Paul Donovan, Chief Economist at UBS Global Wealth Management, reflects on a tumultuous 2022 and offers investors food for thought on how to best position their portfolios for 2023 and beyond.
After one of the most challenging years in history for investors, we’re entering what will be “A Year of Inflections.”
As the year begins, inflation is high, interest rates are still rising, and growth expectations are falling, with geopolitical tensions, financial stresses, and the legacy of COVID-19 adding to the uncertainty. Against this backdrop, we favour defensive sectors, income opportunities, “safe havens,” and alternatives.
There’s no doubting that investors will enter 2023 with many questions about the strength and purpose of the political and financial institutions that support global markets. Yet, provided the world can avoid another geopolitical, financial, or epidemiological accident, we do see a more favourable backdrop for markets emerging as the year evolves. We think inflationary pressures will start to ease, central banks will shift from tightening to loosening policy, and economies, currently slowing, will trough and start to revive.
We think inflationary pressures will start to ease, central banks will shift from tightening to loosening policy, and economies, currently slowing, will trough and start to revive
Evidence of this is already beginning. Year-over-year rates of inflation have peaked in the United States and are in the process of peaking in Europe. We expect that the Federal Reserve, European Central Bank, the Swiss National Bank and the Bank of England will conduct their final rate hikes in the first quarter of 2023, or the second quarter at the latest. As we see the impact of the increased interest rates in the economy, we expect growth and earnings expectations will fall throughout the first half of the year. Overall, we are looking for a 4% earnings contraction in the US, a 10% decline in Europe, and 2% growth in Asia for the full year.
Geopolitical events often spark volatility in financial markets but rarely change the broad trajectory of economic growth. Yet as we enter 2023, there is an elevated risk that politics could shape growth outcomes. Russia’s war in Ukraine poses energy and security threats to Europe and raises the risk of NATO involvement. At an individual country level, the increased politicisation of economic issues like inflation and interest rates broadens the scope for radical policy interventions and market dislocations.
At an individual country level, the increased politicisation of economic issues like inflation and interest rates broadens the scope for radical policy interventions and market dislocations
History tells us that turning points for markets tend to arrive once investors begin to anticipate interest rate cuts and a trough in economic activity and corporate earnings. As we enter 2023, high inflation and rising interest rates alongside elevated earnings expectations and geopolitical risks inform our investment themes of defensives, value, income, and safety.
But we think the backdrop for risky assets should become more positive as the year progresses. This means investors with the patience and discipline to stay invested should be rewarded with time. Investors currently sheltering from volatility will need to plan when, and how, to rotate back into riskier assets over the course of 2023.
Investors currently sheltering from volatility will need to plan when, and how, to rotate back into riskier assets over the course of 2023
So, what does this mean for investors?
Equity exposures are put under the microscope
As we recently observed, market turmoil has been seen as a real opportunity for our users who are more sanguine about risk. Many have been bargain-hunting across asset classes, leveraging an ability to see beyond short-term market gyrations and media noise.
That being said, sophisticated investors are being ever more discerning as inflation soars, bringing with it the ever-growing risk of a truly vicious global recession – fighting the former with interest rate rises, but without bringing on the latter, means treading a real tightrope for central banks. Many people are now paying particular attention to the equities proportion of their portfolios to ensure it is well constructed to weather any coming storm.
The standard advice would be to seek high-quality companies which are able to defend margins in the face of inflation by passing on costs to customers without too much pushback; or contrariwise to maintain earnings if recession really kicks in
The standard advice would be to seek high-quality companies which are able to defend margins in the face of inflation by passing on costs to customers without too much pushback; or contrariwise to maintain earnings if recession really kicks in. It goes without saying, however, that finding that kind of resilience is no easy task – particularly when you need to populate a portfolio with such winners across markets, regions and sectors.
Our users often tell us they know one area very well (often due to their career) and feel very confident in their stock-picking there, but that they would like to defer to the professionals in ones where they feel less expert. If you would like to be able to discuss ideas with specialists and benefit from institutional-grade research of the type you just won’t see in the media, let us set up some free initial conversations with wealth managers for you.
This commentary makes clear the scale of the challenge for even the most knowledgeable and engaged self-directed investors. They must weight defensive versus growth stocks, different markets, currencies, bond issuers and more besides in their quest to construct – and maintain – the optimum portfolio for their needs.
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Defensives and value
Defensive sectors should prove relatively insulated from a weakening economy and have previously performed well when inflation is high. Consumer staples and healthcare sectors outperformed the MSCI All Country World Index by 9 and 11 percentage points, respectively, in the first 10 months of 2022 – and we expect both sectors to continue to outperform in the months ahead as economic growth decelerates.
Energy was the best performing global equity sector in the first 10 months of 2022, with returns of 33% versus a loss of 21% for the broader index. Although slower global growth is usually negative for the energy sector, given the oil market’s tightness, we expect it can support higher prices even if demand falls.
Seek income opportunities
Given the uncertain backdrop, an opportunity to earn more predictable returns is appealing. For instance, through investment grade bonds. The high interest rate sensitivity of investment grade credit proved a detractor from total returns in 2022. Slowing earnings and tighter monetary policy could continue to drive volatility. But we now see the balance of risks as more favourable. In US investment grade, yields are around 5% – a level we find appealing, and which should provide a buffer against volatility.
In US investment grade, yields are around 5% – a level we find appealing, and which should provide a buffer against volatility
Shelter in safe-haven currencies
In currencies, relatively high US rates and slowing global growth should help keep the dollar strong in the coming months. Similarly, the Swiss franc’s safe-haven appeal is likely to attract inflows. Although, later in 2023, investors will need to prepare for dollar weakness as investors begin to anticipate Fed rate cuts.
After unprecedented strength in 2022, we expect the dollar to continue on this track. Given the Fed is more aggressive with rate hikes than other major central banks, this should allow the dollar to maintain its premium valuation – giving investors an alternative safe-haven location.
In terms of the UK specifically, political turmoil and low growth has contributed to a weaker British pound in 2022. It has also spurred on questions about the future of the UK as an investment destination. It may take years before the pound can regain a more “normal” valuation level.
Seek uncorrelated hedge fund strategies
Equities and bonds failed to act as counterweights to each other’s performance in 2022. In 2023, uncorrelated hedge fund strategies such as macro, equity market neutral, and multi-strategy funds should once again play an important role in diversifying portfolios.
In 2023, uncorrelated hedge fund strategies such as macro, equity market neutral, and multi-strategy funds should once again play an important role in diversifying portfolios
The Decade Ahead
We are in the midst of a “decade of transformation”, which has already brought significant changes in the global economic, political, societal and environmental landscape. However, we believe that a more positive secular backdrop remains a possibility due to a number of factors. Firstly, central banks are determined to bring inflation under control. This policy focus should mean that inflation does not become entrenched. Secondly, the global transition to green energy and net-zero carbon emissions has been spurred on by Russia’s invasion of Ukraine. In the long term, the race to create a greener economy should boost growth.
For investing in the decade ahead, lower equity valuations and higher bond yields should also be supportive of stronger returns for diversified portfolios.
For investing in the decade ahead, lower equity valuations and higher bond yields should also be supportive of stronger returns for diversified portfolios
We also believe that we are at the beginning of an era of security, in which energy security, food security, and technological security will be increasingly prioritised by governments and businesses, even if they come at the cost of efficiency. The era of security will drive winners and losers across the investment landscape in the decade ahead.
Navigating inflection points will be key to investment success in the year ahead. For investors who are able to look through short-term noise, the challenges of 2022 should give way to longer-term opportunity in the years ahead.