Research in Action: Preparing for a new investment paradigm in 2023
Paul O’Connor, Head of the UK-based Multi-Asset Team, Adam Hetts, Global Head of Portfolio Construction and Strategy, and Matt Peron, Director of Research, share their views on inflation, the current rate-hike cycle, and the implications for investor portfolios in 2023.
40 minute listen
- Valuation drove markets in 2022, as asset prices adjusted to rapidly rising interest rates. With higher rates now largely priced in, fundamentals such as earnings are likely to be bigger drivers of performance next year.
- Earnings and economic growth forecasts for 2023 may still be too optimistic, leading to market volatility.
- But the repricing that has occurred over the past 12 months could create attractive opportunities for investors who stay focused on fundamentals and diversify across fixed income, equities, and alternatives.
Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.
Alternative investments include, but are not limited to, commodities, real estate, currencies, hedging strategies, futures, structured products, and other securities intended to be less correlated to the market. They are typically subject to increased risk and are not suitable for all investors.
Bank loans often involve borrowers with low credit ratings whose financial conditions are troubled or uncertain, including companies that are highly leveraged or in bankruptcy proceedings.
Commodities (such as oil, metals and agricultural products) and commodity-linked securities are subject to greater volatility and risk and may not be appropriate for all investors. Commodities are speculative and may be affected by factors including market movements, economic and political developments, supply and demand disruptions, weather, disease and embargoes.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
Growth stocks are subject to increased risk of loss and price volatility and may not realize their perceived growth potential.
High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Value stocks can continue to be undervalued by the market for long periods of time and may not appreciate to the extent expected.
Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Credit quality ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
Dividend Yield is the weighted average dividend yield of the securities in the portfolio (including cash). The number is not intended to demonstrate income earned or distributions made by the portfolio.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.
Quantitative Tightening (QT) is a government monetary policy occasionally used to decrease the money supply by either selling government securities or letting them mature and removing them from its cash balances.
Return On Invested Capital (ROIC) is a measure of how effectively a company used the money invested in its operations.
Volatility measures risk using the dispersion of returns for a given investment.
A yield curve plots the yields (interest rate) of bonds with equal credit quality but differing maturity dates. Typically bonds with longer maturities have higher yields.
An inverted yield curve occurs when short-term yields are higher than long-term yields.
Yield cushion, defined as a security’s yield divided by duration, is a common approach that looks at bond yields as a cushion protecting bond investors from the potential negative effects of duration risk. The yield cushion potentially helps mitigate losses from falling bond prices if yields were to rise.
Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.
As we wrap up 2022, investors may be wondering whether the problems that plagued markets throughout the past year – generationally high inflation, rapid rate increases, slowing economic growth, and geopolitical conflict – will get resolved in 2023. Or will they continue? Joining us to talk about it today is Paul O’Connor, head of the Multi-Asset Team based in London. He believes that while none of these issues are going away any time soon, the worst may be behind us.
Paul O’Connor: I think market interest rate pricing now looks fairly realistic. Even though we’re going to see rate hikes in December, January, February, and in March. I think investors can take some comfort from the fact that central banks have front-end loaded this process.
Bigda: We’re also joined by Adam Hetts, Global Head of Portfolio Construction and Strategy, for perspective on how investors should be positioning their portfolios in the current environment.
Adam Hetts: I think at this point it’s about reorienting portfolios to this new paradigm, and this new paradigm is loaded with opportunity.
Bigda: I’m Carolyn Bigda.
Matt Peron: And I’m Matt Peron, Director of Research.
Bigda: That’s today on Research in Action.
Paul, Adam, welcome to the podcast.
O’Connor: Thanks, Carolyn. It’s great to be with you in the podcast today.
Hetts: It’s great to be back, thanks, Carolyn.
