Global Real Return: Our 2023 Outlook

The last 12 months have been characterized 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 labor 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 normalization 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. We believe great power competition, as domestic politics becomes more inward-looking and less accepting of globalization forces, represents an opportunity for sectors such as defense as countries scramble to bolster their military muscle; and we see the transition to cleaner energy as underpinning 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 for us 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 decarbonization, 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 used as a diverse source of return, offering what we perceive to be generally low equity-market beta and often including inflation-protection properties.

Diversified Hedging Strategies

The portfolio’s stabilizing 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 stabilizing layer. As an unconstrained strategy, Global Real Return has a variety of tools at its disposal which are often less than perfectly correlated with more traditional assets. In some portfolios these may include strategies such as alternative risk premia. We factor in such assets’ liquidity profile from the outset, both in terms of position sizing and the rigor 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 lackluster 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 favorable 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 believe 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 favor 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, and on seeking to ensure that our toolkit of assets is well suited to a regime of structurally higher inflation. We believe 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.