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A Sense of Trepidation

6 Jan 2023

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Produced by Bloomberg Media Studios in partnership with Standard Chartered.

As we end 2022, I have huge concerns when looking to 2023. After the year we have just had, that might sound obvious. However, my concerns are probably different to those of most investors.

As Standard Chartered’s Group Chief Investment Officer, I see my job as being twofold. First, coming up with market views that help investors outperform in the short term (6 to 12 months). Second, helping clients achieve their long-term financial objectives, which in the main means fighting behavioral biases and staying invested through the market cycle and, if possible, averaging into markets on weakness.

As we head into 2023, my trepidation is on both fronts. Let’s start with the first objective. We are underweight equities heading into the new year. From an economic perspective, this makes huge sense. While equities are already down significantly, we attach a high probability (75%) to a US recession in 2023. The consensus expectation is for corporate earnings to grow by mid-single digits next year. However, in recessions, earnings usually fall, and when they do, they fall sharply. Therefore, assuming a recession does hit, the adjustment process to earnings expectations could create a pretty stiff headwind for equities. Meanwhile, the stock market has never troughed before a recession started. To me, this is a very compelling narrative.

However, when you look at other historical perspectives, the picture gets a little murkier. First, looking at the last 11 post-war recessions, the average peak to trough drawdown in the US equity market has been 27%. In 2022, the peak to trough was – you guessed it – 27%. So arguably a recession was, at one point at least, already priced in. One could argue, therefore, that even if a recession were to occur, it would not lead to further significant downside to equity markets.

PvB article 7 - A Sense of Trepidation Chart 01

Meanwhile, looking at the calendar year performance of equities over the past 150 years (in the chart above), US equities tend to rebound strongly from severe contractions (the main exception being the 1930-32 Great Depression). That said, what has made 2022 so painful was not that the equity market performance was so poor – in a historical context there was nothing extraordinary about this year’s equity market weakness – but that bonds failed to provide a buffer for investors. Therefore, while this chart hints that the majority of equity market weakness may be behind us, the performance in 2022 was not extreme enough to strongly indicate that equities should rebound significantly in 2023.

The good news is the same chart for the US 10-year government bond is pretty compelling.

PvB article 7 - A Sense of Trepidation Chart 02

So far this year, the performance of the US 10-year government bond has been among the 4 worst in more than 150 years (before the November decline in yields, it was the worst). However, you can see from previous years of extreme losses that bonds rebounded strongly in the following 1 to 2-year period.

These charts look promising for investors, so why the trepidation? When trying to outperform, being underweight equities is a risky strategy. The odds are against you. Equities outperform bonds two-thirds of the time. Therefore, when you go underweight, you have to be right on the macro environment and how this will feed into stock market performance, especially after the market has experienced a year like 2022. What could go wrong? A recession fails to materialize on the time horizon we expect, or earnings do not adjust as much as they have historically, or we merely see a reversal of 2022 such that valuations increase and more than offset the downside adjustment in earnings.

However, it is my second objective I am even more concerned about, as I believe being invested in an appropriate foundation portfolio is far more important than any 6 to 12 month tilts you make to that portfolio. On this front, investors have been scared away by the experience of 2022 and are likely under-invested going into 2023. This has likely been exacerbated by the growing narrative that the 60:40 equity:bond portfolio is dead. While we believe diversifying away from just these two asset classes makes sense, they should still make up the bulk of your investment portfolio, especially when there are increasing signs that inflation has peaked.

To me, the above charts suggest that long-term investors should not be under-invested at this part of the market cycle. Of course, the exact path of the recovery is uncertain, but it looks highly likely that investing today will be profitable over the next two years if one just refrains from over-reacting to short-term market moves.

I worry this message is likely to fall on deaf ears. We launched four multi-asset funds in October, in conjunction with Amundi. When preparing for the launch, we felt it was a great time to launch from a market timing perspective. However, we knew it would be an uphill struggle from a marketing perspective, given how raw the scars are from the investment losses this year. Unsurprisingly, an uphill struggle is indeed how things have worked out. However, successful investors are likely to punch through the noise and refocus on their long-term investment plans by staying invested and averaging into both equities and bonds on weakness.