Strategy – 10 key themes for 2023
MACRO: WE ARE BACK TO THE OLD NORMALITY
1. HIGHS AND LOWS WITH A RETURN TO THE “OLD NORMALITY”
The next 12 months are expected to see lower levels of global inflation, central bank policy tightening, key government bond yields and market volatility, as well as lower levels in GDP growth, corporate income growth and global equity valuations. However, we do not expect a return to a “new normal” like the post-global financial crisis of 2008. We believe that structural changes will lead to persistently higher inflation, hence higher interest and capital costs and lower asset prices. .
2. DIRECTION FOR TOP ISSUES THAT CONTINUE TO TROUBLE THE MARKETS
The cost of capital rises when interest rates rise and investors demand higher risk premiums. This happens at some point in most cycles, but we believe the current correction is structural in nature and is proving to be extremely large and rapid, increasing the risk of it being disruptive. If many mortgage borrowers refinance at 2023 rates, many corporate capital structures designed for a low-rate environment with such sharp adjustment expected could be in for a shock. Moreover, as public debt has soared during the pandemic and “bond watchdogs” are on alert again, some sovereign nations may be forced to question themselves, as the United Kingdom has recently done. We think investors should be on the lookout for these weak spots that could lead to broader disruptions.
3. PASSING DEGLOBALIZATION
Manufacturing supply chains, commodity markets, financial systems, regulatory regimes, fiscal and monetary policy frameworks… all became more integrated between 1980 and 2008 and have become more fragmented since then. The reasons for this are many and varied, and include a strong political reaction to the uneven consequences of globalization, shocks from the global financial crisis and pandemic, the decline of American internationalism, and growing tensions over the realignment of geopolitical blocs. .
We anticipate other significant events in 2023 that should be underpinned by strong political, security and risk management imperatives.
4. TWO FUTURE EFFORTS TO CLARIFY THE TERM “ESG”
The ESG (environmental, social and governance) approach has become increasingly politicized in 2022, particularly as the crisis in Ukraine led to strong performance of fossil fuel-related assets and raised fears that ESG investors are siphoning off supplier capital from national energy companies. To avoid this politicization, we believe that it is necessary to clarify the difference between investment processes and observed results. ESG integration is a process designed to ensure that financially significant ESG factors are considered, among others, in traditional investment analysis. Exceptions are sustainable and effective investments that, in addition to the objective of financial return, aim to achieve a specific additional financial result in the portfolio or in the real world. The industry and its regulators should focus on this clarification in 2023.
ECONOMIC MARKETS: THE RETURN OF DISCIPLINE
5. CONTINUED INFLATION REQUIRES MORE VIGILANCE IN THE STOCK MARKET
We approach 2023 with high inflation and excessive national debt. In this context, we see bond investors more strongly defending their interests against regulators. Markets sanction policy inconsistencies between fiscal and monetary authorities within the same country, as well as extreme differences in fiscal or monetary policies between countries. We believe that sovereign bond yields can be range bound when policies are consistent, but potentially higher and more volatile when policies are inconsistent. Despite the pace of policy adjustment and the resulting shift in market interest rates, central banks outside the UK have not had to intervene to maintain market liquidity. However, there is significant risk to bond markets in 2023 if there is a conflict over which policy to adopt.
6. CAPACITY TO ABSORB HIGHER DISTRIBUTIONS, CREDITS FOR CREDIT
Over the past decade, many financial structures, including many debt structures, have been built around falling or even near-zero rates. So floating rate borrowers will have to adjust immediately, but as we expect structurally higher rates, we’re confident fixed rate borrowers will have to adjust as well. We do not expect a large increase in defaults: the economy has historically been able to generate healthy growth with rates at these levels. In this environment, credit markets are generally supported by strong balance sheets and maturities that are several years apart. However, the sooner investors incorporate consistently high rates into their credit analysis, the sooner they can make the necessary adjustments to their portfolios.
STOCKS: SURVIVORS AND FAILURES
7. RE-CALIBRATION OF EARNINGS ESTIMATES FOR THE MOST POWERFUL
Much of the decline in equity markets in the first half of 2022 appears to be due to the application of higher discount rates to estimates of future earnings, which remain largely unchanged. Earnings growth estimates for 2023 have not fallen as much as real GDP growth estimates, possibly because higher inflation has supported nominal GDP growth. As inflation eases but remains relatively high and the economy slows, earnings estimates are likely to be lowered. We also believe that dispersion will increase, favoring companies that are less exposed to labor and raw material costs, have better pricing power to maintain margins, while adopting profit accounting. This should translate into a more mixed stock performance.
8. MANAGEMENT GROUPS ARE RETHINKING SHAREHOLDER VALUE
When investors demand a higher risk premium and bond yields become a barrier to significantly higher returns, one way to keep the cost of capital low is to refocus on creating tangible shareholder value. During tough economic times, effective management teams typically start by improving capital structures and balance sheets, divesting underperforming divisions, achieving strategic goals for efficiency gains, and creatively engaging with shareholders. In these conditions, we tend to observe the potential of real cooperation between active shareholders and company management: 2023 may be declared alive in the boards of directors.
ALTERNATIVES: CHALLENGES TO BE FACED, BUT THE MOST FLEXIBLE OPTIONS
9. MORE DIFFERENT PERFORMANCES IN PRIVATE MARKETS
Private markets will not be immune from the current slowdown. Exits are more difficult in a volatile listed market environment, and while private company prices tend to fall less than listed market prices, we believe they still have the potential to fall. Such an environment can lead to a dispersion of performance, favoring high-quality companies, especially when management favors well-defined growth plans rather than relying on leverage and multiple acquisitions. It’s important to remember that private equity funds typically invest over several years, allowing new funds and dry vintages to seek opportunities as valuations fall with economic downturns.
10. MORE OPPORTUNITIES TO COME FOR OPPORTUNIST INVESTORS
During recessions and when valuations fall or even fall sharply, liquidity providers can select opportunities from liquid and illiquid alternatives as well as opportunistic niche strategies. Among liquid alternatives, we believe global macro strategies and other trade-oriented hedging strategies may continue to offer opportunities in a volatile environment. As debt structures change, there should be more opportunities among niche equity solutions that should see attractive, if not understated, returns. As for illiquid alternatives, secondary private equity funds have been attractive to investors. Economic stress can create long-term value opportunities within inflation-sensitive real assets in both liquid (such as certain commodities) and illiquid (such as real estate) markets.
