The year 2022 has been described by many investors as an “Annus Horribilis”.
It was a year marked by the highest inflation witnessed in the developed world in four decades. War descended on Ukraine, with Western European security the most seriously threatened since the Second World War. The Covid pandemic continued to rage in part of the world, with an estimated 250 million Chinese infected in just 20 days in December.
However, none of the above was the core reason 2022 was torrid for investors. That dubious distinction belongs to central banks, most importantly the US Federal Reserve (Fed). After a 13-year period of near-zero rates and enormous monthly volleys of liquidity into financial markets – the crescendo of which occurred in 2021 – the music stopped, suddenly. With the benefit of hindsight, the monetary and fiscal response to the pandemic lasted too long and was too big. And drove inflation from being “transitory” to being broad and persistent.
Central banks found themselves shockingly complacent on their primary mandate of ensuring stable and low inflation and were forced into dramatic firefighting. The Fed, the European Central Bank (ECB) and the Bank of England (BoE) increased their base rates by 450, 250 and 350 basis points, respectively: the fastest tightening of monetary policy in modern times. If that wasn’t enough, each institution also sought to reduce its respective balance sheet, bloated after years and years of bond-buying. This came as a jarring shock to financial markets which had come to expect low rates and flood-like liquidity to be permanent.
The landscape for 2023 is challenging, with the degree of success in the fight against inflation remaining the single most important factor determining the outcome of investment returns.
When the realisation of a new paradigm dawned, investment performance across asset classes slumped. Global equities indices, particularly those which were sensitive to interest rates, experienced painful corrections. The NASDAQ – a bellwether for technology stocks – ended the year down 33%. Eight of the largest, most popular US technology companies, the MegaCap-8, nearly halved in combined market capitalization, going from $12.3 trillion to $7.1 trillion, a fall of 41%.
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1 The MegaCap-8 stocks are Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, NVIDIA, and Tesla. The phrase Megacap-8 and these stocks have been popularised by Dr. Ed Yardeni, of Yardeni Global Research.
Equities are a volatile asset class and such swings, while atypical in magnitude, come with the territory. Much more surprising, and painful, were losses in the bond market, which recorded a one-in-a-hundred-year shock. The correction was more marked on indices with long duration, with total returns on long-dated UK gilts amounting to -46.1%. Sterling also depreciated sharply, particularly against the US dollar, due to domestic political volatility, interest rate differentials and strong risk aversion.
Our portfolios were not immune to the chaos in financial markets, with most strategies facing a negative year, reversing much of the gains from 2021. Nonetheless, we benefitted from our widespread diversification, including exposure to the US dollar, a high cash weight and a positive aggregate return from our hedge fund positions. Long-term performance in most strategies remains positive and ahead of peers across most strategies.
Where do we go from here?
The landscape for 2023 is challenging, with the degree of success in the fight against inflation remaining the single most important factor determining the outcome of investment returns. We do expect inflation to moderate, particularly with regards to wages and rents, but it will be the degree of moderation which will be critical and will determine how aggressive central banks need to be regarding further increases in base rates and reductions in their balance sheets. In 2023, we expect rates to continue to rise – market expectations currently expect terminal rates to be 5.25%, 4.5% and 3% in the US, UK and eurozone, respectively (currently 4.5%, 3.5% and 2%).
We also believe monetary policymakers will err on the side of caution, keep policy tight, and only relent with meaningful rate cuts in the face of deep recession and labour market distress. Ironically, central bankers may well wish for some labour market distress. Unemployment is low across all major geographies, and at record lows in the US and UK. Tight labour markets will keep pressuring wages upwards, making inflation sticky. Between the two unpalatable options of high inflation or recession, central bankers will likely opt for the latter and tolerate negative economic growth for some time.
And if negative growth will be tolerable, will the recession be mild or deep? It is impossible to tell in real time. Monetary policy acts with a lag time of about 12-to-18 months and is far from predictable. Geographical idiosyncrasies will also play a role. Most expect the UK to experience one of the worst recessions and the weakest recovery in the G7 in the coming year, facing an unusually high exposure to wholesale gas prices due to lack of storage, a high proportion of fixed rate mortgages coming due, and a relatively inelastic supply of labour.
The US consumer, an engine of global growth, remains another critical factor to the recession question. So far, US consumption has been remarkably resilient.
Partly this is a result of accumulated savings, plentiful employment, and rising wages. This resilience will be tested in 2023. Here too, the Fed will hope for a slowdown, resulting in less systemic price pressure. The Chinese economic reopening in the face of a staggering U-turn on Covid restrictions is another critical question. Here, expectations are for Chinese economic growth rate to be higher this year (~4.8%) than last year (~3.1%).
