16 November 2022

2023 Multi-Asset Outlook: The Elusive Big Pivot

Michael J. Kelly, CFA

Michael J. Kelly, CFA

Global Head of Multi-Asset

2023 Multi-Asset Outlook: The Elusive Big Pivot

Asset pricing indicates that investors believe any recession next year would be soft and shallow – with no increase in the equity risk premium, and merely soft-landing upticks in credit spreads. We think this sentiment is too optimistic. So what does this mean for asset allocations heading into 2023?

Markets seem to be looking for an imminent dovish pivot from the Federal Reserve and other central banks to head off contractions in the US and elsewhere. To our eye, this looks like an extrapolation of the disinflationary playbook of the past 40 years. But times have changed, and central banks may no longer be so quick and eager to come to the rescue.

Despite the reversal of some transitory price increases, slower-moving yet more secular inflationary pressures continue to build. Deglobalization is here and intensifying, commodities are structurally short, and labor forces are now tight and tougher to grow in a non-inflationary manner. While it’s a tough call, in our view central banks will still seek to wring inflationary causes out of the system. This means waiting for labor markets to loosen despite progress on inflation. Meanwhile, the all-powerful dollar is pushing inflationary pressures overseas and forcing those central banks to stay tight as well, even as their economies enter recession.

Against this backdrop, we retain a bearish posture heading into 2023. The monetary deluge in the years following the global financial crisis provided access to capital for many companies with questionable business models. That spigot has now been turned off, and we would be shocked if it came back. Central banks don’t need to be reminded that they, too, helped feed inflation, along with supply-side bottlenecks. They dragged real interest rates to depths they never should have reached, and rates must now settle structurally higher. Given this, most markets are still only at fair value, despite 2022’s carnage – not a great setup for a meaningful bounce in 2023, even if we avoid recession, which is unlikely. Recession-driven drawdowns are a function of: 1) earnings declines, which we expect to resemble historical norms, and 2) liquidity withdrawals, which look poised to be larger and longer-lasting this time. Even once the Fed pauses at policy rates well above today’s levels, tightening will continue through cumulative quantitative tightening (QT).    

We view long Treasuries and commodity carry as the places to be in 2023, as the prime beneficiaries of a likely global recession. Longer-duration, higher-quality credit comes next, with equities presenting little upside from today’s fair values if we avoid recession, and meaningful downside if we don’t. We also see downward pressures on commodity spot prices in 2023, as well as private markets, which are just beginning to “catch down” to public market valuations.

Key Convictions for 2023

We see several actionable trends for investors in the new year.

1. Equities: Look for tailwinds that can power through a recessionary environment – and the companies that benefit from them.

The energy transition has been pulled forward by Putin’s invasion of Ukraine. While corporate earnings overall look poised to fall in 2023, goods-related sectors should witness the worst revisions, dragged down by both sticky labor cost pressures and a reversal of transitory pricing strength into outright declines, teamed with the lagged impact of a pull-forward in demand last year. Yet not all will beat to the same drummer. Companies that are both driving and benefiting from the push for greener energy are demonstrating robust earnings, which we expect to power right through a recession amid strong secular tailwinds from the energy transition.

Interest rate sensitivity affects equities too, though such “equity duration” is tougher to calculate than in fixed income, where cash flows are known. We agree with those who assert that almost the entire decline in the stock market this year has come down to its interest rate sensitivity, with very little, if any, attributable to an increase in the equity risk premium. Yet not all equity segments are created equal with respect to such “equity duration.” Companies with earnings streams that can grow steadily, at a fast clip, and for a long time, without interruption even during recessionary periods, become very high-duration – especially when teamed with high price-to-earnings (P/E) ratios. The tech giants’ advertising-heavy business models used to be able to deliver such earnings profiles as they rapidly gained share of advertising dollars. Now that they represent most of the market, they reflect the cyclicality of advertising, and no longer qualify as high-duration equities, given their earnings misses and declining estimates.

