all-time highs, making the process of managing money deeply challenging. In fact, outside of energy, most assets are down in 2022, just like in 2018:

An oncoming recession may kill inflationary momentum and allow the Fed to pivot and cut rates.

In our view, investors have a distinct choice. Inflation drives monetary policy, which drives returns. With high but falling inflation, one option is for investors to take a big directional bet. They can position their portfolios to exploit one of two hypotheses. Either an oncoming recession will kill inflationary momentum and allow the Fed to pivot and cut rates, which will support asset prices; or they can anticipate that inflation stays higher for longer, and the Fed will keep to its hawkish course. The former scenario is reminiscent of the Fed’s hiking cycle of 2018: bad news is good news, buy the dip and wait for the cavalry of accommodative monetary policy to ride to the rescue. The latter is a regift of what we have experienced in 2022. In our view, investors should short risk assets, especially high-multiple equities in sectors such as tech and ruinously expensive bonds, while being long the US dollar, and flexible in commodities while sticking with trend-following strategies.

When managing volatility, investors need to target risk, not returns.

A key premise when managing correlations is to keep a keen eye on volatility. We note that for most risky assets, cross-asset correlations are highest when volatility is high. In our view then, it follows that by monitoring volatility, scaling exposures to reflect changing volatility is a safer course. Investors should target risk, not returns. By reducing gross exposures when volatility is high and cross-asset correlations spike, investors may be able to avoid a repeat of the sustained bloodbath that characterised 2022. Similarly, trend-following offers help in either case as it takes advantage of volatility and shifting regimes to generate returns and help investors better navigate 2023.

Cash was king in 2022, and thus, perhaps, liquidity will be king in 2023.

In the aftermath of this reckoning for the industry, there is no sign that liquidity is improving. As seen recently, gates are being put up on real estate and credit funds to prevent investors rushing for the exits. Falling liquidity may therefore have two effects in 2023. Illiquid strategies may well see much lower inflows. The illusory safety of private equity may never go away, but no one has any misconception about the liquidity of these assets. Cash was king in 2022, and thus, perhaps, liquidity will be king in 2023.

If the Fed pivots, other central banks may be bailed out, not least the Bank of Japan .

The challenge of managing dollar exposures is unlikely to disappear in 2023. It is worth pointing out that we may be at or close to top when it comes to dollar strength. If the Fed’s hiking cycle is nearing its end, the spread between US interest rates and global rates – in particular the yen, the euro, and sterling – may start to decline. This will disincentivise carry traders and reduce the upward pressure on the dollar. Already, currency markets have begun this repricing late in 2022. Furthermore, if the Fed pivots, other central banks may be bailed out, not least the Bank of Japan (‘BoJ’) whose efforts to keep control of its yield curve may wind up precariously close to coming unstuck. Yields on maturities of Japanese Government Bonds (‘JGBs’) selected for purchase by the BoJ are already out of step with the rest of the curve (Figure 10). If further rate hikes from the Fed keep the carry trade going, it is very likely that yield curve control will collapse, forcing the entire JGB curve higher and possibly prompting defensive and potentially recession-inducing hikes from the BoJ.

Hedging non-dollar investments has been exceptionally tricky this year.

In the meantime, investors must contend with the effects of a strong dollar on portfolios. Assuming the dollar as the portfolio currency, hedging non-dollar investments has been exceptionally tricky this year. Even those positions up in local terms may well be down when converted back into USD. It begs the question of whether investors can take a pro-risk stance in local currency, if the hedging picture remains uncertain. On the other hand, non-dollar-based investors buying US equities and credit have benefitted greatly from USD strength as they typically run underhedged for currency risks in their dollar assets due to the currency correlation effect. In short, a US unhedged investor in global equities has had a much tougher year than their foreign counterparts who own equities locally (with Nikkei, FTSE 100, and Eurostoxx 50 indices all up in local terms) and US investments in USD which has appreciated sharply.

Trend-following once more offers something of an alternative to these questions.

Trend-following once more offers something of an alternative to these questions. For US investors, by taking trend-following positions scaled to match the size of existing non-dollar investments, they should be able to offset fluctuations in the currency market – and live or die by their fundamental analysis rather than macro factors. In the same way, investors from countries with pro-cyclical currencies could apply trend to in a similar way to rebalancing portfolios or to override USD core holdings when their home currencies exhibit changing correlations.

The threat of a further energy shock seriously compromises the relatively optimistic outlook that many still seem to hold.

As such, the threat of a further energy shock seriously compromises the relatively optimistic outlook that many still seem to hold. While it seems that consensus expects growth to stall in Q1 2023, with a simultaneous equity selloff, most 2023 outlooks also expect recovery to begin by Q3. We find it hard to justify this optimism: further deterioration and rate hikes are largely priced in. It therefore follows that it would take something like an energy shock to drive further selloffs – and if so, it is hard to imagine that the resulting problems are flushed out of the system by Q3. Investors may need a dose of clear-eyed realism – if the situation does get any worse, there a good reasons it may become a full-blown crisis rather than simply a brief recession.

Investors may wish to focus on managing correlations, keep liquidity levels high, and avoid large directional bets.

Conclusion

Investors appear to be expecting that 2023 may be bumpy. But it feels as if they are unwilling to accept the logical conclusions of their analysis. many investors expecting a Fed pivot may find it akin to waiting for Godot; there are still many factors which could keep inflation high and demand low, most notably energy shocks. With liquidity falling and correlations high, the chance of a financial crisis is the highest for a decade since the cavalry of supportive monetary policy is far less likely to come to the rescue. In place of the optimistic growth expectations seen across many outlooks we have read this holiday season, investors may wish to focus on managing correlations, keep liquidity levels high, and avoid large directional bets.

Inflation may come down. We may have a soft landing, and the Fed may execute its pivot successfully. But there are more than enough things that could go wrong in 2023. It is just a shame that they may remain the same things as last year.