Bigda: We’re very happy to have you, and we thought we’d start with what has been the dominant market story of 2022 – inflation – and the big question facing all investors: Will inflation continue to be the driving force of markets in 2023, or are central banks winning the battle against it, thanks to their rapid rate hikes? Paul, you’re joining us from London, perhaps you can cover what you’re seeing on the ground in the UK and Europe.
O’Connor: Well, Carolyn, the bad news here is we’re ending the year with inflation still uncomfortably high for central banks in many of the developed economies – in the UK, in the Eurozone, in the U.S., as well. For markets, I think the good news, though, is we’ve priced in a lot. I think after this year’s abrupt repricing of interest rates, I think market interest rate pricing now looks fairly realistic. So, even though we’re going to see rate hikes from many of the major banks, central banks, in December, and in January, February, and in March, as well, I think investors can take some comfort from the fact that central banks have front-end loaded this process. So, I think rates are going to peak in the first half of next year . I think the Fed [Federal Reserve] will get there quicker. Market pricing has the Fed peaking somewhere around the end of Q1; I think that’s pretty fair. For the Bank of England and the ECB [European Central Bank], though, I think it’s going to take a little bit longer. Those central banks have not been quite as aggressive as the Fed this year. They’re also ending the year with inflation not yet having clearly peaked, and they’re also ending the year with inflation in double digits. So, I think where the UK is concerned and Europe is concerned, we’re probably not going to get a peak in inflation until early in the new year, and a peak in rates until sometime in Q2.
Bigda: So, more rate hikes to come, but the end might be in sight, even though it might be on a different timeline for some regions, it sounds like.
O’Connor: That’s right.
Bigda: Matt, what are you seeing in the U.S.? What’s your perspective?
Peron: So, in terms of our analysts talking to their company management teams, on the U.S. side, we’re generally seeing fewer and fewer complaints, if you will, about wages and about commodity and input pricing. So, we’re certainly seeing the slowdown. Now, they’re also seeing deceleration in their business, but in terms of the inflation picture, it’s gotten a lot better on the ground. And from our read of it, U.S. inflation – and Paul alluded to this – is certainly starting to decline very noticeably.
Bigda: And is this easing of price increases, is this directly tied to central bank actions? Are rate hikes having the effect that they were hoping they would have?
Peron: I think we’re starting to see the front end of that for sure, and you’re seeing it in commodity prices, as well, and just the supply chains getting better. So, some of it was that structural or sort of semi-structural supply chain issue. That’s certainly resolving quite rapidly.
Bigda: Adam, you titled your last outlook “Shock Therapy,” and you called inflation the biggest market shock for portfolios this year. How have you seen client portfolios reacting to such an unfamiliar risk?
Hetts: Well, talk about a loaded question after this year, but I guess I could sum it up by saying very early this year, when that inflation shock first hit, it was sort of a shorter-term view from clients, I thought. So, they were asking about the typical knee-jerk reactions to fight inflation. So, I’m talking about those fleeting or tactical additions of gold, or TIPS [Treasury inflation-protected securities], or especially commodities. Matt just mentioned commodities, and Matt just mentioned commodities a bit politely because I think what happened was those knee-jerk inflation hedges showed their true colors. We saw a lot of volatility in commodities, and, of course, gold can run higher vol. than typical core equity allocations; even TIPS can run higher duration or interest rate risk than the typical core fixed income portfolio. So, some of these times it was a case of the cure being worse than the disease, where these new line items caused a bit of buyer’s remorse. So then, at the same time, we witnessed this massive correction or repricing across all markets as they adjusted for the other market shocks we had, including interest rate risk and broadly slowing growth globally.
So, I think at this point, turning into this longer-term view away from that knee-jerk reaction, and now it’s about reorienting portfolios to this new paradigm, and this new paradigm is loaded with opportunity, whether it feels like it or not right now. And it’s not just about those few inflation hedges, it’s the broader rebalance about the entire fixed income portfolio and broadening the equity portfolio way past what was such historic large-growth leadership and concentration in equity portfolios.
