Investment regime shift brings turbulence but also offers returns

The writer is co-head of investment and group chief investment officer at Schroders

The market misery of 2022 was almost universal, inflicted by a seismic regime shift towards both higher inflation and higher interest rates.

Investors faced by tumbling equities couldn’t find the sanctuary in bonds they have grown accustomed to. As the S&P 500 index fell 19 per cent over the year in dollar terms, 10-year Treasuries dropped in virtual lockstep, losing 19 per cent.

This made things very difficult for the popular 60/40 portfolio of bond and equities which usually aims to deliver “inflation-plus” levels of returns. A portfolio of 60 per cent US equities and 40 per cent long-term US government bonds would have underperformed inflation by 28 per cent in 2022.

The “Fomo” market of earlier this decade, where investors crowded into a small number of evermore expensive growth stocks owing to the fear of missing out, was soundly quashed. The handful of tech behemoths that had previously added so much to index returns were the very ones which dragged the US market down last year. A portfolio of the seven largest US companies in the MSCI USA index from a year ago would have lost investors 40 per cent in 2022. A portfolio of the rest would have lost only 14 per cent.

It wasn’t just investors in traditional assets that felt the pain; cryptocurrencies collapsed. Bitcoin fell 65 per cent over the year, while “stable” coins Luna and Terra proved anything but as they plummeted amid a whirl of scandals and failures, most notably at the crypto exchange FTX.

So where does this leave investors in 2023? After a decade of zero rates and quantitative easing, investors need to adapt to an environment where structurally higher inflation will require central banks to run a more active monetary policy.

For 2023, we expect inflation to be falling and, with the risk of recession, bonds will be a helpful diversifier once more. But given medium-term pressures on inflation, the case for owning bonds now rests more on the yield they offer. This is a change from the past decade when bonds offered little or no yield and diversification was their main appeal, rather than the income they provided.

We expect an increased divergence in interest rate cycles across countries and regions. Nations less reliant on external funding and that have showed policy discipline may be rewarded, while others may be punished. There are now more opportunities to invest in different bond markets based on one’s expectations of where rates in those countries are heading.

Similarly, companies that have survived as a result of low borrowing costs may soon find themselves struggling against a backdrop of higher rates. It will be essential to assess which companies are able to pass on higher costs to their consumers: those that can’t will see margins come under pressure.

Price-to-earnings valuation ratios are likely to be lower and investors will be more focused than ever on the earnings part of that coupling. Elsewhere, with a tense geopolitical environment, commodities are a helpful source of diversification, having fallen by the wayside in the loose money period of quantitative easing.

After a prolonged strong period, underlying US profit margins are at record levels. As we’ve seen with the tech sector, cost pressures in the US are now making themselves apparent at a time when revenue growth is clearly starting to slow. Negative operating leverage — where fixed costs comprise a greater portion of a company’s total cost structure while sales simultaneously decrease — is beginning to kick in. Yet Wall Street still expects 4 to 5 per cent earnings growth for the S&P 500 in 2023, which seems optimistic.

The rest of the world definitely looks more interesting, especially Asia.

China’s economy was far more resilient during the “exit wave” from Covid than had been expected. And with high frequency indicators suggesting that activity has already begun to pick up sharply as the number of Covid infections has subsided, the near-term outlook for the economy is good

The new market regime is about more than just inflation and interest rates. Structural changes to supply chains, shifts in energy policy and a surge of investment in technology like semiconductors will create opportunities among a new wave of companies. Some of the investment themes that have emerged in the past few years will only strengthen — and new ones will emerge.

Last year was significant in ushering in these fundamental changes. 2023 is also likely to be turbulent as these shifts becomes more established in investor psyches.