According to analysis by Refinitiv Lipper, outflows from equity funds hit £34.9bn in 2022, as investors fled from risk assets amid an environment of surging inflation and the subsequent spiralling interest rates.
Unfortunately, those investors seeking shelter in bonds were also dealt a blow as last year proved one of the toughest on record for fixed income, with the UT Fixed Income sector down over 23%, more than twice the fall of equities.
Despite these heavy losses, Refinitiv Lipper revealed bond funds only experienced relatively small outflows of £2.6bn in 2022, but it remains the first time the two asset classes have sold off in tandem.
To illustrate the scale of the exodus from equities, in 2007, during the depths of the financial crisis, redemptions only hit £8.3bn. So, as headlines continue to emerge about the death of the 60/40 model of diversifying between equities and bonds, where should investors’ focus be for 2023 and beyond?
In this month’s head to head, Kelly Prior (pictured right), investment manager at Columbia Threadneedle Investments, explains why her team is underweight equities in 2023, while Nordea Asset Management’s Hilde Jenssen (pictured left), advocates defensive positioning and allocations to companies aligned to the green transition.
Kelly Prior
Investment manager, Columbia Threadneedle Investments
Long-term asset return studies show that investing in equities over time should see you comfortably beat inflation. Over the shorter term, however – not least during times of concerns over economic growth, rising rates and persistently high inflation as we are seeing right now – the backdrop for equities is tougher.
We see equities, or more specifically as fund of fund managers, equity funds, as a core part of our portfolios. But we do recognise there is a time and place to be overweight equities, and in our view, now is not one of them.
Equities have seen a solid start to 2023, though there does seem to be an element of those that suffered the most in 2022 rebounding somewhat even though fundamentals have not changed.
What has changed is the economic outlook, with the 2023 recession consensus looking more fragmented, thanks to the positive tailwinds of much lower energy prices off the back off the mild winter, particularly in Europe, and China ending its zero-Covid strategy and re-opening the economy far quicker than expected.
As we know, markets are forward looking – as evidenced by the strong outperformance of Hong Kong and China stocks in the final months of 2022, even as we in the west still expected ‘zero Covid’ to be around for many more months. So, can this momentum continue? We think not.
Warning signals
While the slightly more benign backdrop certainly removes some of the more bearish scenarios around the economic outlook, the lagged impact of interest rate hikes is yet to be felt. In the US, rate hikes only began last March; in the eurozone we saw lift-off last July. As a rule, the economic impact takes 12-18 months, so the second half of the year may well see a marked slowdown in economic activity. While labour markets across the developed world are in robust shape, other indicators are sending warning signals.
We do see equity markets being challenged in an environment where interest rates stay higher for longer than expected. In recent weeks we have seen financial markets coming to terms with the potential for central banks to hike further, and maintain rates at high levels, into 2024. We may well have seen peak inflation, but we may have to live with persistent inflation, and if central banks are determined to bring inflation down to targets, then we likely need to see some economic pain, not least in terms of cooling labour markets to achieve this.
In recessions, we would expect there to be a notable fall in corporate earnings, and history shows equity markets tend to bottom during, or shortly after, the end of a recession. While any recession this year or into 2024 may not be as deep as we feared coming into 2023, equity markets need to price in a slower growth environment, which means corporate earnings are unlikely to accelerate in the near term.
This leaves our portfolios with an underweight in equities and an overweight to bonds, where the risk/reward has become more favourable. In an environment of heightened uncertainty, the yields on bonds – and maybe even cash at some point – are offering a genuine alternative to equities, which is something we’ve been unable to say for more than a decade.
With so much uncertainty over the growth outlook, 2023 looks to be a year when it pays to be active, both in your choice of region and timing in terms of market exposure. Tougher times in markets should present plenty of opportunities for active managers to find mispriced stocks for long-term investing, so while equities may be somewhat less attractive right now, we still see them as a crucial part of a portfolio for long-term investing.
Hilde Jenssen
Head of fundamental equities, Nordea Asset Management
After a tough 2022, global equity markets have come roaring back in 2023. In January, they jumped 7%, which would normally represent a decent return for a full year. We believe a confluence of factors are behind the sudden move higher.
Recession risk in the minds of investors has subsided, as lower inflation pressure is supportive of more dovish central bank actions. Adding to the bullish sentiment are expectations of higher earnings, driven by a re-opening of China post-Covid, and the avoidance of an energy crisis in Europe – at least short term.
Put together, the factors underpinning the recent rallying equity markets may suggest investors are too optimistic in exposures such as cyclicals, and we therefore find better opportunities in the more defensive segment. Medium to longer term, we believe the energy transition spending programmes will create opportunities for equity investors on both sides of the Atlantic.
In the US, what puzzles us the most is the recent strong performance of cyclical stocks. This suggests investors are willing to look past weak PPI figures and short-term earnings pressures and focus on – hopefully – brighter days ahead.
The strong rally in cyclicals has shifted our attention to defensive stocks, including consumer staples, where we find better value. These companies have lagged, owing to profit margin pressure from increasing input costs, which are now easing. As a result, we have tilted our US portfolio exposure towards defensive positions.
Trend reversals
Turning to emerging markets (EMs), the headwinds of last year – peak inflation, peak US dollar, Fed tightening and China’s zero-Covid policy – seem to be either behind us or gradually fading away. This trend reversal already led to significant inflows into EM equity markets this year, which looks set to continue.
Zooming in on China, profitable growth stocks should be well-positioned to benefit from improved business and consumer confidence, and rebounding spending will be focused on goods and services rather than manufacturing. Chinese households also built up sizable excess savings during the pandemic, providing strong demand as the economy re-opens. The re-opening will benefit tourism-linked companies in stages as China is removing travel bans region by region.
In EMs, we focus on structural growth companies with proven business models, strong competitive advantages, pricing power and robust ESG profiles.
We are cautiously optimistic about the outlook for European equities, despite the recent rally. The unemployment rate is still low, many European companies are in a good position to benefit from China’s re-opening, and we have seen a significant reduction in gas and electricity prices in Europe. We are finding good opportunities in the small and mid-cap segment, as many companies are priced for severe recession. Typically, smaller companies underperform in a down cycle but, conversely, they tend to outperform during an upturn.
Medium and longer term, energy transition spending programmes should create opportunities for equity investors on both sides of the Atlantic. The US was first out of the gate with the Inflation Reduction Act (IRA), one of the most important environmental bills in history. We expect considerable upside in companies involved in solar, wind, battery deployment and manufacturing, clean hydrogen and carbon capture.
In Europe, the Green Deal Industrial Plan is a response to the IRA with the goal of making the regulatory environment conducive to accelerating green investment, as well as making existing funding mechanisms – such as REPowerEU and NextGenerationEU’s Recovery and Resilience Facility – easier to access. Fundamental ESG investors can capitalise on opportunities fuelled by these green energy transition programmes.
This article first appeared in the March edition of Portfolio Adviser Magazine
