Absolute return: ready for uncertainty in 2023
In this 2023 investment outlook, Portfolio Manager Luke Newman considers the risks and opportunities for absolute return following a truly challenging year for global markets, marked by inflationary pressures, rising rates and slowing growth.
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- Market volatility seems likely to persist in the short term, given the huge degree of macro uncertainty, but the strength of current balance sheets suggests that many companies are well placed to endure.
- This kind of environment is likely to create a huge amount of opportunities on both sides of the book, with the expectation of higher costs and potentially softer demand already priced in.
- We see absolute return as a useful diversifier for investors following a challenging period in financial markets for both equities and bonds.
How would you summarise 2022?
Trying to summarise 2022 from the perspective of absolute return strategies is difficult other than to say that there have been huge bouts of volatility. We have seen constant inflationary upside surprise. We have seen very negative drawdowns for both fixed income and equity markets. And really the only asset classes that delivered a positive return have been the very narrow areas of energy and perhaps the US dollar.
The benefit of absolute return within investors’ portfolios in this environment is more of a shock absorber within portfolios, looking to mitigate some of the downside damage, [potentially] preserving capital and allowing investors to look forward, hopefully to better periods ahead.
What are your expectations for 2023?
Looking forward towards 2023 and thinking about the opportunity set it is prudent to prepare for a recession. This is unlikely to be particularly deep, but actually throws up a huge amount of opportunities for long and the short books. On the short side, the obvious implications are what happens to demand, both throughout the corporate and the household sectors.
The other focus is the cost base. Of course, most corporates have a degree of hedging strategies place, but we are seeing still a high chance of elevated cost pressures looking forward to 2023.
But it is not all bad news, valuations have fallen a long way within equity markets, and balance sheets which typically would come under stress at this point in the economic cycle are very high. We saw a lot of corporates running with stronger balance sheets. And those that were in more distress used that period in the early stages of the pandemic to raise money and strengthen balance sheets at that point. The upside risks actually balance the downside risks to some extent – not necessarily within the economy or the real world, but more so within stock markets.
What is the biggest unappreciated risk?
When assessing unappreciated risk looking forward into 2023, I am tempted to say the unappreciated risk is to the upside. That sounds strange, when we are all subject to headlines that look very scary, talking about the economy. But as I said earlier, valuations to some extent and throughout a number of listed sectors and companies discount a large percentage of this bad news. The market has begun to worry about all manner of troubles.
This isn’t the 1970s. We are not seeing a cost push spiral from inflationary pressure. This isn’t the late 1980s, where we saw a really nasty consumer recession. There is pain for certain sectors of the economy, but generally, most households have saved throughout lockdown and come into this recession in fairly good shape. Equally, this is not the GFC (global financial) crisis from 2007 to 2008. Balance sheets within the corporate sector are strong, so we are not likely to see the same level of dilution and equity raises required to bring people through to the other side of this recession.
So it is not fashionable, but we are certainly remaining balanced, looking for upside risk as well as downside. Where would incremental downside risk come from? I think another area of geopolitical conflict, perhaps in China or the Middle East, are areas that would concern us. Why? Because I think then you would see supply chains come under pressure again, probably further scarcity within energy, and that could again set back that conclusion.
Why should investors allocate to absolute return in 2023?
For those investors considering absolute return, looking forward into 2023, I would say the strongest argument for inclusion within portfolio is that it is likely to be a very volatile year again. Assets are likely to stay elevated in terms of volatility. There is a huge degree of macro uncertainty, balanced by some valuation factors which appear more supportive.
I would also say the world is unlikely to return, along a number of factors, to where we started. We are unlikely to see central banks cutting interest rates to the degree they were prior to the pandemic, or where they were taken in the early stages of COVID. They have taken the advantage of resetting that higher, and even if we do see a more dovish narrative coming through from central banks, we are unlikely to go back into a world where we are looking at zero or negative rates.
Equally, in terms of inflation, I think nominal inflation probably remains at higher levels than we have seen for the last 10 to 15 years. We are seeing some signs that real inflation pressures are easing and you can see that from the pivot from central banks that appears to be underway at the moment. But again, we are not expecting to return back to that period of structural deflation we have been structuring portfolios through for the last few years.
Absolute return: The total return of a portfolio, as opposed to its relative return against a benchmark. It is measured as a gain or loss, and stated as a percentage of a portfolio’s total value.
Absolute return strategy: Absolute return funds are a type of investment strategy that aims to deliver a positive (‘absolute’) return to investors, regardless of whether markets are rising or falling, although a positive return is not guaranteed. Absolute return funds using ‘long/short’ strategies are designed to make money from shares in companies that go down as well as up.
Cost-push inflation: This occurs when prices increase due to the higher costs of inputs such as raw materials, labour, transport, etc. This can spiral when a rise in prices leads to higher wages, which can lead to reduced supply as businesses cut costs.
Inflation/Deflation: Inflation is the rate at which the prices of goods and services are rising in an economy. Conversely, deflation is a decrease in the price of goods and services across the economy, usually indicating that the economy is weakening.
Long/short investing: An investment strategy that aims to profit from price gains in long positions, and price declines in short positions. This type of investment strategy has the potential to generate returns regardless of moves in the wider market, although returns are not guaranteed.
Long position: An investment in a stock that is bought in the expectation that it will rise in value.
Recession: A significant, widespread, and prolonged downturn in economic activity, commonly accepted as two consecutive quarters of economic contraction.
Short position: A strategy where an investor borrows and then sells what they believe is an overvalued asset, with the intention of buying them back for less when the price falls. The position profits if the security falls in value. Certain derivative investments can be used to simulate a short position without directly owning it.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility.