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.
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.
2 Bloomberg UK Gilt (25+ Y) - Index Total Return Level
