Monthly Investment Letter: New Year’s portfolio resolutions

The end of another turbulent year is a time both to reflect and to make plans, with many of us thinking about our New Year’s resolutions. In this letter, I present our 10 resolutions aimed at helping your portfolio navigate this rapidly changing environment.

1. Pick your battles – policymakers will likely drive market inflection points.
2. Think about the bigger picture – long-term returns from here should be good.
3. Stop procrastinating – plan to gain exposure and anticipate the inflections.
4. Get some insulation – add defensives and value.
5. Boost your income – seek income opportunities.
6. Cook with some new ingredients – seek uncorrelated hedge fund strategies.
7. Keep up with the news – position for the era of security.
8. Invest in what you value most – invest sustainably.
9. Learn something new – seek value and growth in private markets.
10. Spend more time with family and friends – best wishes for the year ahead.

In short, in the near term, the backdrop for risk assets is challenging: Inflation remains high, interest rates are rising, and economic growth is slowing. We therefore enter the new year with a preference for defensive sectors and strategies within equities and for higher-quality bonds.

But we expect 2023 to bring inflection points as inflation falls, central bank policy shifts from tightening to loosening, and growth bottoms. This should mean that the backdrop for investors will improve as 2023 evolves.

Investors will therefore need to stay nimble as different asset classes and regional markets try to anticipate inflection points at different times and in different ways. For more details on our views and the outlook for 2023, see our recently published Year Ahead report, “A Year of Inflections.”

New Year’s resolutions

1. Pick your battles – policymakers will likely drive market inflections

Federal Reserve policy and China’s reopening path are likely to be important variables for markets in 2023, and investors will need to consider how their positioning fits with the directions of these policies.

The Fed slowed the pace of rate increases to 50 basis points in December from 75bps in each of its prior four rate decisions. But we still expect a further 50bps increase in the first quarter of 2023, with the risk of more thereafter. The Fed has said it intends to keep policy restrictive for some time, and the still-tight labor market, strong nominal wage growth, and higher number of job vacancies than unemployed mean inflation could prove stickier than hoped, preventing the Fed from cutting rates in 2023.

In our view, this means investors should tactically position more cautiously for now, but also prepare to shift. Cyclical and growth segments of the market and riskier credits will be more attractive as signs emerge that inflation may fall sustainably back to 2% and that the Fed is considering looser policy.

In China, health authorities this month announced further easing on a range of COVID restrictions—another signal the country is edging toward reopening. This has come alongside additional assistance to property developers and more pro-growth statements from the Politburo. Recent economic measures have progressed faster than expected, but we still see a bumpy transition to a full reopening. Public concern over the virus remains high and could be stoked further as infections strain hospital capacity over the winter. Therefore, we keep a selective approach on China at this stage, focusing on individual winners from the reopening while staying neutral on the market overall.

2. Think about the bigger picture – long-term returns from here should be good

It can be easy to get wrapped up in the day-to-day. But a new year is a time when many of us get some time and space to think about the bigger picture, and for investors, that should mean a more encouraging perspective.

This year, global equity valuations, as measured by the MSCI All Country World Index, have fallen from a 21.3 times 12-month forward price-to-earnings ratio to 17.1 times, while 5-year US Treasury yields have risen from 1.26% to 3.65%. Both suggest decent long-term returns for diversified portfolios.

Historically, current equity market valuations have been consistent with subsequent 10-year returns of 6–9% per year. For bond markets, initial yields are generally a good indicator of subsequent long-term returns, suggesting that current yields—close to the highest since 2009—should mean among the best long-term return outlooks in 13 years.

This more appealing outlook means 2023 should provide a good opportunity to build up a diversified portfolio for the long term.

3. Stop procrastinating – plan to gain exposure and anticipate the inflections

Procrastination is a problem that many people try to solve in their new year’s resolutions. The same is true for investors. Waiting for precisely the “right time” to invest often results in missed opportunities to earn longer-term returns.

The macroeconomic conditions necessary for a sustainable rally may not yet be in place. But trying to time the precise day, week, or month when markets bottom is always challenging and could backfire if proven wrong. So for investors with excess cash balances today, we see “phasing in” as an effective strategy for building exposure to financial markets next year.

