Bonds and equities fell in tandem in 2022 as inflation moved from talk of being transitory to that of multi-decade highs. As a result, many investors looked to alternative assets as a hedge against inflation and a diversification away from bonds and equities. Meanwhile, multi-asset managers made the case for commodities, real assets, food and agriculture, both as defensive plays and to provide uncorrelated returns.
As we head into 2023, talk of global recession continues to get louder and questions remain as to when inflation might subside and the interest rate cycle will peak. So, where are managers placing their bets?
In this month’s head to head Jacob Mitchell (pictured left), founder and CIO of Antipodes Partners, and Ryan Hughes (pictured right), head of investment partnerships at AJ Bell, share which assets and regions they are looking at as 2023 gets underway.
Jacob Mitchell
Founder and CIO, Antipodes Partners
In an environment where many assets have been highly correlated in a way they are not supposed to be, namely bonds and equities, investors have been desperate to find genuine defensive assets.
One area they have crowded into as a defensive play is packaged food companies, like General Mills or Kellogg’s. However, unlike classic defensive sectors such as pharmaceuticals, I do not think investors will get what they expect. This is because following their performance in 2022, their multiples have become much higher, and I struggle to see how they can grow more from here.
Instead – and I know this might cause an audible sigh – the defensive assets we are using are both pharmas and enterprise resource planning (ERP) software stocks, both in the US. In general, the fund is currently underweight the US as we are seeking to avoid exposure to domestic-related stocks, but these are two sectors we like given they are both economically insensitive heading into a recession.
I understand pharmas might be considered boring and will be what every global manager pitches for during periods of market volatility, but they are much better than this. Within the sector there are companies that are growing, such as Merck, Gilead and Sanofi. Not only are they relatively low-risk but you are getting fairly high-quality growth. It is a sector where we are overweight and will continue to be until we see the market reflect it within its multiples.
Another area where we are finding attractive opportunities is in some of the ERP software names, such as Oracle and SAP, where we see a case for structural rather than cyclical growth. These companies have invested quite aggressively in making their ERP software, which essentially runs back offices, into software-as-a-service offerings. There is much more of a tailwind of value creation that will take place for these companies and that is reflected in an accelerating growth rate.
Outside of the US, we head into 2023 overweight Europe. This is mainly a result of our holdings in the large multinationals rather than a bet on the European economy undergoing some kind of renaissance.
For investors looking for defensive structural growth exposure, I think over the next 18 months to two years they should consider more seriously some of the emerging markets outside of just China. Within countries like Indonesia, Mexico and even Brazil we are seeing attractive multiples in stocks where the economies have interesting growth dynamics.
Indeed, from a multi-asset perspective, the behaviour of emerging market bonds last year was different to past market dislocations, and the asset class has been much more defensive. This is because their governments didn’t have an outsized response to Covid and are now in better shape than many developed markets to withstand a recession.
In terms of inflation, we do expect it to fall from today’s extreme levels as money supply growth is slowing and monetary tightening is impacting demand. Meanwhile, supply chain disruptions are easing, China will reopen and food and energy prices will soften. But that’s not the point. What matters for equity market multiples is where inflation settles, and our view is that inflation will remain on average higher versus recent history and, more importantly, be much more volatile.
The range of outcomes is wide and we expect markets to become more stock-specific rather than driven by style. We continue to focus on resilient businesses that can take profitable market share against a backdrop of higher inflation and economic uncertainty – and which are mispriced relative to their growth profile.
Ryan Hughes
Head of investment partnerships, AJ Bell
The year just gone feels like one many people would rather forget, but for investors it’s important not to dwell on the past and instead look to the future. As we enter 2023, the world is a very different place to the start of 2022 and, as a result, it is appropriate that some changes to a portfolio will be needed to ensure they are robust and fit for the future.
The most obvious area is fixed interest, which is a totally different asset class to that of 12 months ago.
Dare I say it, but bonds even look interesting again after a decade of low and falling yields. With the 10-year government bond yield back above 3%, investment grade offering a decent premium above this and high yield living up to its name again, a greater allocation to fixed interest seems an appropriate move now the risk and return balance has been largely restored.
Both investment grade and high yield appear attractive, with the latter particularly so against equities where the returns are similar but with high yield offering some form of recovery should things deteriorate.
Within equities, long-term returns remain appealing in Asia and emerging markets given the low level of indebtedness and younger workforces. Though some of these countries will suffer in the short term during an economic slowdown, we prefer to look further out than just the next 12 months – and the long-term direction of travel remains promising.
It is impossible to ignore the heightened political risk that comes with China, which means portfolio construction must be carefully managed to understand the exposures and risk, though China remains an economy that is too big to ignore.
We maintain our approach of running style-diversified portfolios and not favouring one style over another. Again, this is driven by our focus on the long term and a belief that it is very difficult to call style shifts over short periods of time. We prefer to let the long-term focus of our chosen managers play out over time.
Alternatives is an area that has had a lot of attention in recent years because of a desire to find an alternative to fixed income. That has been a challenge given how linked they are to prevailing interest rates and have exhibited higher correlation than may have been anticipated. Our focus has been on the simpler areas to understand, such as infrastructure equities, and this has played out well.
Understandably, the property sector was hit hard in 2022 as the cost of borrowing increased rapidly, resulting in a sharp sell-off. It will be interesting to see whether this asset class becomes attractive again, particularly given the economic slowdown likely in 2023.
Our process is focused on looking carefully at those areas that others are running away from as it often presents opportunity.
While there are clearly challenges ahead for the property sector maybe these are already priced in and we could be adding this asset class back into portfolios during 2023. No decisions yet but given the strength of the sell-off and our focus on the long term, it certainly warrants a closer inspection.
In many ways, 2023 provides a very different challenge to that of 2022. When, or if, to add duration; whether it’s time to turn back towards growth; and what alternatives can prosper in a world with higher interest rates are all key questions that need to be answered at some point.
Many of these challenges are not yet clear cut and, as a result, we continue to take a cautious and diversified approach without focusing on one particular economic outcome.
This article first appeared in the January edition of Portfolio Adviser Magazine
