December 2022
A year ago, we communicated that inflation and geopolitical risks would dominate 2022. Early in 2022, we predicted the recession would strike within 18 to 24 months. We now expect that the outlook for 2023 will be dominated by the following economic drivers: US and global recession, volatile inflation outcomes, and continuing geopolitical risks. This provides tremendous challenges to traditional equity and property-centric portfolios and great opportunities for unconstrained active management. Let us explore three ways we expect to benefit from this outlook to position and profit in 2023.
(1) Precious Metals and Other Commodities
Inflation has peaked for now. Demand is in decline, and recession is looming, with cooling inflation due to weakening economic growth and the delayed effects of a rapid monetary policy tightening cycle. Inflation is not a spent force, however, and increasing inflation will likely return post-recession due to policy and geopolitical settings. At the same time, given the large structural challenges, including huge debts and fiscal deficits, central banks are unlikely to continue with sufficient tightening for long enough to prevent inflation’s eventual return. Mismanagement of energy and commodity policy, low workforce participation and China’s reopening will likely see higher inflation, energy and commodity prices than has been the case in many prior recessions.
Geopolitical risks remain extreme, and war is a highly profitable business for some instrumental people and entities, with the Pentagon again being unable to pass an audit.
The war in Ukraine is at risk of escalation and is no closer to being resolved. The Middle East remains a risk, and China and Taiwan remain unresolved. Politically the world appears to be fracturing both regionally and ideologically, and many important countries are now openly flouting US hegemony and working on deepening and developing their own trading and financial relationships.
Precious metals was our favoured asset class for 2022 (and one of its top performers) and remains a must to own given the political and economic environment. Gold could easily reach new highs in 2023, offering diversification and some reasonable prospect of substantial gains. As part of a diversified portfolio, we also perceive opportunities in oil, uranium, speciality metals and food.
(2) Active Management, Hedging and Shorting
At the asset class and stock level we perceive numerous opportunities to preserve and add value in 2023. Equity markets are likely to be weak into an earnings recession in the first half of 2023 as decreasing earnings are not priced in and may hence provide opportunities for increased weightings as realism returns. Dynamic asset allocation enables meaningful asset class movements, such as taking advantage of the current rally to sell or hedge equities, hence owning low equity weightings today while being ready to buy equities or high-yield credit when they offer a sufficient risk premium and a better outlook.
Even bonds may provide opportunities. Convertible bonds currently appear attractive as equity substitutes and offer better downside protection. Government bonds with duration have two-sided risks albeit they may still suffer under structural inflation, capital withdrawals or central banks unexpectedly holding their nerve and keeping policy tight for longer. Nonetheless, they will likely provide tactical opportunities to own small weightings.
Liquid alternatives and trading strategies appear attractive for their low market sensitivity and their ability to protect capital. These include long/short approaches, relative value opportunities, contrarian trading, carbon trading and event-driven strategies. These strategies don’t rely upon favourable equity markets to do well and provide a cash alternative, offering better capital preservation in weak markets. It is not necessary to lock up money for 7-10 years in illiquid alternatives to get the benefits of diversification, as liquid strategies provide attractive opportunities while so many stocks remain overvalued..
Investors in large commercial property managers like Blackstone are finding out that favourable published returns are not available to them when they want to redeem. Investors in some large Australian super funds could also potentially suffer similar issues, particularly if economic and financial market conditions further deteriorate.
Stock picking will likely offer good opportunities into 2023, both long and short and even among some very large market leaders. Tesla looks to be the gift that keeps on giving on the short side, with the reality of strong competition, insider sales and lower growth in a recession bringing the company’s valuation back down to earth. (We have successfully shorted Tesla more than once in 2022 and will likely do so again). Numerous still highly priced growth stocks are likely to disappoint further and will provide good hedging opportunities during market weakness in the early part of 2023. Companies like Zoom still fall into this category. Numerous “high promise” but currently unprofitable companies have had a disastrous 2022 whilst diluting shareholder equity by issuing large share and option incentives to management. Many large quality companies and household names where investors are hiding also appear overvalued; companies like McDonalds and Coca-Cola are trading at greater than 30 times earnings with modest growth and consumer sensitivity. Blackrock provides an opportunity to short passive management. Many commercial property stocks will likely be strong shorting opportunities, given the sector’s disastrous outlook.
