7 min read 18 Jan 23
As recent inflation prints around the world appear to be peaking, the narrative in markets is bound to shift from one centred around the pace and trajectory of central bank rate hikes to one focused on the depth and longevity of the global slowdown. Assuming a meaningful global recession ahead, the fixed income market appears better positioned than the equity market, with compelling relative valuations and yields that compensate for the risks ahead, especially if we expect inflation to come down and rate rises to be close to the end. However, as the last three years have taught us, beware of the unexpected. With expectations of a recession being increasingly entrenched – particularly in Europe – a milder-than-expected outcome, perhaps given a more normalised energy market, could be an unexpected bonus that would propel equities higher. Until data points provide more clarity, equity markets are likely in for a volatile start to 2023. The market remains one where selection is the main driver of alpha, and we continue to find attractive opportunities across asset classes, regions and sectors. As we remain mindful that the complexity of the current macroeconomic backdrop brings with it both upside and downside risks, we continue to hunt for the ‘known unknowns’ in the hope of shedding a speck of light on the ‘unknown unknowns’. Whatever 2023 has in store, we are expecting surprises.
Chief Investment Officer – Equities, Multi Asset & Sustainability
The world has changed and so have we. After three years characterised by a global pandemic and a war in Europe, as investors we have learned to shift our mindset from “what should we expect ahead” to “what are we not expecting ahead and, hence, unprepared for”? It is the hunt for the 'known unknowns' hoping to shed a speck of light on the 'unknown unknowns'. We have adopted such mindset when writing this outlook. I don’t believe the conclusions read any differently to what we would have written at a less eventful time, but we are possibly more aware of keeping a door open to alternative scenarios.
Both inflation prints and central bank guidance continued to drive much of the movement in markets throughout the final months of 2022. As inflation prints around the world appear to be peaking, the narrative in markets for 2023 is bound to change from “how much further central banks will continue to hike” to “what extent of growth slowdown should we expect ahead”. Market performance, and particularly the relative performance of equities versus fixed income markets, will hinge on the depth and length of such slowdown versus current expectations.
While markets wait for clearer evidence, we are likely to see continued volatility as we start 2023. Besides the incoming data points on global growth, there are two other potential sources of volatility. First, while inflation across many countries is weakening with higher interest rates dampening demand and supply chains recovering, the tight job market (particularly in the US) is likely to maintain some degree of inflationary pressure for longer in 2023. Second, as we are indeed moving closer to the light at the end of the ‘rate hike tunnel’, with central banks likely to stop hiking sometime in the first half of 2023, markets are starting to build hope that the Fed will cut rates later in the year. I see this as unlikely to happen – unless we are facing a deep US recession coupled with inflation close to 2%, which is not our base case scenario. Importantly, I believe that the Fed will respond to such market expectations by maintaining a hawkish rhetoric as it risks de facto loosening monetary conditions by lowering rate expectations which, in turn, would make the Fed’s job more difficult and potentially force it to tighten more, and for longer.
We all know that equities do not like recessions, and we believe that a deep and prolonged one – whether global or regional – is not priced in and would bring further weakness in equity markets. An S&P500 Index that is up approximately 22% from pre-Covid levels and down peak-to-trough less than half of the ca 55% experienced in the 2007-08 Global Financial Crisis, does not scream of panicked recessionary fears.
Assuming a meaningful global recession ahead, the fixed income market appears better positioned than the equity market, with compelling relative valuations and yields that compensate for the risks ahead, especially if we expect inflation to come down and rate rises to be close to the end. However, as the last three years have taught us, beware of the unexpected. With expectations of a recession being increasingly entrenched – particularly in Europe – a milder-than-expected outcome, perhaps given a more normalised energy market, could be an unexpected bonus that would propel equities higher. Until data points provide more clarity, equity markets are likely in for a volatile start to 2023.
In what, for now, feels like a continuation of 2022, the market remains one where selection is the main driver of alpha. Identifying upside performance requires drilling down into the details. Recent earnings pre-announcements, sales data points and initial 4Q22 earnings announcements, are showing a continuation of what we experienced last year – companies in the same countries and in the same sectors are showing very different results; as better market positioning, tilts in exposure, balance sheet strength and, in many cases, better management, help some weather the storm better than others.
