Practical Implications Of The New Regime

By Niall O’Sullivan

You’ve pinned down your economic and market outlook, but what does it imply for your investment strategy – and how much of that is realistic?

One can think about the portfolio construction process as three essential steps.

First, you establish your views on the economic and market regime. Second, you think about how an asset allocation plan flows from that regime. And third, you adapt that plan to your own circumstances and constraints.

Over recent weeks, our thinking on the fundamentally and rapidly changing financial market regime has been coalescing around four key observations.

Here, we will bring those four observations together and outline what we regard as their practical investment implications – those we believe are relevant not only for 2023 but for several years ahead.

Four Observations

Our first observation is that “the asset allocation facts have changed.” In particular, rates have risen rapidly after more than a decade of falling to historic lows. That makes fixed-income much more competitive and attractive in terms of expected return and volatility, and also, potentially, correlation.

Our second observation is that markets continue to price for a pivot in central bank rates in 2023, despite what policymakers tell them. We tend to take the central banks at their word, and think they will “keep at it.”

Our third observation is that there has been a notable divergence between top-down and bottom-up views on the economy. Macro forecasters tend to be markedly gloomier than company analysts or, indeed, company CFOs.

Our fourth observation is that financial conditions in general have tightened rapidly and that these adjustments seldom occur without accidents, dislocations, and liquidity droughts.

Capital Structures

When we start to think about these observations in terms of investment and asset allocation decisions, the first three become tightly linked.

We think the macro-versus-micro standoff will resolve differently in different asset classes.

If central banks are intent on beating inflation even at the expense of worsening the economic slowdown, that is a threat to corporate earnings, and therefore to equity prices. But we don’t think it’s such a big threat to bond coupons, because most corporate CFOs have done a reasonable job in balance sheet management. On equities, the macro forecasters have 2023 right, in our view; on credit, we think the bottom-up analysts make valid points about fundamental resilience.

In equities, therefore, we favor high-quality companies and value. More generally, however, we think corporate bonds may be a more attractive way to take risk than equity this year, especially with their newly elevated yields.

Liquidity Providers

When it comes to the potential for accidents, dislocations, and liquidity droughts, we see implications in both public and private markets.

Setting aside the multiple collapses within the cryptocurrency industry, one of the most prominent financial accidents so far in this cycle occurred in what ought to be a stable and highly liquid market: U.K. government bonds. The Bank of Japan is working extremely hard to prevent a similar crash in Japanese government bonds as it tries to normalize its policy, with potentially huge implications for global capital flows. Trading-oriented liquid alternative strategies, such as global macro, could take advantage of these dynamics, as they did in 2022.

Markets that reward tactical liquidity providers while offering genuinely uncorrelated returns could be a sweet spot in 2023. For different reasons than global macro, but with similar diversification benefits, insurance-linked strategies are a great current opportunity, in our view. Fundamentally uncorrelated with equity or bond markets, reinsurance markets are also starved of capital following a year of loss events, including Hurricane Ian, which has led to a spike in premiums.

We think private markets – equity, debt, and secondaries – offer particularly abundant opportunities for those ready to step in with long-term capital.

Private equity commitments made at this stage of the cycle have tended to be among the best performers, historically. Also, while there are still relatively high levels of dry powder in the industry, it is not evenly distributed; as a result, many private firms are seeking finance at a time when the “denominator effect” is causing many allocators to pause their allocations, leading them to offer attractive terms.

In order to take advantage of these value opportunities, private equity sponsors need debt financing, and because banks have largely withdrawn from syndicated loans, they are paying a premium to attract capital from direct lenders.

Private lenders can also get attractive yields from companies looking to shore up their capital structures – whether via a specialist capital solution, such as preferred stock, or just a straightforward first-lien loan.

In addition, private equity secondaries have also become a buyer’s market, offering substantial discounts, as both Limited Partners and General Partners seek alternative liquidity for their portfolio companies now that IPOs and acquisitions have dried up.

A Solutions Challenge

So, in our view, this is where steps one and two take us: a focus on income over capital appreciation; a move up the capital structure from equity to credit; a general willingness to include fixed income once again; and a readiness to be more active and more tactical, especially to take advantage of the growing opportunity set in liquid and illiquid alternatives.

Step three is about figuring out, as individual investors, how much of this is practical.

Each of us operates in a different context with regard to, for example, tax, risk appetite, regulation, liabilities, and liquidity. Can a public pension plan make additional private market allocations when the denominator effect makes them appear over-allocated already? How might an insurer close the gap between its book yield and the newly attractive market yield without crystalizing losses on its existing fixed-income investments?

If step one is an analytical challenge and step two is a portfolio management challenge, this third step is a solutions challenge. It leads us to another of our expectations for 2023 and beyond: Clients will look for much more help from their asset managers. Our industry must be ready to meet that demand, or some great opportunities could be missed.

In Case You Missed It

• Japan Manufacturing Purchasing Managers’ Index: unchanged at 48.9 in January
• Eurozone Manufacturing Purchasing Managers’ Index: +1.0 to 48.8 in January
• U.S. Durable Goods Orders: +5.6% month-over-month (excluding transportation, durable goods orders decreased -0.10%) in December
• U.S. Q4 GDP: +2.9% quarter-over-quarter (seasonally adjusted annualized rate)
• U.S. Personal Income and Outlays: Personal spending decreased by 0.2%, income increased by 0.2%, and the savings rate increased to 3.4% in December
• The University of Michigan Sentiment: +5.2 to 64.9; 1-year inflation expectations -0.5% to 3.9% in January

What to Watch For

• Tuesday, January 31:
  • Eurozone Q4 GDP
  • S&P Case-Shiller Home Price Index
  • U.S. Consumer Confidence
  • China Manufacturing Purchasing Managers’ Index
• Wednesday, February 1:
  • Eurozone Consumer Price Index
  • U.S. ISM Manufacturing Index
  • February FOMC Meeting
• Friday, February 3:
  • U.S. Employment Report
  • U.S. ISM Services Index

– Investment Strategy Group

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