To do this, investors can use dollar-cost averaging and establish a set schedule to invest. Market dips such as an S&P 500 loss of 5% or 10% can be used to accelerate the buying. Meanwhile, a strategy of investing capital immediately in bonds and then phasing into stocks is another approach that can reduce the opportunity cost of holding uninvested cash and potentially enhance investors’ ability to buy stocks if there is a market correction.

As well as considering when to put cash to work, investors also need to consider where to put it to work. In our base case, we expect broad equity markets to trade lower in the months ahead. But by this time next year, we think the backdrop will have improved in line with our expected inflection points in inflation, monetary policy, and economic growth.

For more risk-tolerant investors looking to identify parts of the market that could rally most strongly when the inflection arrives, we see select opportunities in early-cycle markets, “deep value” stocks, and the likely beneficiaries of China’s reopening. These include the broad German and Korean equity markets, parts of the semiconductor sector, select companies exposed to China’s reopening, and currency structures that allow investors to navigate the turn in the dollar.

Recent market moves have shown that the US dollar is anticipating the changing macro environment relatively quickly, and we have moved our stance to neutral from most preferred. The Fed’s tightening cycle is moving closer to completion, which reduces potential USD upside, while lower US inflation has reduced the risk of a terminal federal funds rate that is significantly higher than the current market pricing of around 5%. In addition, progress toward reopening in China creates room for growth to improve outside the US, particularly in Asia, lending support to more procyclical currencies.

4. Get some insulation – add defensives and value

Adding home insulation has become a more popular talking point in Europe this winter amid elevated energy prices.

With a backdrop of high inflation, rising rates, and slowing growth, we also think some portfolio insulation for investors makes sense. We currently prefer more defensive areas of the equity market—including consumer staples, healthcare, and quality-income stocks.

The consumer staples and healthcare sectors outperformed the MSCI All Country World Index (MSCI ACWI) by 9 and 11 percentage points, respectively, in the first 11 months of 2022. We expect both sectors to continue to outperform in the months ahead, given that they should be relatively resilient as economic growth deteriorates.

We also favor value stocks, which have outperformed growth stocks by 19 percentage points in the first 11 months of 2022 (based on MSCI indexes). Inflation above 3% has historically favored value stocks relative to growth, and value has also historically outperformed growth by an average of 4 percentage points in the 12 months following the Fed’s last rate hike of a cycle.

5. Boost your income – seek income opportunities

Many people try to find ways to increase their income in a new year.

Rising yields in 2022 have made fixed income assets more attractive as a source of income. But with bond market volatility still high and economic growth slowing, we currently prefer the higher-quality segments of fixed income, including high grade and investment grade bonds. We expect returns in the first half of the year to be largely driven by the yield on offer, which is currently 4.1% for USD high grade and 5% for USD investment grade bonds.

We also like “quality-income” stocks, which combine higher-than-average dividend yields, a high return on equity, low earnings variability, and low debt-to-equity. Quality-income stocks have a defensive sector bias: Based on data going back to 1988, quality-income stocks (MSCI World High Dividend Yield index) have delivered an average 5.1% annualized return while the ISM is below 50, compared with 1.4% for the MSCI ACWI.

Also, elevated volatility can be used to earn additional portfolio income—for example, through premiums generated in structured investments or put-writing strategies.

6. Cook with some new ingredients – seek uncorrelated hedge fund strategies

Cooking more often and trying new recipes are popular new year’s resolutions, and investors should not neglect the opportunity to consider adding new asset classes into their portfolios, either.

In 2022, traditional bond-equity diversification failed to offer portfolios much protection from market events. But some hedge fund strategies fared much better: Macro strategies, for example, returned 8% on average in the first 11 months of the year [HFRI Macro (Total) Index], as managers successfully positioned long the US dollar and short rates and equities.

For investors, this underlines the importance of seeking alternative sources of return that are less correlated with broad market moves.