Importantly, the complexity of the current macroeconomic environment brings risks to both the upside and downside. A convincing resolution to the war in Ukraine, as distant as it may seem, would be a decisive positive – first and foremost from a humanitarian standpoint and, secondly, by bringing relief to commodity supply chains. Other less compelling, but nonetheless market-moving, data points we are closely watching are the evolution of labour markets in developed countries (the US in particular) and the ongoing energy supply challenges. A continuation of the persistent strength in labour markets might drive further inflation pressure, while a deterioration in conditions could shift the emphasis for policymakers away from inflation fighting. And despite the temporary relief from the stabilisation of oil and gas prices, longer-term issues remain in redesigning the energy supply mix across the globe.
While recognising the relative attractiveness of fixed income markets versus equities, our Multi Asset team is mindful of the potential volatility ahead and of the factors that could rapidly change the cards on the table. For this reason, across our portfolios we are neutrally positioned on equities and have a small overweight on duration. The duration position hinges on the long end of the US yield curve and on emerging market local currency debt, which can expect to benefit from a peak in the US dollar cycle. We particularly favour Latin American sovereigns in this space given the high real yields and an inflationary outlook that, for the time being, seems largely under control.
Within Equities, from a country standpoint, we have continued to add to China. We remain selective, but since adding in 2H22, we have rotated out of some stocks that had performed strongly and invested in others that were still reasonably valued. We believe the post-COVID reopening to be a powerful catalyst, not only for the domestic economy but also for the rest of Asia and, via increased commodity demand, other emerging markets. Some short-term volatility may come via a delay in a rebound in macro data points. This is because the long-awaited re-opening boost may face short-term headwinds given large Covid-19 infection rates and early Chinese New Year celebrations. That said, we believe the market will eventually look through these.
Korea offers attractive investment opportunities as companies benefit from China re-opening and stabilisation, as well as a turn in the global tech cycle, especially semiconductors. We also find a number of attractively-valued names in Latin America, which benefit from global commodity price inflation and, in the case of Mexico, further near-shoring. In Brazil, investors remain understandably nervous about the return of President Lula and the economic and fiscal policies to be adopted by his administration. A fragmented Congress (which may water down some of the more market-unfriendly policies from the Lula administration), and avoiding stocks prone to political intervention, gives us confidence in the prospects for harvesting further alpha from a number of Brazilian equities.
Performance in Emerging Markets (EM) across sectors and countries was very differentiated in 2022. We may see a further rise in stock dispersion in 2023, as investors drill down beyond macro considerations to focus on individual stock opportunities. Importantly, while EM equities look relatively well positioned, the biggest risk is that slower growth, disinflation and a peaking Fed rate hike cycle may tempt EM central banks to cut rates. Investors are likely to be wary of premature moves.
Last, but by no means least, we continue to like Japanese equities and believe they represent a compelling long-term investment opportunity. The recent YCC (Yield Curve Control) band expansion by the Bank of Japan and the resulting higher yen is likely to put pressure on the margins of exporters and companies with high levels of debt. Yet, we find a number of companies that are improving operational leverage with a positive impact on earnings growth, alongside increasing shareholder returns via raising dividends and share buybacks.
From a sector standpoint, we continue to find attractive opportunities in Technology. From an overall sector perspective we could see continued pressure due to higher interest rates and increased cost of capital. However, within the technology sector, the picture looks very differentiated. Semiconductors, in particular, stand out as benefiting from long-term structural trends.
One area that seems to have pushed the reset button is the Sustainability ecosystem. Most Sustainable investment strategies had a testing 2022. A combination of inflation, rising rates and the terrible war in Ukraine led investors towards value stocks, commodity, defence and bank stocks – away from the type of stocks that typically dominate Sustainable and Impact strategies. The hefty derating in 2022 has removed the ‘ESG premium’ that some sustainable stocks had experienced towards the end of 2021, offering good entry points. Also, given the strategic shift to diversify energy sources and to curb energy consumption, along with the significant investment in renewables from governments on both side of the Atlantic, this area remains a compelling investment opportunity.
And let’s not forget the convertible bonds market, which started 2023 with higher yields and lower equity sensitivity than has been the case in the last few years. Over 20% of global convertibles now trade below a price of 80% of their par value, and with a yield exceeding 10%. Most commentators expect new issuance to reach $70-80 billion during 2023, figures similar to the pre-Covid levels. Such an inflow of new deals compared to a market size of $356 billion, as at end of last year, would lead to a marked change in market characteristics. Convertibles are attractive to companies as they typically carry a lower coupon than straight debt in exchange for having the option to convert into equities. This may bring a more diverse set of issuers into the convertibles market, whether high yield names and investment grade issuers optimising their balance sheets.
