The investment story of 2023 so far has been marked by ever-evolving narratives that have confounded investors, leaving most active managers struggling to keep pace. Amidst this backdrop, the importance of humility in an investor’s toolkit has been particularly emphasised this year.
The unexpected bull market in equities and the meteoric rise of all things AI have taken many by surprise. Equally astonishing is the resilience of the US economy and job market, which have defied consensus expectations. Meanwhile, the yield curve has been a roller coaster, with US Treasury yields now higher than they were a year ago. After a series of surprises, there is hope that 2023 will bring greater clarity regarding growth, inflation, and monetary policy for 2024.
Market Performance and Challenges
The first half of 2023 saw a strong rally in stocks, but the third quarter brought us back to reality. Q3 proved challenging for risk assets due to surging real rates and a stronger dollar, better reflecting the narrative of rates peaking and plateauing at high levels, with no swift reversal unless something breaks. Fiscal challenges have prompted investors to demand greater compensation for holding long-term bonds, thus driving long-term yields higher.
Developed market equities fell by -3.4 per cent over the quarter, bringing YTD returns down to a still strong 11.6 per cent, while European markets (-2.2 per cent) outperformed US markets (-3.2 per cent). Value stocks exhibited relative resilience compared to their pricier growth counterparts over the quarter. However, the gap between these two styles remains substantial, with growth stocks having outperformed by over 18 per cent in 2023. While the broadening rally over the summer seemed promising, the “Magnificent 7” boasting an average YTD gain of over 50 per cent, equal-weighted indices showed only marginal positivity.
Simultaneously, the yield curve, which began the year deeply inverted, is swiftly normalising, even as both shorter-term and longer-term bond yields edge higher. In fixed income, government bond returns were negative across developed markets during the quarter, whereas shorter-dated high-yield bonds have remained the top performers this year, with spreads remaining broadly stable. As bonds and stocks fell simultaneously in Q3, commodities emerged as notable outperformers, returning 4.7 per cent, reminiscent of the market dynamics observed in 2022.
Navigating Monetary Policy
After initially mischaracterising inflation as “transitory,” central banks were compelled to embark on an aggressive and concentrated hiking cycle. The economy’s remarkable resilience during this period of monetary tightening, driven by pandemic-induced savings and sustained wage growth amid near-record low unemployment, has been noteworthy, especially as China was unable to unable to save the day. These developments have cushioned the impact of rising interest rates, enabling continued consumer spending.
As the trend of disinflation persists, central banks now face the challenge of navigating the “last mile” in the battle against high inflation. This phase is arguably the trickiest, given the difficulty of determining how much of the “long and variable” impact of tighter monetary policies has already played out in the economy. Debates on the appropriate level of monetary policy restraint and questions about whether the 2 per cent inflation target remains suitable in a world undergoing structural changes add complexity to the situation. In the EU, the transmission of monetary policy is more effective due to a higher proportion of floating-corporate debt, suggesting that the ECB may have concluded its rate hikes.
With the economy yet to feel the full impact of tighter monetary policy and consumer savings expected to deplete by the end of Q1 2024 at the latest, as per Morgan Stanley’s analysis, charting a path forward may prove challenging, and the possibility of a recession persists.
One way to navigate this uncertainty is to “not fight the Fed,” to actually listen to what Jerome Powell is saying, even if the communication or believability thereof has at times left much to be desired. Even if a soft landing currently appears to be the most likely scenario for the US economy, the timing of any Fed policy pivot remains uncertain. A hard-learned lesson from previous eras is not to declare victory too soon. However, there also remains a clear danger of doing too much.
As a new era dawns, there may be no return to the cheap and abundant money that characterised the 2010s. A more expensive cost of borrowing, with significant investment implications, could be here to stay. This was arguably the norm in the pre-Global Financial Crisis era. As the credit cycle turns, demonstrated by increased corporate bankruptcies, credit card delinquency rates, and reduced demand for new loans, challenges will mount.
Strategies for a Shifting Market
As markets adapt to the new regime of greater volatility and elevated rates, opportunities are emerging. Increased chances of a US soft landing and stabilising Chinese growth suggest that while downside risks remain, global economic risks appear more balanced. The eventuality of a continued but mild economic slowdown, rather than a full-blown recession, in the face of peaking rates lends support to fundamentals.
The meaningful pullback in Q3 presents a more attractive entry point for investors. As the risk-reward trade-off remains finely balanced between quality and sectors benefiting from secular themes, especially AI, are preferred. Resilient economic data and steady disinflation, robust consumer spending and Q3 earnings may pave the way for typical positive Q4 seasonality.
Fixed income, as a broad asset category, appears oversold following a sharp increase in bond yields. With long-term yields at multi-year highs, bonds now offer higher income potential, enticing investors to capitalise on the current sell-off and extend their duration. However, uncertainties, including unanchored inflation expectations and persistent pressure on the term premium, may result in fixed-income investors enduring a third consecutive year of losses if yields remain elevated.
Elevated correlation observed over the quarter also serves as a timely reminder of the importance of alternative assets as diversifiers as opposed to hiding in cash.
Portfolio Strategy and Conclusion
In conclusion, 2023 has unfolded as a year filled with surprises and uncertainties. In the face of imperfect markets and dynamic macro forces, there are no easy options. It’s crucial to recognise that financial markets tend to be forward-looking but unforgiving when it comes to timing. Being too early or too late can often be as costly as making the wrong investment decisions.
As investors prudently map their path into Q4, a well-balanced portfolio strategy across asset allocation, supplemented by active management across styles, will be indispensable for navigating the ever-evolving investment landscape. Ultimately, thoughtful risk management remains at the core of long-term investment success.
View expressed reflect those of the author exclusively. The author has obtained the information contained in this article from sources he believes to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The author makes no guarantees, representations, or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in this article.
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