As the saying goes, “what a year!” As the world slowly emerged out of Covid lockdowns, two central themes have dominated 2022, inflation and geopolitics. Domestically the annual CPI figure has exceeded 7%. It has been a similar story across most economies globally as a cocktail of years of low interest rates, central bank driven liquidity in the form of quantitative easing, severe supply chain disruptions caused by Covid lockdowns and the Russian invasion of Ukraine placing pressure on commodity prices have all contributed to the current inflationary environment. As a result, interest rates have gone up with key central banks committed to raising rates until inflation shows signs of abating. The rising interest rate environment has fueled volatility in markets with no asset class spared as assets have repriced for the higher interest rate environment. Needless to say, it has been a challenging time for diversified portfolios as equities and bonds have both sold off.
Additionally, as the market has tried to digest the prospect of higher inflation, we also witnessed a sharp rotation into sectors and stocks that were viewed as being beneficiaries of higher inflation such as energy stocks, with sectors such as healthcare and technology selling off irrespective of the quality of the company.
Despite the challenging market environment there have been some bright spots. Alternative assets have generally benefited from the increased market volatility and dispersion in returns. Unlike traditional assets, higher volatility is more conducive to alternative strategies such as relative value approaches as they can exploit market inefficiencies. Value-based investment approaches have also turned around a decade of underperformance relative to growth-style investing as growth stocks, which are viewed as longer duration assets, have been sold off. We have also seen many active approaches able to add value in this challenging period for markets as active investment managers have been able to sift through the market as asset have indiscriminately sold off. Finally, bonds which have been difficult to invest in for years due to the low interest rate environment are beginning to show signs of value as bond yields have risen.
In 2023 the themes of inflation and heightened geopolitical risk are expected to continue to be key focal points. However, the narrative will increasingly focus on the prospect of a recession as the impact of higher interest rates makes its way through the economy impacting households and ultimately demand which we expect will make its way to corporate earnings by Q3 in 2023. At this stage our base case is not for a deep recession in Australia. However, on a global level Europe remains at greater risk of a deep recession as high inflation combined with energy security concerns resulting from geopolitical risks associated with the war in Ukraine continue to impact European markets. Central banks appear to be comfortable with the prospect of a recession as long as inflation is controlled. Against this backdrop we have been gradually neutralising our key active asset allocation exposures away from risk assets in favour of bonds.
The year ahead will be challenging with markets likely to range trade. Our dynamic asset allocation has added significant value over recent years as the decision to be long equities and underweight bonds was a relatively simple one. We expect that bottom up manager and stock selection will be a greater contributor to returns in 2023 as we continue to see increases dispersion in returns within asset classes as market volatility remains.
On behalf of the Lonsec Investment Solutions team we wish everyone a peaceful festive period and we look forward to working with each of you in 2023.
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