We are ready and positioned for 2023. More importantly, we continue to hunt for the ‘known unknowns’ hoping to shed a speck of light on the ‘unknown unknowns’. We are expecting surprises. This is not the time to make big sweeping macro calls but, rather, to follow the data and take advantage of the opportunities that any downturn presents. Importantly, selectivity remains key.
In the following pages, you will find views from the M&G Multi Asset team and our Equities Investment desks, offering more colour at a regional or thematic level. We wish you an enjoyable and – hopefully – interesting read, and a Happy, Healthy and Successful New Year.
 Source: total returns in US dollar. Pre to post covid period: 14 February 2020 through 10 January 2023. GFC Peak to trough period: 10 October 2007 to 03 March 2009. Recent peak to trough period: 31 December 2021 through 10 January 2023.
Fund Manager, Multi Asset
Both inflation prints and central bank guidance continued to drive much of the movement in markets throughout the final months of 2022. Following a US Consumer Price Inflation (CPI) reading that was below expectations, and a softer tone to messaging from central bankers, anticipation of a slowing in rate rises pushed risk assets higher and treasury yields lower for much of the fourth quarter of 2022 (after peaking in late October). However, December saw central banks signalling a slower pace of rate rises but a higher peak in rates which, combined with mounting economic growth headwinds, brought risk-off sentiment and higher US yields back to the table.
The wild swings seen in government bond yields are a good example of some of the tactical opportunities we have tried to exploit during the course of the year. At the end of October, we increased our exposure to long-dated US Treasuries that had sold off aggressively in anticipation of the November inflation print. The rapid U-turn in markets rewarded our trade, and lead us to reduce our exposure to US 30-year Treasuries again, before they resumed selling off in the final few weeks of the year. In the equity space, we have maintained a neutral to slightly positive exposure overall.
After what has been a very difficult year, and despite a complex macroeconomic environment, we continue to see opportunities ahead for active multi asset investors:
Following the past year of drawdowns, value has largely been restored across most asset classes, but we should be mindful that strategic value is conditional upon the nature of the regime we are in. We must acknowledge that the current macroeconomic environment remains hugely complex and often contradictory, with risks to both the upside and downside.
Among other things, we are closely watching the evolution of labour markets in developed countries (the US in particular). A continuation of the persistent strength seen here might drive further inflation pressure, while a deterioration in conditions could shift the emphasis for policymakers away from inflation fighting. The energy crisis also continues to be in our focus: despite the temporary relief from the stabilisation of oil and gas prices, longer-term issues remain in redesigning the energy supply mix across the globe.
Looking forward, we believe that it is as imperative as ever to remain tactical and responsive to changes in the market’s pricing of risk and return. Currently, investor sentiment is swinging between concerns over inflationary pressure and weakening economic fundamentals, but we are not seeing evidence of a polarisation of expectations. In other words, we are seeing a lack of extreme volatility in equity markets that is usually associated with fearful investors becoming concerned about recession risk.
We believe that equity market valuations, although not expensive, remain susceptible to further sentiment deterioration and possible earning downgrades. However, we remain mindful that in the current macroeconomic environment, there is still room for upside surprises. We hold a neutral stance on equities overall, with a skew towards cheaper equity markets (in particular, Europe and Japan over US equities).
Fixed income markets are trading at more attractive yields than they have done in a while, and we see more opportunities in this space for income and diversification. US duration, in particular, could act as a useful diversifier in the event of a hard landing and/or policy shift. We have a small positive overweight in duration across our portfolios. Meanwhile, credit markets offer attractive nominal yields, with some of our portfolios exploring bank credit as well as areas of emerging market local currency debt, which can expect to benefit from a peak in the US dollar cycle – we particularly favour Latin American sovereigns in this space. We continue to maintain elevated cash levels that can be quickly deployed as opportunities arise.
Head of Global Equities
The outlook is finely balanced.
On the one hand the macro picture is still gloomy. Yet many share prices have already fallen. Valuations for many companies and sectors have reached levels where a significant amount of ‘bad news is already priced in’. This tension likely creates a period of volatility and uncertainty, but also opportunities.
With this in mind what are the ‘expected surprises’ for 2023 that global equity investors should have at the forefront of their minds?
