Part 1: The aftermath of 2022, where to next?

Following the most expansionary monetary policy in a generation in 2022, economies around the world abruptly pivoted and entered very aggressive economic tightening cycles as inflation rose and unemployment fell. So where did 2022 leave us and where are we heading? How can advisers best position their clients’ portfolios to deal with what is predicted to be a period of extreme economic uncertainty?

In this piece, we bring you a round-up of the interviews we held with three experts. The next instalment will be published tomorrow.

Fixed income

Stephen Cooper, head of Australian fixed income at First Sentier Investors

Where has 2022 left us regarding fixed income?

Stephen Cooper: The year 2022 has been a challenging one for fixed income investors. The increase in inflation globally has pushed interest rates from pandemic-affected lows up to the highest levels seen in many years, all in a very short amount of time. When yields increase, the price of bonds goes down, which can lead to losses in the shorter term.

Bond yields have adjusted significantly due to persistently high inflation and the probability of higher official interest rates. Policymakers have been scrambling to tighten policy settings, moving away from the ultra-accommodative stance that had been in place for most of the period since the Global Financial Crisis (GFC) more than a decade ago. Much of the increase in inflation is due to supply chain bottlenecks and energy price surges. Factory lockdowns in China and elsewhere — and disruptions to transport and logistics facilities — have affected the availability of various products and componentry, pushing prices higher. At the same time, Russia’s invasion of Ukraine has seen energy prices spike owing to the risk of disruptions to supplies.

We can’t discount the possibility that these pricing pressures will persist for an extended period. If so, the recent increase in bond yields could have further to run. That said, both government bond yields and credit spreads are now back at levels that offer more appealing prospective income and potential returns for long-term investors.

Why is it important for investors to view fixed income with a longer-term perspective before perhaps considering extensive portfolio adjustments?

SC: Fixed income should always be viewed with a longer-term perspective in our view due to the typically long-duration nature of the underlying assets.

With bond yields and coupons now higher, longer-term return forecasts have increased. Investors have experienced the pain as rates have moved higher but should now enjoy increased returns owing to higher rates in the years ahead.

How can advisers approach having these conversations with their clients, especially since investors have largely become used to the favourable investment conditions of the past decade until the onset of COVID-19 and Russia’s invasion of Ukraine?

SC: We believe it’s important for advisers to take their clients through the journey of the economic cycle. Following the GFC, growth and inflation were persistently below target in key regions. Central banks around the world responded by providing markets with unprecedented levels of liquidity to encourage growth. Official interest rates were very low and bond yields moved steadily lower. This was a ‘goldilocks’ scenario for investors, who typically enjoyed strong returns from both equities and fixed income in the years prior to the COVID-19 pandemic.

To maintain the favourable performance track record from fixed income, bond yields would have had to continue falling. But how much lower could they go? They had already fallen to record lows. It’s possible for bond yields to fall below zero — we saw that in Japan and Germany over the past couple of years — but this is unlikely to be sustainable over time, in our view. A move higher in yields was therefore probable over time, as extraordinarily accommodative policy settings started to wound back and as official interest rates were increased.

Now that global growth is rebounding from the COVID-19 shock and as inflation is accelerating, we’ve essentially moved into a new phase of the cycle whereby central banks are required to withdraw their previous support. In turn, we’re now seeing much healthier yield levels and, importantly, higher real yields — i.e. where bonds’ yields to maturity are above where the market thinks inflation will be in the future. All of this increases the appeal of an allocation to fixed income. Again, while most fixed-income assets have seen negative returns in the year to date, in our view they’re now better balanced for the next stage of the cycle.

What’s the biggest threat for fixed income investors in the year ahead?

SC: Interest rates and credit spreads are the two important measures to keep an eye on. Anything that causes either to move materially higher/wider is a threat to fixed income investors, as it will likely result in capital losses.

On the interest rate side, central banks could continue to raise interest rates if inflation is more persistent than expected. This could see bond yields rise further. For example, the latest inflation data in the US suggests pricing pressures are proving quite sticky (Source: US Bureau of Labor Statistics), despite the increases in interest rates we’ve already seen over there. That said, there’s enormous uncertainty regarding the outlook for consumer prices. Most observers expect higher interest rates to have their desired effect at some point, and for inflationary pressures to subside. In fact, in the US and Europe, fixed income markets are now pricing in the likelihood of interest rate cuts in late 2023 and beyond.

On the credit front, spreads will be affected by economic activity levels and the outlook for corporate profitability.

The worst case would be an environment where central banks felt it was necessary to invoke a recession, raising interest rates to extremely high levels to combat persistently high inflation. In this environment, both interest rates and credit spreads could be negative performance drivers for fixed income markets. Thankfully there’s a relatively low probability of this scenario developing, in our view.

What are the biggest opportunities in the fixed income space?

SC: After years of very low-interest rates, the absolute level of bond yields is arguably the biggest opportunity in the fixed income space. With inflation forcing central banks to move away from near-zero emergency interest rate settings, yields and credit spreads are both now back at levels that offer appealing prospective returns for income-oriented investors. For long-term investors, there’s a lot more value to be found across the fixed income spectrum — including high yield and investment grade credit, and even in sovereign debt markets that have generally been out of favour for individual investors for quite some time owing to very low yields.