Bigda: So, before we get into the details of the portfolio itself, Paul, let’s talk a little bit about the sort of broader economic implications. If inflation does moderate next year allowing central banks to ease up on the pace of rate increases, as you expect, what does that mean for economic growth in 2023? Is a global recession sort of a foregone conclusion at this point, or can it be avoided?
O’Connor: I think it’s pretty likely, Carolyn. If you look at what the economists are actually predicting, they are just about predicting recession in the U.S. and the Eurozone, but their forecasts are portraying about as gentle a recession as you could get, just about two quarters of just about negative growth. I’d say, as we think about the balance of risks here, I think one of the positive stories we can focus on is private sector balance sheets in the major economies; [they] are really in quite good shape. You can say that for banks; you can say that for the household sector; you can say that for companies, as well. That’s certainly a positive. You don’t have the sort of excesses that we normally see before a recession. But on the other side of the ledger, the big concern I have is housing. Monetary policy has tightened at an unprecedentedly rapid rate this year, and monetary policy famously works with long and variable lags. And we don’t really know how hard this monetary tightening is going to hit growth in general, housing in particular. I think it could be a big problem next year in many of the major economies. I would watch housing very carefully in the UK, the U.S., and China. People have famously said in the past, ‘Housing is the cycle,’ and I think we’re beginning to see a downturn there already that could weigh more heavily next year. So, on balance, I think the economists’ numbers are still a little bit high. If you look at the forecast, they’ve been getting downgraded progressively over the last few months. So, I think the balance of risks suggest we will get a recession in most of the major economies next year, but I think there are still good reasons for thinking it will nevertheless still be a fairly modest one.
One final thing to add is China, I think, is a real wild card for 2023 from a macro sense. Markets have rallied, obviously, in the last few weeks on growing confidence that there’s going to be a reopening in China and the negative effects of the zero-COVID policy will begin to fade away, and I think that could be a good story. That could really come to help the global economy at some stage in 2023. I think the problem is things could get a lot worse before they get better on the health front. I think we could see further lockdowns in the next few months if we get the usual pick-up in cases when restrictions are eased. So, I feel China could be complicated. I think China could be problematic for the global economy in the first quarter or even a couple of quarters of next year, but it could help in the second half. So, we’ve a fairly tricky outlook in the major economies. The dynamics there were fairly tricky already, but I think China is only going to add further complications to that.
Bigda: It sounds like a lot of unknowns still. Matt, what’s your view? Are you as worried about housing, as well, or other elements of the economy?
Peron: Well, I think Paul makes a really important point about the economists’ numbers still coming down, being too high. That’s likewise the issue when it comes to earnings forecasts. So, they’re just stubbornly high in sort of what is published. We think that they have to come down some more. Our analysts, we model out different scenarios, and sort of tying our base case around a reasonable downside case. So, earnings come down, but we’re not in the crisis mode of past crises where earnings really dropped dramatically by 40%. We’re sort of in a more reasonable downside case, and it does vary by sector. Housing, to Paul’s point, is certainly going to be ground zero. So, those numbers come down a lot, but other sectors we see being a little bit more resilient, and that forms our base case for thinking about earnings. But that’s a risk we see in 2023 in terms of equities.
Bigda: And what does that timeline look like? Do you think earnings have to come down throughout 2023, or is it more like a first-half-of-the-year scenario?
Peron: Well, Paul mentioned the variable lags, so I’m going to hide behind that. But I think we’re starting to see the front end of it. I think you’ll start to see it really hit when you see guidance for next year, people will be very cautious about giving firm guidance, and then as the year goes on, you’ll see, probably through the second quarter, will probably be really the teeth of it. When you look at semiconductors who were first in this, starting January they started cutting, of 2022, they’ve been resetting all the way down. I think the rest of the economy has to follow their lead. So, we probably see four or five rounds of cuts, if you will, in front of us.
