3 Investment Lessons For 2023

Transcript

As I look back on this historic 2022, I have taken away three lessons that I think are important in navigating 2023.

1) Be prepared for a wider range of scenarios

Look at the surprises that 2022 has brought us – the tragic war in Ukraine and also the degree to which central banks were overtightening.

Let me just remind us that market pricing [of interest rate hikes] at the beginning of 2022 was for the Fed to finish the year at 1%. We got more than four times as much and we’re still expecting more.

So all of that is just to say in this new regime of higher macro uncertainty, we should expect a wider range of outcomes.

2) Account for geopolitical risk

In the old regime of the great geopolitical moderation, geopolitics were driven by economics. And now, geopolitics are driving economics.

All of that just to say, as we construct portfolios, baking in persistent geopolitical risk premia is very important, especially as structural trends such as geopolitical fragmentation between the U.S. and China, for example, are here to stay.

3) We need a new investment playbook

This new regime requires a new playbook, which is the centerpiece of our 2023 Year-Ahead Outlook. These are some of the most tactical environments that I have seen in a very long time.

And more frequent adjustments to portfolios are needed.

It’s important to be aware of some of the behavioral biases that can hold us back from implementing more frequent changes.

Also, it’s important to ahead of time have a game plan in order to pivot quickly.

_______________

The historic shocks of 2022 – war, soaring inflation and a perfect market storm – shape our three investment lessons for the new year. First, widen the lens of possible scenarios and beware of inertia and other behavioral biases. Second, factor in compensation for geopolitical risk. Third, we need a new investment playbook – the key theme of our 2023 Global Outlook. That means more frequent portfolio changes in the new regime of greater macro and market volatility.

A historic year

Notes: The chart shows to returns for the MSCI ACWI index (orange) and Bloomberg Global Aggregate index for bonds (yellow) since the year-to-date start of the year. Data as of December 29, 2022.

Last year’s shocks were extreme, causing sharp stock and bond sell-offs. See the chart. Russia amassing troops on Ukraine’s border quickly erupted in the full-blown war that is still raging. That sent energy prices soaring, stoking already hot inflation from pandemic-induced production constraints. Headline inflation surged to 40-year highs, spurring the Federal Reserve to embark on the steepest rate hike path since the early 1980s. A year ago, markets expected policy rates to rise to 1% by year-end. They are four times as much now, and we see more to come. Other shocks like the UK gilt crisis showed a return of the so-called bond vigilantes: market forces punishing fiscal splurges with higher yields and diving currencies. The Bank of Japan also surprised markets by loosening its yield control policy just days before year-end.

The lesson: we must widen the lens of possible scenarios because the new regime of higher macro and market volatility entails a wider range of outcomes. And it requires quick reactions. We must fight behavioral biases like inertia that make it hard to embrace change or carry out too little to make a difference. Sometimes you know something is happening but just don’t want to believe it – either because recency bias or out of sheer disbelief.

Our second lesson

Geopolitical risk now warrants persistent risk premia across asset classes, rather than being something markets only react to when it materializes. We see a fragmented world of competing blocs replacing an era of globalization and geopolitical cooperation. Geopolitics are driving economics now instead of economics driving geopolitics, in our view. We think the war in Ukraine and strategic competition between the U.S. and China are long-term geopolitical risks, not just market drivers of short-lived sell-offs. Fragmentation could also create more supply and demand mismatches as resources are reallocated. We see this keeping inflation pressure higher than before the pandemic and contributing to market volatility.

Our final lesson

We need a new investment playbook in the new regime. This means not being lulled into thinking what worked in the past will work now, like automatically buying the dip. We see stock rallies built on hopes for rapid rate cuts fizzling. Why? Central banks are unlikely to come to the rescue in recessions they themselves caused to bring inflation down to policy targets. Earnings expectations are also still not fully reflecting recession, in our view. But markets are now pricing in more of the damage we see – and as this continues, it would pave the way for us to turn more positive on risk assets.

We don’t count on long-term government bonds as diversifiers. We expect central banks to pause hikes when the economic damage becomes clearer – but keep rates at high levels. We also see long-term yields rising as investors demand more compensation for the risk of holding them amid persistently high inflation and record debt levels. We see services inflation as sticky due to worker shortages fueling wage growth. And we see long-term drivers keeping inflation pressures higher than before the pandemic: aging populations, geopolitical fragmentation and the net-zero transition. All these expectations feed into our new investing playbook of granular views and frequent portfolio changes.

Our bottom line

We’re widening our lens of scenarios, factoring in geopolitical risk and using a new playbook for 2023. We’re tactically underweight developed market equities and long-term government bonds. Investment-grade credit, U.S. mortgage-backed securities and short-term Treasuries offer attractive income. And we prefer inflation-linked bonds over nominal peers.

Market backdrop

Global stocks fell 18% and bonds dropped 16% in 2022 – a rare joint selloff that only happened in two other years (2015, 2018) since the Bloomberg global aggregate bond index series started in 1990. And those losses were only single digits. Soaring inflation and aggressive rate hikes in response roiled markets as the pressure from production constraints tied to the pandemic converged with an energy crisis brought by the war in Ukraine.

PMI data around the world will help confirm if recessions are starting to take root. A strong U.S. payrolls gain would embolden the Fed to stay hawkish. We don’t expect much improvement in labor participation – worker shortages have been a key production constraint driving up wages and keeping inflation persistently higher.