To navigate 2023 investors need to be ‘free of the market truisms’

Out of a pandemic, into a war – with a heavy side of inflation.

In an environment where the traditional building blocks of portfolio construction was upended, fixed income and equities sold off resulting in the worst performance of the so-called ‘Balanced’ portfolios seen in recent times.

This has challenged the long-held belief of bonds being the ‘safe’ asset class.

Hence, the way forward needs a more open-minded and pragmatic approach.

Recession looms over markets in 2023

Historically, inflationary environments have been due to excess demand in economies.

The current inflationary scenario, instead, has been supply driven – a situation which Central Banks have never had to handle.

The approach to controlling this from Central Banks in developed economies has been to increase policy rates in tandem, which, as expected, has triggered a recession.

This recession is likely to continue into the next year.

However, this comes with a caveat, which also remains a major risk in our view – while Central Bank participants expect to engineer a mild recession, it is often the case that recessions take on a life of their own, which results in significantly more damage to the macro environment than anticipated.

While inflation is expected to taper off through the next year in response to policy rate hikes, there is concern around a more permanent destruction of demand through negative consumer confidence that higher borrowing costs create.  

Geopolitics will be an influential factor, going forward more than ever.

Before Covid, we lived in a globalised world, with interconnected supply and distribution chains.

This created a disinflationary environment as the global manufacturing systems pursued efficiency relentlessly, whether through sourcing of raw materials or the transportation of finished products.

Post-Covid, there has been a greater focus on near-shoring, not only to counter supply disruptions, but also from a geopolitical standpoint.

Tensions between the US and China over Taiwan, which incidentally is the source of 80% of global chip supply, as well as the ban on sharing technology, has resulted in splitting of the existing supply chains.

The Ukraine situation has disrupted energy supplies in Europe as well as global food supply chains.

We expect further global polarisation, as countries use financial levers including tariffs, export restrictions and sanctions to advance national priorities.

After 30 years of structural decline in interest rates, a new regime begins with yields on fixed income rising to pre-Financial Crisis levels, on the back of increasing policy rates and surging inflation.

Given tapering inflation expectations, this interest rate readjustment appears to be nearing completion.

Private markets to face reality check in 2023

What this leaves us with are opportunities in the fixed income market which look quite attractive. The resultant higher yields are a welcome leg up for investors starved of income, without having to go too far down the credit ladder.

An active approach to investing can help reveal outsize yields in the short-dated bond market as well as selective choosing duration across the government and quality corporate yield curves.

Equities have already priced in a moderate recession going forward, with value stocks being more reasonably priced than ever in history.

Developed markets moved sharply downward in anticipation of the destruction of earnings through elevated inflation and interest rates.

At current levels, the reduction in corporate earnings priced in may not be enough, but notwithstanding, there remains a high probability that equities end up higher.

An active, research driven approach can uncover companies with stable cash flows in sectors such as financials (especially given higher interest rates), industrials (which manage to share cost burdens with clients) and even some parts of the technology sector could provide sources of sound prospects. 

In conclusion, to chart a path through this rapidly changing landscape, asset allocation will need to be approached with an open mind, free of the market truisms in an active way to seek opportunities that will emerge from this change in macro regime.

Abhi Chatterjee is chief investment strategist at Dynamic Planner