Bigda: And just very quickly, what is the issue with housing this time around?
O’Connor: I think there’s two issues, Carolyn. I think, first, there’s affordability. If you look at housing affordability, I think it’s at a multidecade low in many of the major economies. But I think the second issue is just the speed of rate hikes. By the end of this year, the Fed will have raised rates by more than 4% in a year, and, obviously, you’ve seen mortgage rates move up by about a similar amount. So, it’s quite hard to evaluate that shock. So, I think we go into next year with affordability already very stretched with consumers still feeling the effect of these rate hikes working through. We don’t quite know at what stage that will really bite because, obviously, for various people, the mortgage hit will come at different times depending on when you struck your mortgage, when your mortgage rolls over. So, I think that’s where the uncertainty is; it’s the scale of the shock, and the speed of it, and the fact that it’s already taking affordability into this sort of territory from which, in the past, we didn’t normally see housing market run into trouble.
Bigda: So, Adam, it sounds like we’re going into an economic slowdown in 2023; the scale of it we don’t know at this point. What do you think that could do to portfolio returns? Should investors expect this to drive another painful year of negative returns across the entire portfolio?
Hetts: So, a lot of pain out there, and Matt and Paul did a great job articulating the risks out there. And there’s a paralyzing amount of risk, I think, on the macroeconomic front. But I think it’s really important for investors not to get that analysis paralysis, and they need to divorce the economy from markets. So, simply put, we’re not doomed to this negative year of returns, or negative years of returns; I think it’s far from it. So, it’s more about looking at different asset class returns that can either diversify that growth slowdown, or maybe some places that are looking past the slowdown already with some markets being more of a forward-looking mechanism.
So, fixed income, simply put, that big painful jump in rates we had this year, that was the pains. And now it’s time for gains. You’ve got more attractive yields and maybe some attractive total return if recession drives rates lower from here. Then, U.S. equity is a bit more difficult if multiples are somewhat range-bound, and like Matt explained, earnings are flattish or maybe even going down from here into next year. But just remember, equities are that forward-looking market. So, it won’t be long ‘til their looking forward into the eventual rebound. And I think, meanwhile, it’s not just about muddling through. I think there is flattish earnings overall, but there’s a lot of companies that seem to have already experienced their own mini recessions and maybe are even closer to their version of the rebound. So, for example, some of the consumer discretionary areas, and also some really early turnaround stories in companies across all sorts of sectors that were particularly sensitive to all the raw material headwinds, for example. And maybe they’re already making good progress towards recovering their margins and their earnings ahead of the broader trend. And I’m just thinking about the U.S. there. Then, in Europe, P/Es [price-to-earnings ratios] are well below averages and you’re getting 2x to 3x the dividend yield of U.S. equities. So, again, it’s not just a matter of muddling through next year; there’s a lot of attractive places to build exposure and prepare for that broader rebound ahead.
Bigda: So, it sounds like there’s a lot of variation in the market, whereas maybe in years past, a lot of assets were moving in lockstep with each other. At this point, there seems to be different valuations, different timelines that investors could potentially take advantage of in 2023.
Hetts: I think that’s exactly right, and that’s also where you’re seeing a lot of renewed interest in alternatives – these long/short and unconstrained strategies. We’re talking about a lot of divergence across markets globally and just a lot of elevated volatility. So, alternatives can make those divergences and volatility their friend. And so, you’re seeing more of a role of alternatives in portfolios than, I think, the last few years, and a lot of investor interest is coming online for that.
Bigda: Maybe if we could just quickly talk about the math of bonds because it’s always a little bit tricky. So, the advantage now is that investors are actually earning a more decent yield on their bonds at this point compared to a year ago, and that helps with your interest rate risk and duration risk as well?
