The investment story of 2023 so far has been marked by ever-evolving narratives that have confounded investors, leaving most active managers struggling to keep pace. Amid this backdrop, the importance of humility in an investor’s toolkit has been particularly emphasised.
The highly concentrated bull market in equities and the meteoric rise of all things AI (‘artificial intelligence’) have taken many by surprise. Equally astonishing is the resilience of the US economy and job market, which have defied consensus expectations.
Meanwhile, the yield curve has been a roller coaster, with US Treasury yields now higher than they were a year ago. After a series of surprises, there is hope that 2023 will bring greater clarity regarding growth, inflation, and monetary policy for 2024.
The first half of 2023 saw a strong rally in stocks, but the third quarter (‘Q3’) proved challenging for risk assets due to surging real rates across the yield curve. Markets are now better reflecting the narrative of rates peaking and staying higher-for-longer and demanding a higher term premium for fiscal challenges.
Developed market equities fell by -3.4% in Q3 (EU: -2.2% vs US: -3.2%), bringing year-to-date (‘YTD’) returns down to a still strong 11.6%. Growth stocks have outperformed value by over 18% in 2023 but the latter has exhibited relative resilience over the quarter.
In fixed income, government bond returns were negative across developed markets in Q3. High-yield bonds have outperformed YTD benefitting from their short duration and stable credit spreads. As bonds and stocks fell simultaneously in Q3, commodities outperformed (4.7%) reminiscing the market dynamics observed in 2022 and highlighting the importance of select alternative assets for diversification.
After initially mischaracterising inflation as ‘transitory’, central banks have been on an aggressive hiking cycle. The economy’s remarkable resilience so far has been driven by resilient consumer spending leaning on pandemic-induced savings and sustained wage growth, especially as China was unable to come to the rescue.
As the trend of disinflation persists, the challenge of navigating arguably the trickiest ‘last mile’ in the battle against inflation remains. Debates on the appropriate level of monetary policy restraint in a world undergoing structural changes adds complexity to the situation.
Given the relatively more effective monetary policy transmission in the EU due to a higher proportion of floating-corporate debt, the European Central Bank may have concluded or is close to concluding its rate hikes.
Even if a soft landing currently appears to be the most likely scenario for the US economy, the timing of any Federal Reserve board policy pivot remains uncertain. A hard-learned lesson from previous eras is not to declare victory too soon. This might explain the continued hawkish tilt. However, there also remains a clear danger of doing too much.
As a new era dawns, the cheap money of the 2010s may be replaced by a more expensive borrowing landscape resembling the pre-Global Financial Crisis. A turn in the credit cycle adds to this challenge.
As markets adapt to the new regime of greater volatility and elevated rates, opportunities are emerging. The eventuality of a continued but mild economic slowdown, rather than a full-blown recession, lends support to company fundamentals.
The correction in Q3 presents a more attractive entry point for equities with quality and AI still being preferred. Resilient economic data and steady disinflation, coupled with robust consumer spending and Q3 earnings may pave the way for typical positive Q4 seasonality.
Fixed income appears broadly oversold following a sharp increase in bond yields. With long-term yields at multi-year highs, investors may be enticed to generate income and extend duration. Unanchored inflation expectations and continued pressure on the term premium may, however, result in bond investors enduring a third consecutive year of losses if yields remain elevated.
In conclusion, 2023 has unfolded as a year filled with surprises and uncertainties. In the face of imperfect markets and dynamic macro forces, there are no easy options. It’s crucial to recognise that financial markets tend to be forward-looking but unforgiving when it comes to timing.
As investors map their path into Q4, thoughtful risk management and a well-balanced portfolio strategy in terms of asset and sector allocation, supplemented by active management across styles, will be indispensable for navigating the ever-evolving investment landscape.
Josef Luke AzzopardiJosef Luke Azzopardi is a portfolio manager at BOV Asset Management Ltd.
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