Later in 2023, there may be significant opportunities on the long side in small caps and selective growth companies to play a recovery. On the long side, selective resource stocks still offer good longer-term opportunities, but many managers need to be avoided in the space due to demonstrably poor risk management and track records. If 2022 has proven anything at all about many money managers, it is that too many are like passive funds and rely upon rising markets, offering little risk management or capital preservation on the downside. Poor downside risk management can reveal who to avoid and switch away from!
(3) Genuine Diversification and Differentiation
Uncorrelated assets and strategies combined provide superior risk-adjusted returns to any one of the underlying components. Investing in multiple assets across various strategies provides greater downside protection. A diversified portfolio provides the owner with the knowledge that their risk is substantially lowered in a precarious and uncertain world compared to betting on any one outcome such as in equity or property risk alone. No matter how experienced you are, you never know anything for sure in this crazy world full of bad actors, and hence it is prudent to be protected from concentrated risks.
We expect that markets will remain challenged in early 2023 as economic mismanagement, increased corruption and malfeasance, geopolitical, valuation, and volatile inflation and interest rate pressures continue haunting broad market outlooks. This will again prove highly challenging for passive management, which must wear all these factors to its detriment. Genuine active management, fundamental research, risk management and conservatism appear essential in this environment.
We still see the end of a previously favourable period of globalisation and peaceful prosperity. Wages pressure, demographic issues and greater protectionism, regionalism, autocracy and greater socialism, along with less workforce participation, mean the labour and capital balance is shifting. Higher structural inflation and volatile inflation outcomes in coming years, along with various tail risks, must be carefully considered when building a portfolio and mean that the portfolio of the 2020s should be fundamentally different from years past. It is essential to be more conservative and have better diversification in this environment rather than simply gambling on strong financial asset returns, as the latter approach is best suited to a period that has now gone. 2022 has shown that many bottom-up investors who ignored these crucial top-down factors have been severely punished, for example, by holding large allocations to growth stocks or investing in what were traditionally defensive investments such as government bonds.
DISCLAIMER: WealthLander Pty Ltd ACN 646 957 119 is a corporate authorised representative (CAR; WealthLander) of Boutique Capital Pty Ltd (BCPL) ACN 621 697 621 AFSL 508011, CAR Number 1285158. CAR is the investment manager of the WealthLander Diversified Alternative Fund (Fund).
To the extent to which this document contains advice it is general advice only and has been prepared by the CAR for individuals identified as wholesale investors for the purposes of providing a financial product or financial service under Section 761G or Section 761GA of the Corporations Act 2001 (Cth).
The information herein is presented in summary form and is therefore subject to qualification and further explanation. The information in this document is not intended to be relied upon as advice to investors or potential investors. It has been prepared without considering personal investment objectives, financial circumstances or particular needs. Recipients of this document are advised to consult their own professional advisers about legal, tax, financial or other matters relevant to the suitability of this information.
The investment summarised in this document is subject to known and unknown risks, some of which are beyond the control of CAR and its directors, employees, advisers or agents. CAR does not guarantee any particular rate of return or the performance of the Fund, nor do CAR and its directors personally guarantee the repayment of capital or any particular tax treatment. Past performance is not indicative of future performance.
The materials herein represent a general summary of CAR’s current portfolio construction approach. Depending on market conditions and trends, CAR may pursue other objectives or strategies considered appropriate and in the best interest of portfolio performance.
There are risks involved in investing in the CAR’s strategy. All investments carry some level of risk, and there is typically a direct relationship between risk and return. We describe what steps we take to mitigate risk (where possible) in the Fund’s Information Memorandum, which must be read prior to investing. It is important to note that despite taking such steps, the CAR cannot mitigate risk completely.
This document was prepared as a private communication to clients and is not intended for public circulation or publication or for the use of any third party without the approval of CAR. While this report is based on information from sources that CAR considers reliable, its accuracy and completeness cannot be guaranteed. Data is not necessarily audited or independently verified. Any opinions reflect CAR’s judgment at this date and are subject to change. CAR has no obligation to provide revised assessments in the event of changed circumstances. To the extent permitted by law, BCPL, CAR and its directors and employees do not accept any liability for the results of any actions taken or not taken on the basis of information in this report or for any negligent misstatements, errors or omissions.
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