With a likely global recession in 2023 there is understandable investor cautiousness with respect to the banking sector.
Despite attractive valuations, robust capital ratios, and relatively benign credit quality trends, the banking sector – from a share price perspective – has historically struggled in a recessionary environment. Recessions always throw up some surprises for banks. The speed with which interest rates have risen and central bank liquidity has been withdrawn will likely make this true again in 2023.
Whilst the trajectory may not be any different in 2023 than in previous cycles, it’s worth remembering that bank share prices typically bottom early. Waiting for the macro data to turn positive before investing in the sector is generally too late, and the biggest excess return opportunities will be missed.
The fact that 2023 earnings forecasts for the sector have already started to come down (as the market starts to factor in peaking net interest margins and other headwinds) means there is very much the potential for upside surprise sometime during the year. This is despite the almost inevitable recessionary concerns, on both sides of the Atlantic, where the probability of recession has markedly increased amid slowing growth. A more challenging backdrop in the UK and Europe continues to weigh on corporate margins and household purchasing power. Across the pond, the Fed remains committed to tackling inflation, and if it maintains a relatively hawkish stance until we see definitive signs of slowing activity and labour market weakness, a deeper US recession could ensue. A stronger for longer dollar could weigh on Emerging Markets, but China may prove more resilient and bounce back faster than consensus currently expects.
At some point in 2023, it is likely that investor focus shifts increasingly to the 2024 US presidential election. Although the actual election isn’t until November 2024, there will likely be a cacophony of newsflow building throughout 2023, particularly in the run up to the ‘primaries’ (the process for selecting the main parties candidates) where potential candidates debate, jostle, and announce proposed policies.
The pharmaceutical sector is one area of the market that has been historically vulnerable at this point in the political cycle.
It was a tweet from Hillary Clinton in September 2015 – over 12 months before the 2016 US presidential election – expressing outrage over “unjustified” drug price hikes that led to considerable share price underperformance for many of the pharmaceutical companies in the subsequent months.
Having performed so strongly in 2022, there is arguably even more downside risk in 2023 if political events end up following ‘the 2015 playbook’.
On the other hand, the 2024 US presidential election cycle could easily turn out to be a ‘non-event‘ from a pharmaceutical perspective. The Democrats have only just recently passed a bill that addresses prescription drug pricing in the US. Congress is divided and the Democratic candidate is almost certainly the current US president. The risk of incrementally negative news flow (or ‘unknown unknowns) is somewhat lower in our view.
2022 marked a big change for the tech sector. Having previously delivered eight years of relative outperformance, 2022 was the sector’s weakest absolute year since the 2008 global financial crisis and the worst relative performance year since 2002 (the collapse of the TMT bubble).
This raises some obvious questions – where does the sector go from here? Does the 2022 pull back represent an outstanding buying opportunity? Or does it mark the beginnings of a multiyear period in the investor wilderness, as it did back in 2002?
We believe the answer is complex and nuanced. From an overall sector perspective we could see continued pressure due to higher interest rates, given the implications for the cost of capital and growth stock (i.e. many technology companies) valuations.
But within the technology sector the picture looks very different. Semiconductors in, particular, stand out as benefiting from long term structural trends (with increasing content in everything from electric vehicles to industrial applications to household appliances), having share prices that already reflect some near-term macro concerns, and trading on attractive valuations.
So although the tech sector may no longer be a “one way bet”, that does not mean there are not plenty of opportunities within the sector, when taking a longer-term perspective, as long as we remain selective.
Head of UK Equities
The end of 2022 brought relative calm to an otherwise tumultuous year in UK markets, with calamitous domestic politics complicating an already difficult investment backdrop. The fourth quarter began with the fallout of the government’s disastrous ‘mini-budget’, which prompted Bank of England intervention in gilt markets; the appointment of a new prime minister; and a more fiscally-restrained Autumn Budget. This subsequently helped the FTSE All Share Index deliver a strong total return of 8.7% in Q4 2022.
Over the calendar year, the UK FTSE All Share Index delivered a relatively flat total return of 0.3%,but this was stronger than other major developed markets, thanks mainly to a high concentration of large-cap energy and mining stocks. Combined with a weak sterling, this led the overseas-focused FTSE 100 Index to deliver a positive total return of 4.7%, outperforming the more domestically-driven FTSE 250 index by +22.0%, the biggest margin on record.