Finally, as well as seeing higher yields and credit spreads, we’re now seeing a much higher level of volatility in bond markets. In turn, this is presenting some interesting relative value opportunities in the fixed income asset class. Skilled active managers that are able to identify and exploit these opportunities will be able to boost overall returns from the asset class.

Domestic equities

Ray David and Joseph Koh – portfolio managers for the Schroder Australian Equity Long Short Fund

Where would you say 2022 has left us regarding domestic equities? Earlier in the year, we were predicting a normal period for equity markets following what was termed a wild ride, but did that eventuate?

Joseph Koh and Ray David: The COVID-19 recovery certainly did take place, however surging inflation caused by labour shortages and supply chain disruptions have continued to pose a challenge to profits. Consequentially, while showing signs of peaking, inflation remains at around a 30-year high which is an unpalatable situation for central banks. Therefore, central banks have embarked on a much more aggressive monetary tightening cycle than many expected, which will pose a challenge for growth assets such as equities.

The implication for equities is lower multiples applied to valuations as investors weigh up the opportunity cost of more attractive bond rates and, secondly, reduced corporate earnings given the resulting economic slowdown and higher interest cost on borrowings. The ASX 200 index has declined by 7 per cent year to date, which reflects the move up in bond yields. The Australian Government’s 10-Year Risk-Free Rate is now at 3.7 per cent, a level not seen since 2014.

Some parts of the market have already adjusted to reflect a more challenging growth outlook, such as consumer discretionary, building materials and commodities, while more defensive sectors such as technology and healthcare sectors remain at elevated valuation levels as investors search for stable earnings. As corporate earnings start to weaken, we expect this will cause more market volatility, but this should throw up some good opportunities to invest in high-quality companies at valuations not seen for some time.

Last year, you said navigating elevated levels of demand and COVID-induced supply chain disruptions were by far the largest challenge for corporates. This year, not only did these persist, but we had a complete set of new challenges following Russia’s invasion of Ukraine, while also experiencing an inflationary environment and eventually a steep series of interest rate rises. So, what would you say are the biggest challenges this year?

JK & RD: Labour shortages and higher energy prices are currently the most concerning issues that management teams highlighted to us over reporting season. Many companies we spoke to — covering sectors such as childcare, hospitals, equipment hire, and retail — commented that vacancy rates were at levels not seen before. As a result, wage growth is accelerating, forcing companies to readjust prices more frequently. At companies we spoke to, price rises of 6 to 7 per cent in February were common, followed by another round in July, taking total price rises to 12 to 14 per cent.

Management teams were also cautious about the impending consumer slowdown, given the pressure on disposable income from higher energy costs and food prices. Yet despite this, few companies reported slowing conditions in the August trading period given the impact of lockdowns on the prior corresponding period. Companies did express concern for the December trading quarter, as the impact of rate rises is expected to be felt by then. Lead indicators such as consumer confidence are below GFC lows and industrial production has also started to soften.

How do you expect these ongoing uncertainties to impact domestic equities in 2023?

JK & RD: The two most important drivers for equities are interest rates and forecast company profits, which are inputs into equity valuations. However, given the various challenges in the macro environment, sectors will be impacted in different ways. We expect the energy sector to be a winner as higher energy prices translate into decade-high profits, after years of sub-economic returns. A more disciplined approach to reinvestment coupled with an appetite to reduce emissions by energy companies will keep supply constrained.

Within financials, we expect that banks should also benefit from higher net interest margins as they have been slow to reprice deposits compared to mortgage rates. The offsetting factor will be a gradual increase in provisions as banks prepare for rising delinquencies. The other winner we see is the insurers, which are benefiting from rising premiums following an elevated claims environment. Insurers will also benefit from higher interest rates earnt on policyholder funds.

Relative losers will be the consumer discretionary sector, which benefited disproportionately from government stimulus and a low inflation environment, as well as households undertaking ‘retail therapy’ during the lockdown. Today they face a margin squeeze from accelerating labour and rent costs and elevated inventory levels. Building materials companies also face similar headwinds, although attractive industry structures mean an ability to pass on inflation.

We also expect speculative companies such as loss-making technology, battery technology start-ups, and biotechnology companies to face a more difficult funding environment given constrained capital markets. Investors likely face dilution from distressed equity issues should these companies persist in running operating losses in the hope of building a commercial business. We tend to avoid loss-makers, as we prefer companies that return cash to shareholders as opposed to cash burners.

Global equities are still so popular among retail investors in particular. Will their appeal grow as major economic issues hit the US and Europe?

JK & RD: Equity markets globally are correlated, with Australia being no different. Some of the themes such as the boom and then bust of the loss-making technology sector have played out across all markets including Australia. As central banks are operating in unison to tame inflation, we believe equity markets will behave in a similar fashion. Investors also need to consider currency cross rates, with the Australian and US dollars having weakened substantially. When global growth accelerates, the Australian dollar will typically appreciate against the US dollar as Australia is a commodity-rich market that is seen as a proxy for global growth. This may diminish the appeal of international equities if investors are unhedged. The other advantage that the Australian equity market offers is a large commodity and energy weighting, which we believe positions it well as the world moves towards net zero emissions.