Q4 2022 Investment Market Update
The fourth quarter of 2022 brought some much-needed relief for investors as markets climbed after a challenging previous three quarters. We saw a strong rebound from October, with markets rallying as much as 10% to late November, before retreating throughout December. Australian equities generated strong returns for the quarter outperforming international equities. Currency markets remained volatile as the Australian dollar appreciated around 3% against the USD.
We do not believe the market rally was born out of any single event but can be explained by a handful of positive markers seen throughout the quarter:
The bond market has stabilised and stemmed its bleeding, which has been supportive for equities.
The ‘street’ continues to talk up and anticipate some sort of pivot in monetary policy as the likelihood of an economic slowdown/recession continues to increase.
Year-on-year inflation remains high however recent inflation prints have come in lower than analyst expectations.
China announced a pivot in their COVID-19 strategy, retiring their zero covid stance.
In total, we believe the rally had little fundamental fuel and question the longevity of recent performance, particularly in the short term.
Throughout the quarter, the Reserve Bank of Australia (RBA) increased rates from 2.35% to 3.10%, whilst the US Federal Reserve increased rates from 3.25% to 4.5%. We anticipate Central Banks will continue to hike rates during the first half of 2023, albeit at a slower rate compared to the increases seen in 2022, and potentially pausing hikes in the back half of 2023.
Inflation continues to be a major focal point for Central Banks. In December, the inflation rate in the US eased to 7.1%, below analyst expectations. Year-over-year inflation peaked at 9.1% in June, and since then, monthly readings have steadily declined. Whilst headline inflation has cooled, other economic indicators across the labour market & wage growth remains remarkably strong. Whilst the economy remains so resilient, we see the likelihood of a policy pivot remaining low and therefore we see restrictive policy settings being in place well into 2023.
From a portfolio perspective, our investment portfolios climbed throughout September & October and declined in December, ending the quarter up between 3.5% & 4.1%, depending on the strategy. The investment committee was active across the portfolios during the fourth quarter which I will detail later in this note. The portfolios ended the fourth quarter marginally underweight equity exposure, overweight property & holding some deployable cash which adds optionality to the portfolio.
INTERNATIONAL EQUITIES
International Equities rose during the December quarter returning 4.18% but returned -12.05% on the year. Currency was a detractor of performance as the Australian dollar rallied more than 3% against the US dollar. Our international equity allocation outperformed by roughly 2% during the quarter as both currency hedging and our Asian overweight performed well.
Drawdowns in markets throughout 2022 were largely associated with multiple compression. To date, corporate earnings have remained resilient and, in many markets, increased throughout 2022. There is an argument that rising costs due to inflation and higher interest expenses are yet to filter through to company earnings & should this eventuate, markets may drift lower. This may occur in the short term. We continue to believe an emphasis should be placed on high-quality businesses that can both manage expenses and pass-through increased costs to end users.
One positive development seen in the final quarter of 2022 was a clear pivot of China’s Covid policies, downplaying the severity of the virus and easing several Covid restrictions. Our view is that China is well on a path to reopening and we anticipate this will be supportive for their equity market, in line with many other covid reopening stories seen globally over the last couple of years. Sentiment across Chinese equities has been notably poor throughout 2022 with many market commentators declaring the region as un-investible. As we have seen in the past, these periods of extreme negative sentiment and blanketed indiscriminate selling can often create opportunities when sentiment turns. We suspect that as China’s reopening continues to gather steam, investor sentiment will improve & Chinese equities should continue to re-rate in the short term. The portfolios are well-positioned to take advantage of this.
In early December, the investment committee elected to reduce the portfolio’s exposure to international equities. The magnitude of the market rally throughout the quarter caused the equity allocation of the portfolio to drift from a neutral allocation to an overweight position. We did not believe an overweight position to equities was warranted given we see heightened risks to the downside as we are yet to see any repercussions of tighter monetary policy reflected in company earnings. The proceeds were utilised to fund a new position in the enhanced income allocation of the portfolio.
Throughout the quarter we also increased the level of hedging across the international equity allocation of the portfolio. We anticipate this to enhance returns if we see markets return to a risk-on environment that may see an appreciation of the Australian Dollar.
AUSTRALIAN EQUITIES
Australian equities rose strongly during the third quarter returning 6.54%. Australian equities fared well during 2022 on a relative basis, returning -1.08% for the year. Our Australian equity allocation underperformed during the fourth quarter as materials and large-cap equities generated strong returns, two pockets we remain underweight.