Hetts: That’s right. So, it’s a little bit complicated because it depends on the investor’s starting point and where they’re at in their portfolios and maybe where the rebalance priority is. But if you’re looking at the U.S. yield curve, we’ve had this inverted yield curve. So, it’s been a boon to fixed income investors, with short duration yielding the same or more than intermediate duration. So, you can add investment grade into a core fixed income portfolio with investment-grade style yields without having the duration risk that normally comes with investment-grade core fixed income, if you’re using short duration. But then I mentioned the mid- to high-single-digit returns and the attractive total return of intermediate duration if we have a recession from here. So, even though yields are flattish or even inverted across the curve, if you move from short duration up to intermediate in your bond portfolio, maybe you’re essentially treading water on yields, but if rates do plummet because of recession, that’s the situation where intermediate duration can vastly outperform short duration on that total return basis. So, there’s a lot of opportunity in fixed income, and fixed income was a much more difficult question earlier this year. But going back to bonds or math, things have gotten a lot more straightforward after all the volatility and the rate reset we had this year.
Bigda: So, investors have options, which sounds like a good thing to me…
Hetts: Very good thing.
Bigda: …when it comes to positioning their portfolio.
So, each of you has published an outlook for 2023, and one common theme across all three was quality. Specifically, you each argue investors should look for quality as a way to try and minimize volatility in the new year. What do you mean by quality, and why is it so important in the current environment? Paul, let’s start with you.
O’Connor: Okay, for me, Carolyn, this is really about the sense that markets are moving from a valuation-driven regime in 2022 towards a more growth-driven regime next year. And I mean, just to think about that a little bit further, if we think about this year, the big macro themes were inflation and interest rates, and the big market themes that came from them were a compression of valuations. So, if you’re in the equity market, the most important thing to focus on was valuations; high P/E stocks, high value stocks generally did really poorly, and cheap stocks or [low] valuation stocks generally did very well. It was very much a valuation-driven market regime. But then, as we look into 2023, the idea that rates are going to peak means that that story begins to diminish, and I think for equities, for example, it means next year becomes much less about the P/E. Market P/Es are looking fairly reasonable now; I think we’ve done most of that adjustment. But I think the emphasis shifts from the P/E towards the E [earnings], and I think that’s because as we get a slowdown, investors will be focusing a lot more on trying to work out which companies are resilient, which companies can survive in that environment. When I think of quality, that’s what I’m thinking about. It’s really about resilience in an economic slowdown, and, obviously, that’s a theme in equities, but we see a similar theme playing out in credit as well next year.
Bigda: Matt, what’s your perspective?
Peron: I think Paul covered it all.
Bigda: Paul, you’re doing Matt’s job for him. Adam, what about you?
Hetts: I agree with Paul, he’s making my life easy, too. So, we’ve re-rated or de-rated down on multiples this year, and that was a lot of the price pain investors took on indices. So, here we are at average multiples, and if you kind of fix multiples and you’re worried about that earnings weakness, what do you do? You look for stable earnings, and stable earnings are a hallmark of quality investing. So, I think it’s important to highlight, though, that quality doesn’t just cleanly map to one style, or size, or sector, or even region. Quality sort of transcends all those categories, and that’s part of what makes this environment ripe for hands-on, active, research-driven stock picking.
Peron: And I would just say in addition to looking at quality in terms of earnings and earnings resilience, also balance sheet and financial leverage – you want to avoid those because those are going to be potentially where any crisis might unfold. So, keep it high quality, keep risk tight, I think, in this year. And the old saying that stocks follow earnings, I think, will be especially true, and the dispersion you’re talking about between asset classes will also be true within asset classes. So, I think you’ll see a good dispersion in equity returns next year.
Hetts: Yeah, and another thing Matt’s hinting at, too – quality, it’s not just one factor or just one thing to buy. So, it could be earnings stability; it could be looking for more symptoms of healthy financials like free cash flow yield, or ROE [return on equity], ROIC [return on invested capital]; it could be looking for wider margins that are less sensitive to the inflation shocks we’re still going through; it just could be great competitive advantages going through a recession; or just the financing side of things, like Matt just said, as far as in a rising interest rate environment, having companies that are less dependent on short-term financing or external financing.
