January, time for forecasts for the new year. 2023 “outlooks” proliferate in reports from brokerage houses (sell side) and investment houses (buy side). These are largely economic and market forecasts that represent the “house view” and often have little to do with the investment strategies actually implemented by individual managers. For our part, as argued in the last CEO letter, when it comes to prognosticating the economic or market outlook for the coming months, “we know we don't know.” We prefer to simply take stock of the situation by describing the reference scenario (baseline) of our portfolio.
The very act of building the scenario helps us understand what kind of game we’ll be playing in the year that lies ahead. It is the baseline for setting the portfolio. Not only that, it allows us to be on guard against so-called “confirmation bias”, which only confirms strategies that the portfolio already reflects. What might the alternative assumptions be? Where might the tail risks appear?
What follows here is an attempt to define the pitch where we think the 2023 game will play out, without claiming to make detailed predictions about market directions or economic variables. Playing conditions can change as the game unfolds, and decisions about how many and which risks to take constitute dynamic decision-making, rather than a binary yes/no choice to be made at the beginning of the year.
Where, then, is the 2023 game being played out? Inflation and central banks constitute the first playing field; Geopolitics the second. Let's look at them one at a time.
Like it or not, inflation and interest rates will remain the driving forces determining the direction of financial markets in 2023. Our assessment of the rules of the game on this field is summarised as follows: despite central bank actions, there is no return to the pre-2021 status quo; the new normal scenario is now one of financial repression.
We began red-flagging inflation risk in February 2021 (“Investing in the age of financial repression”) and raised the issue again after the outbreak of war in Ukraine (“Easy trends are behind us: what to do?”). Spiking inflation and the central banks’ reaction were the dominant themes of 2022, first with their downplaying of the problem (it’s transitory!), then with decisive action to hike rates. The effect on financial markets was brutal: 2022 was the first year since 1870 that both U.S. stocks and bonds both fell more than 10%!
What is the situation at the beginning of 2023?
Let's start with three factual data points:
1) Powell (and Lagarde) did not want to go down in history for letting inflation get out of control. They said as much and acted accordingly.
2) Inflation, while remaining high, began to recede late last year.
3) The market consensus is that the monetary tightening implemented so far is sufficient, and expects the Fed to start lowering interest rates as early as the second half of this year (the so-called “pivot”).
In other words, the market expects that after the flare-up in 2021/2023 we will return to the situation prevailing between 2009 and 2021, namely price stability, low interest rates and moderate but sufficient growth to maintain full employment.
We are not convinced of this at all, for a number of reasons:
1) Real interest rates, when measured by actual inflation, not that implied by so-called breakevens (market expectations), are still negative.
2) Long-term U.S. bond yields are consistent with the assumption of a recession, albeit a mild one, but do not reconcile with still robust earnings expectations or with the level of corporate bond spreads, which remain below historic highs.
3) The cyclical effects of China's reopening after three years of severe lockdown are inflationary, due to rising demand for commodities, including energy.
4) All the secular inflationary factors we have listed in past CEO letters remain: ongoing geopolitical conflicts, demographics, low productivity, structural scarcity of commodities, energy, etc.
Is it possible that inflation will continue to retreat in the coming months? Absolutely. Is a mild recession in 2023 still in the cards? It is. But that doesn’t mean we should lower our guard against inflation. Historical precedents (the 1970s) teach us that inflation proceeds in successive waves, and that beating it back requires a strong dose of monetary tightening (i.e., positive real rates), administered for as long as necessary.
So there are two possibilities: the first is that inflation stabilises at a higher range than before (say 4-6%), as a result of the policies already implemented, but this is not consistent with the current level of long-term yields and an inverted yield curve.
Otherwise, it will take a stronger dose of monetary “medicine.” But this raises a second question: how far are central banks willing to go in fighting inflation? In our opinion, the most likely answer is: not all the way. The reason is that they will not be able to afford it due to the vast sums of public- and private-sector debt, accumulated over the past decades (especially in the phase of super accommodative monetary policies and ultra-low interest rates of the last twelve years).
This is financial repression. The cost of servicing debt, both private and public, increases as interest rates rise, with the effect intensifying over time. The ratio of debt (stock) to GDP (flow) isn’t so much the problem. What matters is the weight of debt service on national income, which has already reached critical levels in several countries: 20% in France, 15% in Japan, 15% in the US.
This ensures that central banks will stay determined to fight inflation, but not SO determined as to make the cost of servicing debt too onerous. They will have to let inflation do the “dirty” work of reducing the cost of debt in real terms, as has already happened several times in the past, with heavy repercussions in terms of value redistribution: from savers and creditors in favour of debtors (especially debtor nations).
We’re not talking about doomsday scenarios, but we will have to learn to live with higher inflation than we experienced in the last 20 years, and with interest rates insufficient to preserve the real value of money and savings. It’s quite a paradigm shift for investors.
The second major playing field in 2023 is geopolitics. If on the macroeconomic level, making predictions in the short term is a risky endeavour, it is all the more so for the geopolitical framework, due to the unpredictability of the prime movers. What follows, therefore, is a mere readout of today’s global flashpoints rather than a list of possible scenarios, and an attempt to foreshadow some alternative risk scenarios.
Our basic assumption is that the geopolitical picture will remain unstable because the major conflicts have become structural and not easily resolved, at a time of cyclical weakness in the world economy. Not only will stocks and bonds be impacted, but commodities and currencies as well.
As for commodities, producer countries usually see their power increase on the geopolitical chessboard in periods of severe supply constraints, such as the one we’ve experienced for several years now. In the energy sector we’ve seen significant under-investment in fossil fuel production capacity globally. This has also been true for the mining and processing of metals needed for the energy and digital transformation of the coming years (e.g., copper, lithium, and cobalt). China, for example, has sought in recent years to take control of the entire supply chain of some key industrial metals.