The Australian equity markets sector composition led to satisfactory performance relative to other global markets throughout 2022. Our market is dominated by the materials sector through both BHP & RIO, but also the financial sector through our major banks. Both these sectors are value-orientated and were less impacted by the PE (price/earnings) multiple compression seen throughout 2022.
As mentioned above, we are still yet to see any substantial impact from higher rates and dwindling sentiment, filter through to company earnings. We will be paying close attention to announcements in the coming months. Saying this, we believe some sectors of the market are more at risk than others. More cyclical pockets of the Australian market, such as commodities, may face some pressure as global economies slow and the demand for raw materials fades, however this could be supported in the short term by a re-opening China. The same can be said for the consumer discretionary sector, where demand may dwindle as the belt tightens around the consumers’ wallet.
We continue to believe the best opportunities may be found across mid and smaller companies. We categorise these businesses as quality growers who will be able to grow independently of the economic cycle by riding a wave of innovation & long runways of growth. For many of these names, fundamentals remain relatively unchanged and may offer an appealing entry point for investors with a long-term horizon.
The Australian equities allocation of the portfolio went unchanged throughout the fourth quarter of the year.
PROPERTY & INFRASTRUCTURE
Property and infrastructure both added to portfolio performance during the quarter. Australian listed property returned 11.56% whilst global listed infrastructure returned by 5.15%.
During the quarter, the committee elected to change the composition of the portfolio's property allocation from a majority unlisted to listed exposure, seeking to take advantage of the discounts available across listed property.
The higher-than-expected jump in interest rate expectations and increased concerns over the near-term economic cycle has warranted some adjustments in the valuation of listed property. However, the magnitude of the change in listed property prices appeared to be excessive in our view. Whilst we foresee some declines in the valuation of commercial real estate globally in the coming months, we do not believe the impending correction will be anywhere as severe as what public markets were pricing in. Many publicly traded real estate investment assets were trading at substantial discounts to their net asset values (more than 20-25%). As such, the discounted valuations would appear to create an opportunity for investors.
Our direct property exposures had been resilient throughout 2022 and were not subject to the drawdowns we have seen across publicly traded real estate. Essentially allowing us to sell high and buy low. Looking forward to 2023, I struggle to see how unlisted property trusts will be able to complete appraisals at increased valuations meaning investors will likely need to rely on rental income and capital improvements to drive returns.
We still retain an overweight position to infrastructure assets as we believe the assets are trading at sound valuations and should provide defensiveness and consistency to the portfolio. However, we do recognise there are more investable alternatives to listed infrastructure today, relative to what there were 12 months ago.
PRIVATE EQUITY & VENTURE CAPITAL
Our private market exposures generated positive returns for portfolios in Q4. Noting we are still awaiting the end of December valuation for some assets.
Private Market Valuations have been incredibly resilient throughout 2022 against a backdrop of one of the worst-ever periods for stocks and bonds. There is an argument that the valuation of a Private Equity Fund should be driven by the underlying performance of the companies it is invested in - rather than the surrounding market sentiment and emotional bias’s that influence publicly traded equity valuations. Despite this, there are a number of ways private assets can be valued and there is a large amount of dispersion in methodologies across the universe. We remain cautious around stale valuations and allocating to the sector blindly. Instead, we favour allocating to skilled managers who can identify value & attractive opportunities with a preference for fresh pools of capital to hunt said opportunities.
The outlook for private equity is somewhat cloudy at current. On one hand both the ease of financing and borrowing costs have worsened throughout 2022, however on the other, the opportunity set for managers with dry powder is likely very favourable given the uncertain economic backdrop. We maintain exposure to the asset class albeit at a relatively neutral position.
There were no changes to the private equity allocation of the portfolios during the fourth quarter.
FIXED INCOME & BONDS
Bonds snapped their losing streak during the fourth quarter of 2022 returning 0.56%. Whilst the bond market remains volatile, the sector has stemmed the declines seen in the first half of 2022. Bonds were underwhelming for most investors throughout 2022 given they were unable to provide the defensive characteristics and diversification that many rely on them for. Australian bonds returned -8.71% on the year.
The bond markets have undoubtedly been the most interesting part of the investment landscape given the asset class underpins the valuation methodology for almost every other asset. The key market theme has been the Central Banks fighting inflation with fast-paced, globally coordinated rate hikes. Current inflation rates imply that much higher cash rates are still needed, but there is uncertainty in the ability of economies to tolerate higher rates.
Government bond yields rose substantially throughout 2022, the Australian 10-year rose from around 1.7% to over 4% whilst shorter duration bonds such as the 1-year now yield more than 3% vs roughly 0.3% 12 months ago. This is a dramatic reset across a brief period and vastly improves the attractiveness of bonds relative to other asset classes on a forward-looking perspective.