Bigda: And Paul, you mentioned that quality is just as important when looking at credit markets, which is interesting because equity markets declined in 2022, but bonds, they really took it on the chin. And some investors might think, well, valuations have become so low at this point that all areas of fixed income look attractive now. What would you say to that?
O’Connor: Well, as Adam touched on earlier, I think there is an argument that can be made that says fixed income is looking generally attractive compared to equities this year. I still think within fixed income there is still a relevance of that quality focus in an environment where growth is slowing. I think as long as growth is under pressure and investors are worried about the recession risk, I think in fixed income the relevance of that will be as equity investors worry about downgrades, credit investors will worry about defaults. And I think whilst we remain in that regime – and I think that’s certainly going to be the story for the first half of next year – investors will tend to prefer the quality end of corporate debt over the lower quality end. So that keeps a preference for IG – investment grade – over high yield.
And I think more broadly an argument can be made, as Adam touched on earlier, that the quality end of the bond market – government bonds and IG – could be seen as regaining a role as core holdings in multi-asset portfolios next year. As you say, they’ve all struggled this year, but I think in an environment where rates are peaking and growth is slowing, these assets should begin to perform better. And there are lots of different cyclical frameworks that we could look at that would help us think about when one should own more fixed income compared to equities, and a lot of them look quite attractive for next year. I mean, one simple one I tend to look at is when unemployment is rising, credit, particularly IG and government bonds, tend to outperform equities, and we certainly expect that to be the story in the first half of next year. We expect unemployment to rise in most of the developed economies, and typically that would tell you that’s an environment in which to own the quality end of the fixed income market.
Bigda: Adam, are you seeing investors shifting their fixed income portfolio for this type of environment yet?
Hetts: We’re starting to see that. So, I think going into the new year it’s going to be a new look for a lot of fixed income portfolios. So, like Paul was just talking about, when you had rates at 1% or 2%, that’s the yield, and there wasn’t much yield available to cushion any other price losses in bonds as rates rose. As rates rise, the value of older, lower coupon bonds goes down. And so, now when you’re in a healthier yield environment – call it 3%, 4%, 5% yields – if rates go up, you’re going to take some price losses, but now you have double or triple the yields to offset those price losses. So, that yield cushion is a lot bigger in this system. So, that’s part of the reason investors are falling back in love with fixed income.
But I guess the narrative up to this point this year is that, throughout the year, a lot of clients got it right, I think, because the average fixed income portfolio that we saw coming into our team was essentially this barbell of very ultra-short duration in the core and a lot of floating-rate bank loans outside the core where they wanted to reach for yield but not take interest rate risk. So, that was the perfect allocation in a sense, or at least as perfect as you could ask for, for this year. But now, for all those reasons that Paul laid out and I just mentioned, it’s about getting back to basics on fixed income. So, it’s been a bit of this waterfall approach. So, for those clients that were broadly underweight core and overweight the non-investment grade piece outside the core, if you’re trying to get back to a more traditional fixed income benchmark, a few months ago the first part of that waterfall process was adding back short duration because the yield curve inverted, which was terrifying as far as recession implications, but great for fixed income investors. So, you added back short duration, and you got competitive intermediate duration style yields without the interest rate risk. So, that was the first piece. But now I think the focus is on adding back more intermediate duration. And I mentioned earlier, even though intermediate has yields that are roughly competitive with short duration, it’s more interest rate sensitive, and instead of duration being a pejorative term like it was throughout the year , that’s actually a positive risk, we think, in fixed income portfolios, is to have that interest rate risk. So, if we have the recession and rates go down, there’s a positive response in bonds from that reduction in rates.