The UK’s outlook for 2023 is far from positive, as reflected in the FTSE 250 Index’s sharp decline last year. At the top of investors’ minds are expected weakness in the economy and currency, sticky inflationary pressures, and ongoing disputes between the government and unions. However, just as 2022 brought us huge surprises, it is likely that the biggest stories of the coming year have yet to be anticipated or priced in by markets.
Given most market commentators have a negative view of the UK as a destination for investment, by far the biggest surprise would be another year of outperformance. We would not rule this out. Mid- and small-caps may start to recover given the attractive valuations on offer, while the FTSE 100 Index could also confound predictions to deliver another strong year of performance, should the mix of higher inflation and interest rates persist. As Figure 2 shows, UK valuations remain at a significant discount to global markets despite last year’s outperformance.
Historically low valuations of UK companies, alongside currency weakness, have also created potentially-attractive takeover targets. We may, therefore, see high-profile companies leave UK indices. While we do not base our investment decisions on such speculation, we would not be shocked to see a big name in the oil and gas or mining sectors subject to a bid, with companies like BP trading at a significant discount to their US peers, even after a strong year of performance.
UK corporates with large pension schemes may also be in better shape than the market expects, with higher interest rates having reduced or eliminated unfunded liabilities. Less cheerfully, these benefits will be augmented because mortality rates are also rising. Some of the UK’s lumbering industry giants may therefore start to emerge from the shadows of their large pension liabilities, which could come as a surprise to investors, given the negative headlines about UK pension schemes last year.
After a difficult 2022, many investors are eager for a return of the global investment themes that have worked so well for them over the past decade. However, should our surprises come to pass, it’s possible 2023 may well turn out to be a rerun of the previous year, with old economy and value stocks potentially benefiting UK markets once more.
 Source: Datastream, total returns, as at 30 December 2022
 Source: Panmure Gordon, MSCI, Refinitiv, December 2022. *Blended (equal weight) average forward P/E, EV/EBITDA and P/B *GBP for UK and World to 30/12/2022
 Source: Statista, https://www.statista.com/statistics/281478/death-rate-united-kingdom-uk/
Co‐Head of Asia Pacific Equities
The BoJ finally announced a change in its Yield Curve Control (YCC) policy in December. Whist the initial change was itself modest, the move signals something more meaningful; long-awaited normalisation of Japanese monetary policy. We do not make it our business to forecast macro policy but we had believed that Japan’s monetary policy was at odds with the prevailing growth, inflation and wage backdrop in Japan, which is now as constructive as we have seen it this century. Something had to give.
Earnings in 2022 were favourable in Japan. But with much of the growth having been fuelled by a weak yen, the recent strengthening in the currency will no doubt take the shine off earnings revisions in the near term. But the big picture is clear. Japan has exited its affair with structural-deflation. This will likely provide a supportive environment going forward to nominal GDP and equities. Policy normalisation reflects healthier economic fundamentals and should be celebrated.
Our view throughout 2022 was that Japanese equities represented a compelling, long-term investment opportunity. Our view has not changed. Structural earnings growth, principally derived from corporate self-help, is at the core of our thesis.
We expect more evidence of self-help in 2023 and another year of solid underlying profit growth. The corporate change agenda bodes well for stock pickers while the more constructive outlook for prices and wages adds to our long-term optimism. Looking further out, the stage seems set for another decade of high, single-digit earnings growth, double-digit dividend growth and an approx. 2-3 percentage points worth of annual buybacks. Even before an uplift from low valuations, therefore, Japan could plausibly return mid-teen compound returns in the decade ahead. Add to that stock-picking alpha on offer from this poorly covered market, and we remain upbeat about the long-term opportunity set.
Co‐Head of Asia Pacific Equities
Compared to the first half of 2022, when much of the region was still locked down, this year will see all Asian economies finally open post-COVID. In addition, Asia, with a lag, will see a big fillip from the region’s main economic engine, China, fully opening from COVID. The lag element is important. China’s economy exited 2022 on a very weak note. The real estate market is incredibly depressed, with new starts and land sales effectively down 50%, while the current COVID wave is also weighing on consumption and activity. Weak external demand will act as a further material head wind. To add icing on the cake, Chinese New Year is early this year, in the third week of January, so it will be very hard to gauge levels of activity until halfway through the first quarter at the earliest. This suggests a set up where markets will be struggling to determine how much to focus on near-term Chinese economic weakness versus looking through to post-covid normalisation. The potential for material market volatility is clear as the market could be pulled one way and then the other.