For bonds with a greater degree of credit risk, concerns of potential economic weakness have seen credit markets weaken this year, with credit spreads increasing significantly as traded credit markets have actively repriced the risk of recessions and company defaults. Credit spreads are now well above the average level seen over the past 10 years and may offer positive returns through spread compression assuming they revert to historical averages.
This combination of a material rise in yields and credit spreads has been beneficial for the asset class and forward-looking returns are attractive with yields on offer at the highest levels in over 10 years. Diversified credit portfolios are now generating high single-digit to low double-digit yields depending on the level of credit risk. We view this as highly beneficial for investors given the asset class can now generate equity-like returns from a lower-risk part of the capital structure.
During the quarter we took a new position in credit seeking to capitalise on the dynamic discussed above. From a credit risk perspective, our enhanced income allocation remains very defensive which provides us with the opportunity to continue pursuing this strategy into 2023.
2022 was certainly a year to forget for investors as both stocks and bonds had one of the worst periods for many years. Fortunately for many Australian investors, Australian equities fared ok, and the home bias exhibited in many portfolios lessened the impact. Traditional 60:40 equity/bond portfolios underperformed against more modern investment approaches (like Arrow Private Wealth’s Investment Philosophy), as equities and bonds went through a period of abnormally high correlation which made it difficult to stem drawdowns.
On the year Arrow’s returns varied from -8.8% to -11.63% depending on the strategy, with a couple of positions to still finalise end-of-year numbers. The committee was able to add value from an asset class perspective (meaning we are overweight asset classes that performed well and underweight asset classes that performed poorly). However, our equity allocations both underperformed their respective benchmarks for the year, particularly in the first half of 2022.
Looking forward, the range of outcomes for markets and economies continues to be highly uncertain. The narrative for investors will be around whether the Central Bank policy settings priced into markets will be enough to tame inflation and what impact this will have on economies. With the goldilocks (soft landing) scenario, being reseeding inflation with limited economic impact, however, the odds of this are becoming increasingly slim.
Our investment committee continues to position portfolios for a range of economic outcomes ensuring we have assets that will be beneficiaries of varying scenarios. This is done by repositioning capital towards asset classes where there is less dispersion of expected return outcomes depending on where the economic outcomes land, whilst maintaining awareness of our desired long-term positioning.
We continue to believe the decline in multiples represents an opportunity for investors with long time horizons. At these levels investors can invest in equities and benefit from multiple expansion rather than compression, should markets revert to historical averages. Saying this, in the short term the earnings side of the valuation equation may face pressure and markets could drift lower.
One substantial change going into 2023 is the return available on risk-free assets, such as cash and term deposits increasing from 0% to 3% - 4% throughout 2022. Going forward this should reset return expectations across all other assets classes, assuming the return premium investors demand adding incremental risk remains consistent. Given the higher forward-looking returns on lower-risk investments, investors no longer need to reach so far up the risk spectrum to achieve their return objectives. Alternatively, should the level of risk in a portfolio remain consistent, the expected forward-looking returns are now higher. A good result for investors.
Now for some sport. Whilst I certainly fall into John Kenneth Galbraith’s camp of believing “there are only two kinds of forecasters: those who don’t know, and those who don’t know they don’t know,” it would not be any fun if I finished this report without making some predictions for 2023. So, for 2023 I will unashamedly make the following predictions:
Central Banks will moderate the pace of rate hikes during 2023, however there will be no cuts to rates during the year.
Bond yields will end 2023 lower than where they were entering the year.
Emerging Market equities will be the strongest-performing sector of the equity market, buoyed by a reopening of China and an unwinding USD.
Listed property will outperform their unlisted counterparts.
Cryptocurrency will enter a long winter, but Bitcoin will base out at a level higher than the 2019-2020 winter.
The AUD will appreciate against the USD.
The value factor will outperform the growth factor. Albeit at a narrower margin to that seen in 2022.
Australian residential property prices will decline further throughout 2023. Declines in 2023 will be worse than those seen in 2022.
Of our investment universe, credit portfolios of moderate risk will be the best-performing asset class in 2023.
Let us review in 12 months……
I would also like to take this opportunity to thank our investors for their continued support through what has been a challenging year for both markets and many people personally. As always, should you have any queries about any of the material outlined in this letter then please do not hesitate to reach out to me.
Kind regards,
Ryan Synnot
Associate Director, Investment Research & Solutions