"Royal London Asset Management's investment teams will continue to make individual investment decisions that respect the macro backdrop, but do not defer to it." – Piers Hillier, CIO
2022 has been an extremely challenging year for investors with increased geopolitical tensions, rising inflation and a pullback in asset prices. In Outlook 2023, our investment managers consider the key risks and opportunities that investors will face in the year ahead. CIO Piers Hillier discusses the extent to which 2023 may offer a degree of normalisation after a volatile 2022 and puts forward three issues he believes we should all be looking at over the next 12 months. He also explains why Royal London Asset Management's (RLAM) diverse investment processes should help in identifying and acquiring value, ensuring that we are getting the balance of risk and reward right for our clients.
Discover the focus for Royal London Asset Management in 2023
In our Outlook, RLAM’s fund managers assess the challenges and opportunities in their respective asset classes for 2023.
With continued rising energy costs and supply chain disruption, we ask: will inflationary pressures become more entrenched in the year ahead, or will they drop as economies move into recession? And with markets already reflecting a lot of bad news, could the year ahead offer something of a revival? We analyse the areas of concern and potential growth.
Extracts from our Outlook 2023
What challenges did global stocks face in 2022?
Rising interest rates, bond yields, inflation and threats of a looming global recession have been significant challenges for stocks globally in 2022. This formidable set of headwinds has seen global equity markets post significant losses in US dollar terms.
With the ‘transitionary’ inflation pressures of global supply chain disruption that first appeared in the aftermath of Covid being exacerbated and prolonged by the escalation of Russian aggression in Ukraine, an inevitable tightening of monetary policy globally in order to try and control this has resulted in interest rates rising sharply over the course of the year.
With this rise, the present value of future company cash flows, upon which stocks are valued, painted a very different picture for many of the previous market leaders. As a result, traditional higher growth areas, such as technology stocks, saw sharp sell-offs over the course of the year and, as inflation pressures took hold, those companies with less pricing power also began to come under pressure.
For anyone with a historical perspective of investment markets, 2022 will go down as one of the most historic and memorable. The scale and speed of change in key asset markets, such as equity and debt, has been at times breath taking. This in itself reflects a fundamental re-assessment of the outlook for investment markets that was not captured or considered by outlooks a year ago.
At the start of 2022, a reasonable view would have been that inflation was indeed transitory, created by the supply chain bottle necks we saw in the wake of the pandemic, which in turn would have been expected to work through by the end of the year. What was unknowable at the time was the structural shift in energy and commodity markets that would be created by Russia invading Ukraine. This created a skewness to markets which is unprecedented, leading to energy being the only area of material positive returns this year within equity markets.
A relic of the 1970s, Stagflation, returned to haunt financial markets in 2022. Broad diversification was very beneficial, with inflation hedges like commodities surging and commercial property posting solid returns. For balanced funds investing only in stocks and bonds, there was nowhere to hide. Bonds suffered a once in a generation crash as central banks hiked rates to counter double-digit inflation, despite a slowdown in growth. Higher bond yields, in turn, saw growth stocks de-rate with global equity markets seeing their worst year since 2008 in local currency terms.
Much of this pain was offset for UK investors by a slide in sterling which raised the value of overseas assets – and this currency effect helps to explain why many bond-heavy ‘low risk’ portfolios saw much larger losses in 2022 than those with a higher equity exposure. We believe that inflation is set to drop as economies move into recession and this should benefit government bonds over 2023. Equity investors may need to be patient. The earnings recession is yet to start and, if history is any guide, we could see a second leg downwards in stocks which could be amplified for UK investors if dollar strength reverses.
2022 was a terrible year for most fixed income investors. The causes are well known: rising inflation, higher bank rates, the impact of Covid and the Ukrainian war, ballooning government debt.
So, will 2023 be better? Our view is that the outlook for sterling credit is the best it has been for some time. There are several factors at play here. Most importantly, valuations are attractive and this has two component parts. Gilt yields have risen and now factor in a lot of monetary policy tightening whilst credit spreads are nearly 1% higher over the year.
A key question is whether the widening in credit spreads is justified. In our view there will be a pick-up in defaults over the next year. However, this will predominantly be a sub-investment grade event. We do not expect to see much change in investment grade defaults, reflecting the size and nature of these companies. Downgrades to sub-investment grade will be a threat to valuations but we believe that the current spread of 1.75% for non-gilt sterling bonds provides more than adequate compensation. If we look at historic default rates and assume zero recovery from defaulted bonds, current spreads offer significant opportunities. Assuming a 20-year timeframe, investment grade investors require less than 30bps of excess yield to compensate for this risk. There is an argument that the nature of credit markets has changed, with a much higher weighting to the riskiest part of the investment grade universe (BBBs). However, when we look at this cohort over a 20-year timeframe, less than 50bps is required as compensation over government bonds.
Around a year ago, we confidently predicted that for high yield markets, it was ‘Looking good for 2022 after August reboot’. With our global high yield benchmark index down around 15% for the year to the end of October, it quite clearly wasn’t all good. Against that, global high yield has outperformed gilts and sterling credit as predicted, however; and emerging market debt has been the key area of weakness, delivering returns well below the US and European regions.
So, what did I get wrong? Like most people, I didn’t foresee the Russian invasion of Ukraine and how it would supercharge inflation – the downstream impact on interest rates and risk of recession have been painful. Of course, unlike annual outlook predictions, fund managers are able to revisit their assumptions as new information emerges (albeit within a clear and consistent investment philosophy and process).
In recent years, the prospects for gilts and other government bond markets have seemed somewhat dull, as the backdrop of historic low interest rates and quantitative easing meant the only sense of drama was how low yields could go. As a result, investors have viewed these assets as a dependable, risk-free, low-volatility, low yield asset. However, after 2022 – and notably for gilts, after the events in September – investors will be looking at these markets in a new light.
Of course, it had already been a challenging global environment, played out against a backdrop of persistently high inflation, war in Ukraine and escalating energy prices. For the UK though, the crunch came after then-Chancellor Kwasi Kwarteng’s unfunded ‘mini-budget’ threw the gilt market into crisis. A fire sale followed, and gilt yields soared to levels not seen since the global financial crisis of 2008, while sterling fell to an all-time low. Only Bank of England intervention – including committing to buy £65 billion of longer dated gilts – brought relief to the market, preventing a ‘doom loop’ that threatened the UK pension industry.
Investment markets in general have weakened quite significantly during 2022, as investors have grown increasingly concerned about the global economic slowdown, and by the deteriorating economic outlook for the UK. The real estate market is no exception. A heightened level of uncertainty and pessimism has been affecting the price that investors are willing to pay for UK properties across the board, albeit with some sectors more heavily affected than others. As a result, investment volumes have dropped and pricing has moved out quite considerably.
The sectors most affected by this shift in investor sentiment are those that performed best some 6-12 months ago. According to MSCI, industrial values have fallen by 16.6% since June compared with 7.7% and 8.1% falls for offices and retail respectively. In the case of retail, it still hadn’t recovered from its drawn-out retrenchment over the last decade, particularly during the pandemic. While the residential property sector has remained relatively resilient, there’s been a noticeable deterioration in sentiment since September.
Overall, occupational markets have remained remarkably resilient, particularly for high quality or prime stock, and we’re still seeing rental growth with pockets of strong growth in logistics where the fundamentals remain strong.