While not wanting to get into the game of forecasting the future, we would humbly note two factors. The first is that for much of Asia, and especially China, inflation is at a lower level than in the US, UK and Europe, particularly in a historical context. Consequently, Chinese economic policy has been eased across the board, in terms of lower interest rates, fiscal policy and easing numerous real estate restrictions. The impact of this policy easing has been hindered by zero-Covid policies weighing on consumer sentiment and activity more generally. With the latest policy change, the hope is that these easing measures will start to bear fruit.
Second, currency competitiveness offers Asian policymakers additional economic flexibility and also implies the potential for additional returns through stronger currencies. Regional currencies, including the Renminbi (RMB), for the most part are floating and competitively valued, having depreciated versus the US dollar. This is becoming ever more the case, given current inflation differentials between Asia and the West. There should be less fundamental downward pressure on regional currencies from here, and local central banks will have flexibility to set their own monetary policy accordingly. Looking forward, at some point the undervaluation should right itself leading to FX gains in the future.
Importantly, despite their recent bounce, Chinese equities for the most part are attractively valued both in absolute and, especially, relative terms. Consequently, investors are still being paid to back a positive outcome in the push and pull between short-term weakness and a medium-term COVID recovery outcome.
Head of Emerging Market Equities
In 2022, Emerging Markets (EM) equities had their worst year since the Global Financial Crisis (GFC). The MSCI Emerging Markets Index finished down 22% in US dollar terms – the sixth year of negative absolute returns over the past decade.
In 2023, while growth is likely to slow, equity returns may improve as investors digest the impact of China re-opening, and the diminished shock of higher US rates as we approach the peak of the Fed cycle. Inflation is not a concern for EM as the central banks dealt with it sooner, and more decisively than in developed markets. Slower growth, disinflation and a peaking Fed rate hike cycle may tempt EM central banks to cut rates, albeit the market will remain wary of premature moves. India, Indonesia, Brazil and South Africa don’t have monetary headroom whereas Korea and Taiwan will be heavily driven by the opposing forces of China’s recovery and a slowing global economy.
China, in our opinion, looks poised to perform especially well given the combination of low valuations and a recovering economy. The long-awaited China re-opening play may face short-term headwinds given large Covid-19 infection rates, but we feel the market will begin to look through these as we approach the early Chinese New Year celebrations. In tandem, China re-opening should boost commodity demand which we think can feed positively into other EMs. With many investors still trying to appraise whether or not Beijing’s ‘common prosperity’ extends to shareholders, or if re-opening and greater concern for economic outcomes post-Covid are favourable for companies, we see an attractive entry point.
Korea also looks very attractive and will itself benefit from China re-opening and stabilisation, as well as a turn in the global tech cycle, especially semiconductors. In addition there are a number of attractively-valued names in Brazil, as the country continues to benefit from global commodity price inflation and supply-chain disruption. For now, investors remain understandably nervous about the return of President Lula and the economic and fiscal policies to be adopted by his administration. A fragmented Congress (which may water down some of the more market-unfriendly policies from the Lula administration), and avoiding stocks prone to political intervention, gives us confidence in the prospects for harvesting further alpha from Brazilian equities.
Conversely, there is much debate in EM investor circles as to whether or not India has run too far, with long-run valuations several standard deviations higher than history. Corporates have benefited from the monetary and fiscal largesse adopted during Covid, which has also boosted market valuations. While the economic stimulus is reduced, investors will likely find other EMs offering more attractive risk/reward, especially with China re-opening. Valuations in India are at absolute highs and their most expensive relative to the rest of the Emerging Markets. We remain underweight India.
MENA (ex-North Africa) had a very strong 2022, due to high energy prices delivering resilience from global woes. Regional index weights reached record highs. That resilience may continue, spurring the growth diversification story in, for example, Saudi Arabia which saw fresh Initial Public Offerings (IPOs) broadening the equity opportunity set. Saudi Arabia is now the MSCI EM Index’s sixth largest country weight at 4%, approaching that of Brazil at 5%, as at 31 December 2022.
Performance across sectors and regions was very differentiated in 2022. We may see a further rise in stock dispersion in 2023, as investors drill down beyond macro considerations to focus on individual stock opportunities. As US rates peak, EM FX should benefit especially if EM central banks are slow to cut. The environment, as such, is almost perfect for active managers to thrive.