The most important theatres where our geopolitical game is being played out in 2023 are the Russia-Ukraine war; the China-Taiwan tensions; the US-China standoff over semiconductors; and Iran’s nuclear weapons challenge.
The most likely scenario for the war in Ukraine is ongoing conflict: neither side has the decisive military force to overpower its adversary, while a solution at the diplomatic table appears distant. The tail risks of this scenario are the use of nuclear weapons by Russia, but also a unilateral cut in Russian oil production, which would lead to a global oil shock.
The Middle East remains another potential flashpoint in 2023. Following the diplomatic breakdown between the United States and Iran over the nuclear weapons issue, an Iranian attack on the energy infrastructure of other countries in the area is a plausible scenario. In fact, a military attack on neighbouring countries is a solution that the Iranian regime has adopted before in times of domestic tension, such as the one the country is going through due to the fierce suppression of protests. Again, the tail risk is an oil price shock.
In China, President Xi Jinping consolidated his power at the party congress in late 2022 and is trying to stabilise the nation’s economy with a U-turn on its Covid policy and ongoing accommodative monetary and fiscal policies. In this case, the shock is a positive one in terms of stimulating domestic demand after three years of tightening due to lockdown. It should also result in an increase in global demand for raw materials and industrial metals, which implies a further boost to global inflationary tensions.
A Chinese military attack on Taiwan appears unlikely in the short term, but it is not off the table in the medium to long term, since the “peaceful” alternative that China envisions, namely an integration process similar to that adopted for Hong Kong, is not acceptable to Taiwan, due to costs associated with the loss of freedom and security.
Finally, the U.S. administration continues in its policy of curbing the growth of its Chinese military rival, technologically and economically, especially in resorting to export controls on crucial technologies such as advanced semiconductors.
The risk scenario here appears with the U.S. resorting to further secondary sanctions to ensure that allied countries fully adopt restrictions on Chinese companies. In this case, political tensions with China and the risk of an attack on Taiwan would be bound to increase.
The conclusion of this brief and non-exhaustive roundup of geopolitical risks is that the tensions that emerged in recent years and exploded in 2022 do not have clear solutions in the short term, with the implication that volatility on risky assets remains high. Most of the risks listed also have inflationary implications in the tail scenarios, and only one case — the cessation of hostilities in Ukraine — has deflationary implications from falling oil prices.
One of our basic theses is that the traditional diversification model based on the equity/bond pillars (the so-called 60/40 model) is in crisis. This model has held up asset allocation strategies throughout the 40-year phase of falling interest rates, but it does not fit in a phase in which the deflationary process that took hold in the 1980s seems to have wound down.
The year 2022 proved the validity of this thesis, with the stock market and the bond market both in strong decline. This is not to say, of course, that a balanced portfolio cannot outperform in individual years, even in 2023!
In fact, in the bond market, a more acceptable risk/return combination has been reestablished after the 2022 price collapse, although corporate bond spreads still do not discount the levels reached in the past, during periods of global recession or slowdown. In equities, there remain areas of overvaluation that have been only partially corrected (Big US Tech), but in some cases — Europe, Japan, emerging markets — valuations appear reasonable, although not so much so as to provide a robust defence in the event of a widespread recession.
If, however, we start from the assumption that the scenario we’re now facing is characterised by the two elements discussed above — namely financial repression and structural geopolitical instability — the inadequacy of the 60/40 model to address them once again becomes apparent.
In an era of financial repression, the government bond markets of those countries intent on implementing such a policy — namely the major developed countries — should be avoided. In an era of endemic geopolitical instability, on the other hand, riskier assets, such as equities, are more exposed to the resulting increase in market volatility. What’s to do, then?
The first point is that the objectives and priorities of portfolio management change. The main objective becomes protecting the value of portfolios in real terms, rather than seeking the highest returns as in the previous phase (a phase in which market volatility was artificially constrained due to central-bank policies).
Thus, there can be no shortage of commodities/metals (both industrial and precious) as a structural component of the portfolio, despite the fact that the lack of cash flow has in the past often resulted in their exclusion from portfolios as a primary asset.
Second, liquidity (cash) will have to be reconsidered in its traditional role as a risk-free asset: its optionality, in fact, makes it a strategic asset in periods of endemic volatility.
On the other hand, the so-called liquidity premium, which has favoured the heavy reliance on the inclusion of private assets (private equity and private credit) in portfolios, will have to be reconsidered in a structural way. It’s because of the presence of strongly leveraged components in past yields from these asset classes, or that returns are put at risk in the face of rising interest rates. It’s also because in a phase of financial repression and endemic volatility, the strategic value of liquid assets increases structurally, compared to a historical phase of price stability and medium to low volatility. In other words, the lack of mark-to-market valuations rather than constituting a “risk premium” becomes a structural disadvantage. The risk premium has been shredded due to the huge demand for these assets in the past few years, just when volatility would dictate that we need it most, while the disadvantages of non-liquidity are still apparent.
Finally, in the new paradigm of financial repression and volatility, the traditional two-step investment process of asset allocation and stock picking is challenged, precisely because of the difficulty that individual asset classes — traditional and alternative — have in performing their historic roles. A new method is needed, which we have identified as “deconstructing” traditional asset classes (e.g., equity, bonds) in order to “reconstruct” them into uncorrelated strategies deployed according to risk/return objectives.
This is what we have proposed and adopted since the launch of Plenisfer and our first Fund. It is paying off at the moment. There is still a long way to go, and the game to be played out in the coming years will remain complex. The conditions for winning are to be clear on where the game is really being played and what the (new) rules are.
CEO and Co-CIO Plenisfer Investments SGR
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