And then, outside the core, spreads are looking a little too optimistic, given the realistic recession risks we’re seeing out there. But there are a lot of these high-single-digit or even double-digit yields outside the core. I just think the best implementation to reach for those types of yields is a more flexible, risk aware, multi-sector strategy at this point and not a single sector benchmark-constrained approach like traditional bank loans or traditional high yield, just given where spreads are at, and that’s something that we’re watching closely.
Bigda: Is it possible to find the extra duration in high quality bonds across the globe, or do you have to stick to certain regions at this point? Because if central banks are raising rates across the world, I would think that yields look attractive on a global basis at this point, or is that not the case?
Hetts: Short answer is, yes, investors should be global in their core fixed income approach because in the U.S., for example, just like in equities, you have a lot of home bias in fixed income. The average fixed income portfolio for U.S. investors is almost all U.S. sovereigns and U.S. investment grade. But U.S. is not the majority of the global aggregate benchmark; it’s actually the minority of the global aggregate benchmark. So, there’s a really deep opportunity set globally for fixed income investors.
So, the first point of caution is when you’re looking global for your fixed income is currency risk. So, basically, unequivocally, we would hedge currency risk out of a global core bond portfolio because currency risk can run 4x or 5x the volatility of traditional core bond risk. And then, that’s a bit of the caveat to your question and my answer about should investors always be global because it also depends on your local yields versus the foreign yields and whether hedging’s a cost or actually a boost to your yield, and that can also influence how globally you should be diversified. But the short answer is, yes, it’s a global opportunity set, and you shouldn’t have a home bias in fixed income, but the currency wrinkle can either be a benefit or a cost, and that can actually drive a lot of the decision making, ultimately.
Bigda: Paul, would you agree?
O’Connor: Yeah, I would agree, and I would say also when we split the world into investment grade or high yield fixed income, if I look at high yield, it’s far from clear to me today that investors are fully compensated for the recession risk that we see ahead, and that’s the case in most of the major economies. Yet, when we look at investment grade, we can find some places, particularly in Europe – actually UK and the Eurozone – where we feel recession risk is priced in, valuations now look attractive. So, I think, yeah, there’s still differences regionally and differences between the different quality categories.
Bigda: So, maybe let’s end this conversation by taking a step back. So, the year 2022 has been remarkable, not just because global markets sold off, but because it marked a major shift in monetary policy and inflationary trends. And I think the big question now seems to be, is that shift a temporary one, or are we seeing a structural change in the economy? And if it’s the latter, what does that mean for how investors should think about investing and structuring their portfolios? Paul, do you want to start?
O’Connor: Sure, big question to finish off.
Bigda: Yeah, exactly.
O’Connor: I think, arguably, we could say both. There is a temporary component to this, which is, I think, we’ll see fade away next year. We enter 2023 with inflation at double digits in lots of developed economies and very high in the States, and I think we’re going to see inflation fall away almost month by month throughout 2023. So, that’s the temporary bit. I think the bit that’s plausibly more enduring is it could well be that once we get through that process, we do find that inflation ends up at a level much higher than pre-pandemic. I would not assume that next year is the start of a return to pre-pandemic inflation or pre-pandemic policy ratings. And really, the reason for that is, I think, when we step back and look at the bigger picture, the last few decades – the so-called Great Moderation, which started in the ‘80s and ended a year or two ago – that was a world of declining inflation, declining interest rates; a world of low inflation, low rates, and low bond yields. And if we think about what drove that, there’s lots of factors: globalization, the arrival of China into the world trade system, deregulation, technology, central banks, etc. But many of these factors are now exhausted, and some of them are even reversing. We’re seeing deglobalization, we’re seeing China begin to withdraw in certain sectors, we’re seeing other factors that might push inflation up, and some of the climate related spending, some fiscal spending to address inequality. So, if you step back and look at the big picture, I think there’s a reasonable view that says all these factors that were disinflationary for the last few decades are no longer working quite as powerfully, and it’s quite plausible, I think, that we settle in a world going forward over the next few years in which inflation and rates are oscillating around higher levels than we have been used to in the last few decades.