Looking forward, macro strategies have historically performed well in periods of high implied volatility (i.e., VIX above 25), capitalizing on market stress to generate annualized returns of 6.1%, compared with an average loss of 11.3% for global equities during those periods. We also think equity market-neutral strategies stand to benefit from divergent stock performance in 2023, while multi-strategy funds can offer a simple way for investors to build a diversified hedge fund allocation.

7. Keep up with the news – position for the era of security

The most important geopolitical event of 2022 was Russia’s invasion of Ukraine in February, an event that has intensified a drive for self-sufficiency in strategically important areas such as energy, food production, and technological development.

While we don’t yet know what news 2023 will bring, we believe this era of security will be one of the enduring trends of the decade, stimulated by measures like the US Inflation Reduction Act, which includes investments in green energy, and the CHIPS Act, which aims to boost domestic semiconductor production.

The global drive for energy security should favor investments in active commodity strategies, greentech, and energy efficiency, while efforts to improve food security should favor stocks linked to improving agricultural yields and water conservation.

Cybersecurity is another potential beneficiary of this trend. The sector is a relatively defensive part of the broader technology space, as companies and governments tend to maintain spending even in the face of economic downturns. We expect the cybersecurity market to grow by 10% per year through 2025.

8. Invest in what you value most – invest sustainably

The new year is a good time to review whether you are investing your time, energy, and resources in the things you value most.

Sustainable investments aim for compelling financial performance by tapping into key environmental and social trends that present long term opportunities and are in line with investor interests.

Many sustainable strategies underperformed in 2022 due to higher exposure to growth sectors, though their long-term performance remains strong on an absolute and relative basis. And fund flows to sustainable investments remain more resilient than the broader market. According to Morningstar, while net inflows into sustainable funds slowed to USD 22.5bn in 3Q22 from the revised USD 33.9bn in 2Q22, the overall fund market suffered USD 198bn net outflows over the period.

We see diversification within sustainable investments as key to improving the risk-reward of portfolios—and helping mitigate potential volatility over shorter time horizons. Investors can can diversify across sustainable themes, including more value-oriented topics, alongside growth strategies; focus on environmental, social, and governance (ESG) improvers, as well as companies that are already ESG leaders; and include sustainable bonds as counterweights to equity exposure.

9. Learn something new – seek value and growth in private markets

One of the most notable trends in financial markets over the past decade has been the growth of the private market asset class. The industry is likely to continue growing as companies opt to stay private for longer, and investors seek diversification, higher returns, and access to growth.

Private equity (PE) managers are likely to mark down their portfolios further in the months ahead. But it is unlikely that private investments will be marked down to the same extent as public markets. Looking at the past three recessions, US PE markdowns on average only reflected 55% of the S&P 500 drawdown, as measured by Cambridge Associates US Buyout.

We also see 2023 as a good year to put new money to work in private markets because investing in vintages after public markets peak has historically generated outsize returns. Based on our analysis of Cambridge Associates data stretching back to 1995, investing in private equity vintages one year after a peak in public markets delivered a subsequent internal rate of return (IRR) of 18.6% per annum. This compares with an IRR of 11.4% for vintages one year prior to a public market peak.

For investors looking to augment their core private equity exposure, we see attractive returns for value-oriented buyout strategies with a focus on healthcare and technology. The trend toward a green economy is generating new investment strategies in a growing sector. Finally, secondaries could present both new and existing investors with a timely opportunity to enter the market at a discount.

Investors should of course remember that investing in alternatives like private equity comes with certain drawbacks, including the risk of illiquidity, and investors need to be willing and able to lock up capital for longer.

10. Spend more time with family and friends – best wishes for the year ahead

Given the unprecedented disruption to everyone’s personal lives caused by the COVID-19 pandemic in recent years, our last resolution is to spend more time with family and friends over the holiday season and in the coming year.

Being more sociable can also have benefits in your professional life. Numerous studies point to a link between social skills and success in the classroom, being valued by employers, and entrepreneurial success. One of the most well-known proponents of this view is the Dale Carnegie Foundation, which claims that “85% of your social and financial success in life is determined by your social and communication skills.”

Whatever your aspirations for the coming year, I hope these resolutions can help you build a robust portfolio for 2023 and beyond. We wish you a happy holiday season and a prosperous year ahead.

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