We’ve been averse to these companies for some time, given their anti-trust risk as well as the unappreciated maturation of their earning streams. We have instead favored the business-focused technology companies (our “Productivity Basket”), which do possess these sturdy, fast-growing earnings. As in the new-energy segment, tight labor markets are driving the need to step up such investments in people saving productivity, enabling these companies to power through a recession. Despite this, the rise in long Treasuries in 2022 put massive downward pressure on these long-duration equities. We expect the long end of the yield curve to pivot in 2023 (long before the Fed does), supporting longer-duration equities like those in our Productivity and New Energy baskets. Their powerful earnings profiles will need to do the rest.

China H share valuations overstate the medium-term impact of greater state control. While the Chinese Communist Party (CCP) will keep moving toward more collective ownership and centralized control, disincentivizing the private sector and slowing China’s growth over time, in 2023 at least, we expect a counter-trend acceleration of growth. China’s National Health Commission just released a new 20-point plan with less-disruptive zero-Covid policies, including steps that will ultimately pave the way for a reopening, and another branch of the government just reloaded its support for private property developers. China’s central bank is now easing as other central banks tighten. We expect these changes to gradually lift China’s economy as 2023 unfolds. If so, China will be one of the very few accelerating economies next year, while most others fall into recession. Nonetheless, more state-driven direction will ultimately slow China to a 2%-3% growth range. This would still be twice Europe’s growth and at a fraction of the price. The longer-term weight of greater state control appears more than fully priced in, presenting a 2023 counter-trend opportunity.

2. Fixed income: Move up in quality and liquidity while awaiting better valuations.

The longer end of developed market government bond yield curves has become more attractive. With yields rising to levels not seen in a decade, the standalone value of developed market government bonds is no longer meaningfully overvalued. Longer-duration US Treasuries in particular are now reasonably valued, yet with the prospect of benefiting substantially from a recession. We expect the long end of the yield curve to pivot long before central banks do.

Credit spreads have widened more than equity risk premia, but are not quite there yet. Credit spreads are more in line with a soft-landing scenario than equities, which haven’t even priced that in yet. When teamed with long duration, high-quality longer-dated US investment grade looks quite interesting to us in 2023. Toward midyear, as the US dollar peaks more sustainably, Latin American local currency bonds look poised to begin a very strong run.

3. Commodity carry: A risk premium for the times.

We expect commodity risk premia over the long term to earn a roughly 3% return for 4% volatility. However, during periods when economies are emerging from recession and spot prices rise from the floor to the ceiling, we’d expect to lose money in commodity carry. In contrast, when prices are closer to the ceiling and we’re anticipating a recession that will drive spot prices to the floor, commodity carry could be expected to earn 6% or more with 4% volatility. We’ve seen returns like that this year, even as real interest rates have been adjusted higher. Despite that, commodity carry still looks poised to deliver attractive returns. When spot prices go into free-fall, triggered by recession, we would expect commodity carry to return upwards of 20%. It’s historically a prime beneficiary of recession.

4. Alternatives: Private equity and private credit face vulnerabilities in the period ahead.

Like public equity and fixed income, financial assets are the prime victims when real interest rates abruptly rise. But unlike with their public brethren, this impact has yet to be fully reflected in most private asset valuations, given their typical nine-month delay for most mark-to-model valuations. Private equity has also been a major beneficiary of record-low and downward-trending all-in yields for well over a decade. Credit is now significantly more expensive and less freely available. This will affect internal rates of return (IRRs) for private equity. Private credit was aided in 2020 by the combined fiscal and monetary response to the pandemic. Longer periods of recession could blunt the benefit private markets experienced during the short 2020 Covid downdrafts, where private valuations never had a chance to “catch down” to reality. Today, weaker underwriting standards and limited access to capital might begin to materialize in this credit market segment.

For more investing insights, visit our 2023 Investment Outlook.


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2023 Investment Outlook

Five Themes Driving Global Markets in a Year of Pivots