Overall, EM is much cheaper on most simple valuation metrics than developed markets, and with earnings starting to stabilise (while yet to meaningfully fall in the US) we could see overdue outperformance from the asset class.
Despite the short-term newsflow soap opera, the long-term EM drivers are still intact. Near-shoring will benefit Mexico and ASEAN. India and Indonesia remain structural growth winners, albeit stocks are trading at more expensive multiples. The likes of Korea and Taiwan still have very strong competitive advantages, and strength in MENA gives a new depth to the asset class.
Markets, as ever, will continue to price in the changing macroeconomic circumstances in China and elsewhere, well ahead of time. Amidst the uncertain backdrop, we maintain our bottom-up ethos, and remain poised to take advantage of idiosyncratic stock opportunities.
John William Olsen,
Head of Impact Equities
Most Sustainable investment strategies had a testing 2022. A combination of inflation, rising rates and the terrible war in Ukraine led investors towards value stocks, commodity, defence and bank stocks – away from the types of stocks that typically dominate Sustainable and Impact strategies.
The unsurprising ‘Is ESG dead or just destroying value’ debate which followed the rotation, has been terribly misguided but also in some ways helpful. It has helped educate investors, combat greenwashing and sharpen definitions. This temporary setback, in combination with the macroeconomic environment, should help shape 2023 stock markets based on a few different observations:
The potential surprise in 2023 could be that investors coalesce around these observations sooner rather than later. We continue to invest in quality companies that are competitively advantaged. Not necessarily super exciting or controversial, but solid, well-positioned companies – a segment of the market well set up to surprise positively in 2023. Even for portfolios with limited turnover like ours, the recent market volatility has offered opportunities to initiate new positions in a number of attractive impactful companies. The upside is not necessarily based on their expected 2023 fortunes, but on their likelihood to survive and thrive over the next decade, and offer much better long-term upside potential after the big 2022 reset.
Head of Convertibles
The convertible bond market starts 2023 with higher yields and lower equity sensitivity than has been the case in the last few years. Over 20% of global convertibles now trade below a price of 80% of their par value, and with a yield exceeding 10%. As a result of the rise in interest rates during 2022, the market has greatly changed in shape and characteristics. Highly-valued, high-growth names (a large proportion of recent convertible issuers) have sold off, giving rise to a sizeable amount of busted convertibles – those whose price is substantially below par, deep out of the money, with high yields, high conversion premia and low deltas that make them less sensitive to stock moves and more similar to straight bonds.
2023 is expected to see a recovery in new issuance, in the order of 20% of the current market size. Last year, new issuance fell 75% to $40 billion, well below the $159 billion and $148 billion seen in 2020 and 2021 respectively. Most commentators expect new issuance to reach $70-80 billion during 2023, figures similar to pre-Covid levels. Such an inflow of new deals compared to a market size of $356 billion, as at end of last year, would lead to a marked change in market characteristics. New issues come in as balanced, at the money deals. They will reduce the overall market’s conversion premium and increase its delta. Given prevailing market conditions, we expect a large number of the new issues to be refinancings and exchanges / rollovers of existing bonds, and reckon they will be well received by investors as these will provide the opportunity to reinvest proceeds at more desirable and attractive terms than those available in 2020 and 2021.
At the same time, we think that firms will seek to lower their cost of debt in an environment of higher interest rates. Convertibles typically carry a lower coupon than straight debt in exchange for having the option to convert into equities. This may bring a more diverse set of issuers into the convertibles market (including crossover/high yield names and investment grade issuers optimising their balance sheets).
We expect M&A to continue to be a significant feature during this year. In 2022, corporate activity amounted to 12% of all convertible redemptions, a six-year high. We think that the lower valuations and small size of many convertible issuers will attract the interest of larger, cash-rich firms, especially in the technology, healthcare and consumer discretionary sectors. Such M&A can offer rich returns to convertible investors, in the form of takeover protection ratchets, pulls to par and acceleration of the yield received.
We would expect the default rate to rise somewhat, in line with movements seen in the high yield market, but we do not expect a large wave of financial trouble. The increase of defaults, if it takes place, is highly unlikely to materialise during 2023 as a very large part of the market was issued during 2020 and 2021 by firms with little or no other debt, whose maturity walls will fall due after 2025.
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