Real Return: our 2023 outlook

The last 12 months have been characterised by a reversal of previous trends witnessed in the aftermath of the market trough in March 2020 and the longer-running disinflationary era that prevailed following the 2008 global financial crisis. A combination of less abundant global liquidity and slowing global nominal growth led to very different market outcomes, notably sharp equity-market declines, defensive equity-market leadership, wider credit spreads and a bear flattening of the yield curve combined with yield-curve inversion. A strengthening US dollar bucked this trend, representing a bright spot amid broad-based market weakness during which there were few places to hide; indeed, this has undoubtedly been one of the toughest environments faced by investors in recent decades.

The key challenge that both policymakers and the markets have been grappling with is one that is front of stage in 2023: high inflation, the extent of which has been exacerbated by the Russia/Ukraine conflict. The ensuing cost-of-living crisis, which policymakers were forced to address by raising interest rates, is likely to persist as inflation becomes more structurally embedded in the system, defying those who had assumed that it would quickly recede to post-global financial crisis levels. We believe this has profound implications for asset-class and equity sector leadership, as well as for the reliability of certain fixed-income assets as safe-haven hedges.

But what can move the dial in 2023 in terms of big-picture events? Clearly investors are focused on signs that the sequence of interest-rate rises is drawing to a conclusion, which could potentially lead to a more sustained risk-on sentiment. This will largely depend on inflation and the labour market, neither of which have decisively declined at this juncture. A European recession looks inevitable given the extent of the energy shock, while the US appears likely to follow suit with a lag, being affected by corporate earnings declines. Companies may find it more challenging to pass through increased input costs as demand slows, leading to narrower profit margins. Moreover, higher costs of capital, which are likely to drag on capital spending plans, a tighter liquidity picture, and the normalisation of demand in many areas are already starting to squeeze the engorged profits of many of the prior Covid-19 beneficiaries, not least the giant technology platforms.

High-conviction security opportunities across asset classes

This presents a challenging backdrop with a potentially wider distribution of outcomes than in previous years, and we would continue to advocate caution as it is difficult to envisage interest rates falling significantly in 2023 as many investors would like. Nevertheless, we believe there will be compelling opportunities to deploy capital, with such an environment lending itself to high-conviction security opportunities across asset classes, as well as decisive asset-allocation moves.

The strong thematic drivers behind our investment considerations are likely to gather impetus as 2023 unfolds. Great power competition, as domestic politics becomes more inward-looking and less accepting of globalisation forces, represents an opportunity for sectors such as defence as countries scramble to bolster their military muscle. The transition to cleaner energy underpins both pure renewable-energy players and those energy companies with more traditional business models set to benefit from the need to navigate the transition over the medium term with interim energy solutions. Many of these companies offer strong free-cash-flow generation. Other long-term areas of focus include health care, where demand is supported by an ageing population in the developed world and widening access in emerging markets.

However, we do anticipate that, as 2023 progresses, we will move into the next phase of the economic cycle, and we are readying ourselves for this with a wish list of securities in areas such as industrial companies, particularly those that can harness the trends of decarbonisation, infrastructure spending and efficient manufacturing. For the return-seeking portion of the portfolio, contingent-convertible bonds can provide high-single-digit yields, while we believe select investment-grade bonds offer attractive valuations, and we will continue to source new opportunities in these areas. Alternatives, such as infrastructure and renewables, will continue to be prominent as a diverse source of return, offering what is generally low equity-market beta and often including inflation-protection properties.

Diversified hedging strategies

The portfolio’s stabilising layer previously had limited exposure to government bonds owing to rising yields, and inflation breaking out of the relatively low and narrow channel it had been in for the last decade. While we do not consider that government bonds will be as reliable a hedging tool as in the era which followed the global financial crisis, they could start to play a useful tactical role against a backdrop of persistent inflation and slowing economic growth.

Moreover, prior to the bond sell-off, we were already looking at ways to diversify the stabilising layer. As an unconstrained strategy, Real Return has a variety of tools at its disposal which are often less than perfectly correlated with more traditional assets. These include strategies such as alternative risk premia, which we have been deploying both in the return-seeking and stabilising parts of the portfolio, albeit with different risk/return profiles to suit the characteristics of the different layers. We factor in these assets’ liquidity profile from the outset, both in terms of position sizing and the rigour with which we undertake due diligence. We seek investment strategies which have longevity and persistence in their ability to generate returns.

Gold – shining again?

Finally, the outlook for gold merits a comment given its somewhat lacklustre performance in US-dollar terms following its strong rally on the outbreak of the Ukraine-Russia conflict. We use physical gold to hedge against a broad range of outcomes including those connected to equity and credit risk, but also against fiat money debasement, geopolitical tail events, and high-inflationary regimes. A strong US dollar and rising real yields were a persistent headwind for gold in 2022. However, we believe the outlook for 2023 appears more favourable and we could look to increase our allocation. We expect a softer US dollar to be a tailwind for gold, but we do not think real yields will fall materially in 2023, which will keep the opportunity cost of owning gold high. On the demand side, we should see increasing demand for gold from emerging-market central banks. The confiscation of Russia’s sovereign currency reserves prompted some major emerging-market central banks to reduce their US Treasury bond holdings in favour of gold. We think this trend is likely to underpin demand.

Dynamic approach amid volatility

In summary, we anticipate a volatile backdrop in 2023 and will continue to focus on seeking to preserve capital for our clients and to generate returns opportunistically, ensuring that our toolkit of assets is well suited to a regime of structurally higher inflation. There is likely to be greater bifurcation across asset classes, creating the potential to enrich the strategy’s return opportunities, as well as helping us as we seek to take advantage of short-term market dislocations and employ the dynamism that our mandate affords us.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Newton Real Return strategy – key investment risks

• Performance aim risk: The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for returns to vary significantly.
• Currency risk: This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.
• Derivatives risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the strategy can lose significantly more than the amount it has invested in derivatives.
• Changes in interest rates & inflation risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the strategy.
• Credit ratings and unrated securities risk: Bonds with a low credit rating or unrated bonds have a greater risk of default. These investments may negatively affect the value of the strategy.
• Credit risk: The issuer of a security held by the strategy may not pay income or repay capital to the strategy when due.
• Emerging markets risk: Emerging markets have additional risks due to less-developed market practices.
• Shanghai-Hong Kong Stock Connect and/or the Shenzhen-Hong Kong Stock Connect (‘Stock Connect’) risk: The strategy may invest in China A shares through Stock Connect programmes. These may be subject to regulatory changes and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
• China Interbank Bond Market and Bond Connect risk: The strategy may invest in China interbank bond market through connection between the related Mainland and Hong Kong financial infrastructure institutions. These maybe subject to regulatory changes, settlement risk and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
• CoCos risk: Contingent convertible securities (CoCos) convert from debt to equity when the issuer’s capital drops below a pre-defined level. This may result in the security converting into equities at a discounted share price, the value of the security being written down, temporarily or permanently, and/or coupon payments ceasing or being deferred.
• Counterparty risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the strategy to financial loss.
• Investment in infrastructure companies risk: The value of investments in Infrastructure Companies may be negatively impacted by changes in the regulatory, economic or political environment in which they operate.