The above questions only represent a tiny fraction of those that will influence global economies and markets in 2023. There are many push-and-pull factors that could lead to both upside and downside surprises.
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2 Bloomberg UK Gilt (25+ Y) - Index Total Return Level
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EQUITIES
New Year, Old Bear
The new year is set to begin as the last one ended: with significant uncertainties and renewed focus on the path of inflation and monetary policy. We prefer to maintain our prudent stance with an underweight to equities specifically with regard to the more highly valued US market.
United States. Even before the first earnings season of the new year arrived, further signs of an economic slowdown emerged from corporate America, this time from the banking sector: Goldman Sachs, among other investment banking behemoths, is set to embark on the biggest cost cutting campaign since the Great Financial Crisis, highlighting a marked decline in capital markets activity and general economic environment. We, too, remain cautious on US equities, given still elevated valuations compared to its developed markets peers and further potential downward revisions in corporate earnings. We are Underweight.
United Kingdom. Following a (relatively) tremendous year in 2022, the FTSE 100, the UK’s equity bellwether, hit another milestone right out of the gate in the new year: helped by strong performances of its financials and consumer discretionary names, the index rose above 7,700 points, its highest in more than four years. We continue to like the region for its favourable sectoral composition and attractive valuations, which are likely to benefit from continuing pressures on energy and commodity prices amidst a rapid reopening of the Chinese economy. We are Overweight.
Eurozone. Surging 8% since New Year’s Day, the Eurostoxx eclipsed both its US and UK peers in the beginning of 2023. Indeed, analysts have been taking note of the remarkable resilience of continental equities in the face of an energy crisis, surging consumer price pressures, and a war on its borders. Forecasts are being revised upwards from their initially pessimistic base lines, however, much still depends on the course of the war in Ukraine and the EU’s success in diversifying their collective oil and gas supply. Valuations remain attractive amidst more positive GDP forecasts but, for the time being, we remain Neutral.
Valuations remain attractive amidst more positive GDP forecasts but, for the time being, we remain Neutral.
Japan. December’s data release revealed inflation to have risen to 3.7% amidst a still extremely weak yen - moderate by western standards, but exceeding levels not seen in four decades in Japan. The Bank of Japan has yet to indicate any action to stabilise the freefall and we do not anticipate any major catalysts for the local equity market in the near term. We are Underweight.
Emerging markets. Most indicators point at a forceful recovery of social and economic activity amidst China’s chaotic withdrawal from its zero-Covid policy. The road to normalcy is likely to remain rocky in the short term, however the Hang Seng’s 45% rise from its October lows suggests investors’ confidence in a sustained period of growth that is poised to lift along other economies in the region. We are Neutral.
Price/Earnings of Major Regions - 5 year range
Source: KH, Bloomberg, 11/01/2023
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
FIXED INCOME
Back to Basics
The emergence of positive real yields and likely return to a negative correlation between equities and fixed income markets have made bonds a more attractive investment in 2023 than it has been in years. However, with inflation lingering, uncertainties around monetary policy remain. We are Neutral.
SOVEREIGN
United States. 10-year Treasury yields have ended the year at 3.87%, a whooping 236 basis point (bps) increase throughout the course of the year. Coming into 2023, encouraging wage statistics and somewhat less hawkish comments by Fed chair Jerome Powell have prompted a degree of optimism amongst bond investors, sending yields plummeting some 30 bps. We deem some of this optimism to be excessive: following a peak of Fed rates just below 5% in June this year, the market is pricing in a policy pivot resulting in almost immediate cuts, leaving the rate at 4.5% in December. Recognizing the more attractive valuations and defensive benefits we are Neutral on US Treasuries; however, we are positioned further towards the short end of the curve to reduce sensitivity to any upside surprises on yields.
United Kingdom. After a tumultuous year – to say the least – gilt yields ended 2022 at 3.67%, up 270 bps on the previous year, but 83 bps below their highs in the immediate aftermath of Liz Truss’s disastrous “mini budget”. Rishi Sunak has so far succeeded in reassuring markets that orthodoxy has returned to UK fiscal policy, reversing a brief period of gilt yields exceeding their US counterparts, however the UK’s economic and political environment continues to weigh on bond investors’ minds. Meanwhile, the Bank of England remains unlikely to initiate any meaningful monetary policy pivot despite a rapidly deteriorating local economy as doing so would exacerbate energy price pressures in the face of a continually strong dollar. We are Neutral.