Now, if we do end up in this world where interest rates through the cycle are higher, inflation’s higher, I think there’s a few implications for markets. I think, firstly, it’s probably a more volatile market environment because inflation will force central banks to respond more frequently than it has in the last few decades. I’d say for valuations, markets probably need higher risk premia to attract investors out of cash in a more volatile market environment. And I think the third thing is that will be an environment in which cross-asset correlations would be more unstable. These are often related to inflation dynamics and interest rate dynamics. So, that could make diversification more tricky; it could make hedging more tricky, as well. I think it would be a much more challenging market environment, but it would also be one that would offer an awful lot more opportunities. Because, I think, in a sense, when you step back and look at the last few decades, a world of low volatility, that is a great world for passive investing; that’s a great world for buy-and-hold investing. But I think a more volatile market regime both demands and rewards a much more active approach to investing.
Bigda: Matt, would you agree? Do you think that the pendulum is shifting more towards an active investing environment now?
Peron: Yeah, I think Paul is right in the sense that in that sort of Great Moderation, it was really a big macro trade one way of all asset classes, correlations. So, I think he’s exactly right, that we’ll see more dispersion between asset classes and within asset classes. And one of the things that we’re excited about is valuations are getting very interesting, and we’re going to be able to get growth at a reasonable price again. And that’s been hard for almost a decade. And that really will also allow active managers to choose stocks that have those valuation characteristics but, yet, have growth opportunities. We’re getting excited. We have to get through this earnings reset, but on the other side of that, I think you mentioned at the top of the podcast, that there’ll be opportunities emerging, and that’s one of them that we’re excited about.
Bigda: Adam, what do you think? What’s your long-term view?
Hetts: So, longer-term view is, well, ever since the Global Financial Crisis in 2008, it’s basically been this awesome run for awful portfolios. So, to Matt and Paul’s point, I mean, it was an awful portfolio from a risk perspective but awesome for returns, meaning that huge passive overweight to U.S. growth and high yield was really the best version of the 60/40 [portfolio]. So, the economy is structurally shifting, so should portfolios. And I think listeners are picking up on a lot of these structural shifts from Matt and Paul, especially that focus on rates. It makes me think about Warren Buffet; pretty good investor, even though he doesn’t work here. But Warren Buffet said that interest rates are like gravity to all asset prices. So, it’s just a fact that we’re in a different reality now for asset allocations. So, I think the most common needs we’re seeing in equity portfolios is adding back that fundamental approach to quality, and then also zooming out and globally diversifying. Then, in bond portfolios, we talked about that plenty already, but this big silver lining to all the pain in the rate reset we had this year. And we also touched on alternatives briefly. So, that volatility, that divergence – those unconstrained long and short, non-traditional strategies in alternatives are going to have a role in portfolios more than they’ve had the last few years.
Bigda: Does it feel like the markets are finally getting back to normal in sort of the long-term sense?
Hetts: Well, if this is normal, we’re in for a rough ride. But I guess you could argue that maybe things are getting back to basics in a lot of places – more broadly diversified across equities and fixed income. So, I’d like a little more peaceful normal going forward, if we’re going to get back to normal, but at least things are getting a little more fundamental and a little more straightforward, I think, as far as asset class implications.
Bigda: Well, Paul, Adam, thank you so much for joining us today and sharing your thoughts about 2023 and beyond. Here is wishing everyone a Happy New Year and hopefully better investment returns ahead.
In January, we plan to catch up with John Jordan, lead analyst on our Financials Sector Team, to discuss how banks and other areas of the financials sector might be well positioned for this new higher rate, higher inflation environment. We hope you’ll join.
Until then, I’m Carolyn Bigda.
Peron: And I’m Matt Peron.
Bigda: You’ve been listening to Research in Action.
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