Eurozone. Bond markets in the eurozone were not spared in 2022’s fixed income rout: yields on 10-year German bunds rose 275 bps throughout the year to clock out at 2.57%. Indeed, the global stock of negative-yielding debt, a symbol for the monetary largesse of yesteryear peaking at some $18tr in 2018, has now been eradicated. As the immediate surge of gas prices in the aftermath of Russia’s invasion of Ukraine abated and inflationary pressures continue to moderate in the eurozone, the ECB should be able to pause their tightening cycle towards the end of 1Q23, resulting in a low but sustainable positive real yield barring any further geopolitical surprises. Nonetheless, trading in euro fixed income markets is likely to remain relatively volatile throughout 2023 and we are Neutral.
Developed markets. Citing a build-up of macro risk, Fitch’s 2023 credit market outlook saw the proportion of “deteriorating” names surge to almost 50% from 5% a year earlier. Reflecting these risks, spreads have widened significantly and are beginning to look attractive for high grade credit, however we are wary of the impeding recession and remain Underweight for the time being.
10yr Government Bond Yields in the UK and US
Sources: KH, Bloomberg, 11/01/2023
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
Currencies
A weakening dollar
Recent December inflation data in the US was in line with expectations at 6.5%, its slowest rate in over a year. Investors now believe that this is a signal that the Fed will dial down its pace of tightening and the market consensus for a 50bps hike at the next meeting quickly fell to 25bps. Thus, the downward trend of the dollar continues.
GBP/USD. A further weakening dollar coming into 2023 and an inflation figure in line with expectations for December likely means a less aggressive Fed, causing the currency pair to tick higher to around 1.23 GBP/USD. The UK Office of National Statistics has reported the UK economy expanded by 0.1% in November, a far more resilient picture than the -0.2% expected. This suggests a more robust UK economy than many were expecting which should lead to further strengthening in Sterling.
EUR/USD. The ECB are still adamantly committed to a hawkish outlook as inflation might be stickier, while the Fed might start to be less aggressive. German preliminary GDP expanded by 1.9% in 2022, slightly above the 1.8% expected. The currency pair is likely to trade range-bound in the near-term.
USD/JPY. Yen continues to fall against the dollar and has dropped 14% since its October highs. There is speculation however that the Bank of Japan might reverse its ultra-loose monetary policy in 2023, which could reverse the trend.
Dollar Index. The dollar continues its decline against major developed and emerging currencies into 2023. It has fallen -10.5% since its September highs. The likelihood of the Fed being less aggressive suggests a sooner-rather-than-later end to the hiking period and therefore it is likely that further dollar weakening will take place over 2023.
Emerging market currencies. A weakening dollar and the re-opening of China are strengthening EM currencies. The latest Covid data out of China seems suspiciously low, causing many economists to question the data but real time data of train travel seems to suggest that the picture is one of re-opening.
The dollar continues its decline against major developed and emerging currencies into 2023.
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
The Dollar weakens further coming into 2023
Source: Bloomberg, Kleinwort Hambros, Data as at 13/01/2023
ALTERNATIVES
Gold advances
A weakening dollar and inflation that was in line with market expectations has tipped Gold back into positive momentum. Oil continues to trade lower going into 2023 as recession risks dampen demand but China re-opening could cause some upward price pressures.
Oil. Oil continues to trade range bound between $70-80 a barrel, far below the $120 a barrel seen in the middle of 2022. Recession fears continue to lower demand for Oil globally, but real-time data from China suggests that the economy is returning to full force despite the everchanging Covid policy confusion. An international price cap has been imposed on sales of Russian crude which took place early December but thus far Russia claims that this has led to no difficulties in securing export deals.
Gold. A weakening dollar has benefitted Gold and it now trades above its 10-month moving average, trading in positive momentum at $1,900 per troy ounce. Inflation in December was in line with expectations, easing the market consensus for an aggressive Federal Reserve. That said, it is by no means guaranteed and the Fed is likely to remain committed on its path of tightening to get inflation under control. Given the heightened recession risks and change of a “hard landing” for the US economy, Gold also retains its safe-haven properties, and we therefore remain overweight.
Gold Bullion (USD/Troy Ounce) vs. 10 Month Moving Average
Source: Bloomberg, 10/01/2023
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
Hedge Funds. In unstable market conditions hedge funds can help a portfolio, but selectivity is key. We prefer strategies which hold their own in bear markets, such as Merger Arbitrage, trend followers and Equity long/short. These strategies provide relatively safe, uncorrelated sources of returns from equities. Our hedge funds allocation has performed well over 2022 and been a great diversifier in our strategies.
Real Assets. We hold an allocation to a diversified portfolio of infrastructure (such as energy storage and efficiency, smart grids, waste-to-energy, air treatment and digital infrastructure) and specialist property assets (including care homes and e-commerce and logistics warehouses). These real assets offer additional diversification from other risk assets such as equities, as well as an attractive income stream and reasonable sensitivity to inflation.
Tail Risk Protection Note. Tail risks are typically understood as unlikely but severe crisis events which shock markets and dramatically impact the value of risk assets negatively. The dot-com bust at the turn of the century and the Great Financial Crisis in 2008 and 2009 are examples of such events. Despite conditions not being favourable for it in 2022, we believe the Tail Risk Protection Note offers our portfolios yet another critical source of safety and complements the existing diversifiers.
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
Important Information – *Please Read*
IMPORTANT INFORMATION – PLEASE READ
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This document is intended to report solely on the services, products, investment strategies and opportunities provided by or identified by SG Kleinwort Hambros Bank Limited. The services, products, investment strategies and opportunities described herein may not be suitable for all clients. Potential clients should consult their financial adviser to assess the suitability of any proposed transaction before taking any action.
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Hedge funds
The document may include funds which have not been specifically approved for sale in the jurisdiction of the recipient. In view of this, special care should be exercised when investing in this type of fund. We draw your attention to the following:
Shares of this type of fund carry no guaranteed return of capital, which, under certain circumstances, may lead to the loss of your entire investment;
The investment management methodology implies a degree of risk linked, among other factors, to the use of derivatives, leverage and short selling; and
The terms and conditions applicable to redemption may continue to expose you to risk during the period between the redemption request and execution (usually prior notice of 45 calendar days before the last business day of the end of each quarter is required but can be longer for some investments).
Some funds are subject to extended redemption periods or a restriction is placed on the amount of withdrawals from the fund during a redemption period. This is known as gating. The implementation of a gate on a hedge fund is up to the hedge fund manager. The purpose of the provision is to prevent a run on the fund, which would impact on its operations. Investors should consider a hedge fund with a gate as illiquid, as withdrawals from these funds are restricted.
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SG Kleinwort Hambros Bank Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG.
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Jersey
SG Kleinwort Hambros Bank Limited, Jersey Branch is regulated by the Jersey Financial Services Commission. SG Kleinwort Hambros Bank Limited is also authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority in the UK. The bank's principal address in Jersey is PO Box 78, SG Hambros House, 18 Esplanade, St Helier, Jersey JE4 8PR. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG. Services provided by SG Kleinwort Hambros Bank Limited, Jersey Branch will be subject to the regulatory regime applicable in Jersey, which differs in some or all respects from that of the UK. For UK-resident clients certain FCA protections may apply in addition to those available under the Jersey regime in certain specific circumstances.
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SG Kleinwort Hambros Bank Limited, Guernsey Branch is regulated by the Guernsey Financial Services Commission to provide banking services and investment business services and is also registered as a money services provider in Guernsey. SG Kleinwort Hambros Bank Limited is also authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority in the UK. The bank's principal address in Guernsey is PO Box 6, Hambro House, St Julian’s Avenue, St Peter Port, Guernsey, GY1 3AE. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG. Services provided by SG Kleinwort Hambros Bank Limited, Guernsey Branch will be subject to the regulatory regime applicable in Guernsey, which differs in some or all respects from that of the UK. For UK-resident clients certain FCA protections may apply in addition to those available under the Guernsey regime in certain specific circumstances.
Gibraltar
SG Kleinwort Hambros Bank Limited, Gibraltar Branch is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority and is authorised and regulated by the Gibraltar Financial Services Commission in respect of banking, investment and insurance mediation business. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG and is registered in Gibraltar under the Gibraltar Companies Act with its principal place of business in Gibraltar at Unit 5.02, Madison, Midtown, Queensway, Gibraltar GX11 1AA. The liability of the members of SG Kleinwort Hambros Bank Limited is limited.
Services provided by SG Kleinwort Hambros Bank Limited, Gibraltar Branch will be subject to the regulatory regime applicable in Gibraltar, which differs in some or all respects from that of the UK. For UK-resident clients certain FCA protections may apply in addition to those available under the Gibraltar regime in certain specific circumstances.
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