Below market views are provided by the respective fund house.
Global equities experienced pressure in 2022 following an impressive run of performance in 2021. Investors appeared to grow concerned that the lagged effect of higher rates would lead to slowing growth and weaker corporate earnings in 2023.
The Healthcare sector modestly declined during the period although it significantly outperformed global markets. The sector provided relative protection in the challenging market environment and was the third-best performing sector in 20221. The biotechnology and healthcare providers & services sub-sectors performed best providing solid absolute returns, while healthcare technology and life science tools & services companies underperformed during the year.
We see compelling reasons why the healthcare sector warrants a long-term allocation in the current economic environment. Global healthcare equities have outperformed the broader market by over 3% (annualized) since 1995.2 The sector has historically delivered strong outperformance throughout economic cycles, particularly during economic downturns. Its defensive characteristics should help the sector outperform the broader equity markets through a full market cycle, while its propensity for ground-breaking innovation will provide strong growth avenues. New methods in treatment and prevention will continue to drive long-term governmental spending toward healthcare products and services. Additionally, the underlying secular trends of ageing demographics, medical advancements, and profound unmet medical needs support long-term investments in global healthcare companies.
Structural investment opportunities
We believe there are investment opportunities in select companies within the healthcare sector that offer the potential for strong long-term outperformance.
The COVID-19 pandemic has invariably created structural changes to the healthcare industry providing enhanced opportunities for innovation across the sector. Several diagnostics and tools companies as well as biopharmaceutical companies have generated incremental returns due to the sales of vaccines, diagnostics, and therapeutics developed to combat the virus. As we had anticipated, many of these companies have reinvested these excess cash flows to augment their discovery capabilities, capital spending and pipeline investments, thus compounding further advances in non-COVID unmet medical needs.
Further, emerging evidence of the health outcomes of patients previously infected with COVID increases the importance of addressing such unmet medical needs. As a result, pursuing treatments and advancements for other unmet medical needs (serious illnesses without existing treatment or prevention) remains a core focus for the industry – these include cancer, rare diseases, and central nervous system disorders.
As we transition to a post-COVID environment, we expect innovation to accelerate across the sector as we believe it is poised to reap the rewards of the structural changes it has experienced as a result of the COVID pandemic.
1 FactSet, as of the end of December 2022.
2 Manulife Investment Management, January 2023.
Whilst headline inflation is expected to be lower next year, we see long-term drivers keeping inflation above pre-pandemic levels. ‘Stickier’ inflation is likely to be driven in part by a trend we’re seeing in the natural resources space, where underinvestment in supply is leading to higher prices; this inflation driver won’t be remedied through higher interest rates. We don’t believe commodities and natural resources equities will be immune to weaker global economic growth caused by central banks tightening monetary policy.
On the supply side, commodity supply is being heavily constrained by producers’ continued focus on capital discipline following years of underinvestment. This has in part been driven by investor pressure on companies to prioritise shareholder returns over production growth. Turning to the financial health of natural resources companies, levels of debt have been dramatically cut and today, the mining companies have amongst the strongest balance sheets out of all sectors globally. Meanwhile, the companies continue to trade on attractive valuations, in our view, both relative to their history and relative to broader equity markets.
In short, we see a strong argument for adding to gold and gold equities for diversification benefits. The Russia Ukraine crisis, higher energy costs, and rising interest rates put much greater uncertainty around global economic growth. Significant inflationary pressures look likely to persist, whilst we see central banks as unlikely to slam the breaks on monetary policy. This suggests to us that real interest rates are more likely to move lower than higher, which should be supportive for gold. Encouragingly, we have seen a marked change in behaviour in the sector with companies returning this capital to shareholders in the form of dividend increases and share buybacks.
We do, however, see cost inflation as a risk for the gold equity sector and have been rotating the portfolio towards those companies we see as least vulnerable. We continue to manage the portfolio with a quality bias so are focused on companies with stronger-than-average balance sheets, lower-than-average costs, higher-quality management teams and better ESG credentials.
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US rapidly rising consumer prices in 2022 has compelled the Federal Reserve (Fed) to respond with aggressive interest rate hikes. Unsurprisingly, fixed-income asset classes, including preferred securities, have endured a challenging period. In 2023, higher rates are likely to hamper growth and possibly push the US economy into recession. However, we believe that there are various tools within the preferred securities space that we could bring to bear, along with three investment themes that could prove supportive. In our view, when the Fed pivots in its rate hikes policy, we think this would be positive for preferred securities, which have strong rebound potential. The current low level may be an attractive entry point for income seekers.
Three themes underpin preferreds in 2023: Higher quality, favour utility, and duration management
We have identified three themes that should underpin preferreds should the US head into an economic slowdown or a mild recession in 2023.
The biggest of these themes is the quality play. We know that the Fed’s goal is to bring down inflation and that they can only do this by slowing the economy. As such, we have to be careful in avoiding securities that are susceptible to spread widening. While most preferreds are issued by high quality companies, there are some low quality preferreds that we need to stay away from. Also, because of the market conditions, we would expect defaults to rise in the high-yield market. This is why we have been focusing on quality companies, default risk will not be a big worry.
Next, our second theme is continuing to favour the utility sector. We believe that many sectors within the S&P500 will struggle in 2023, with their earnings likely to face downward pressure. In contrast, utilities will show their resilience once again, by maintaining their allowable earnings growth of between 5 to 7 percent, which we believe will outpace that of many other sectors.
Finally, our third theme is increasing in duration. If the Fed slows down and eventually pause rate hikes into 2023 – as is widely expected – this would be positive for preferreds. This is because they tend to perform well when rates are stable or declining. Now that we believe we are nearing a peak in rates, we have started thinking about increasing duration again.
2022 has been a stormy year for bond investors, and the forecast calls for more of the same.
The Storm: Global Slowdown, Stubborn Inflation
Rising prices continue to confound expectations that slowing global growth will ease inflation pressures. While the US Federal Reserve and other central banks are aggressively hiking rates to combat inflation, most drivers of today’s high inflation are outside of central banks’ control. The Russia-Ukraine conflict and the pandemic continue to disrupt fuel, food and goods supply chains, feeding high inflation and throttling global economies.
Sticky inflation may compel central banks to tighten monetary policy still further, which increases the potential for a global recession. In turn, fear of recession is leading investors to take refuge in the US dollar, the world’s reserve currency. As their own currencies tumble, other countries feel the pain of both the strong dollar and higher interest rates. Emerging-market (EM) countries are especially vulnerable, since their sovereign debt is often issued in US dollars; when the dollar strengthens, their debt burden increases. Financial market turbulence may be here to stay for some time.
The Silver Lining: Higher Yields
The risk of recession is contributing to market volatility and episodic liquidity challenges, but it’s also creating opportunity. Investment-grade corporate yields and spreads are at multiyear highs.
The specter of a recession usually scares investors away from corporate debt. Credit fundamentals tend to have weakened prior to any slowdown, causing issuers to enter a downgrade and default cycle as growth and demand slow further. But today’s situation is different.
Today’s issuers are in better shape financially than issuers entering past recessions. The corporate market went through a default cycle just two years ago when the pandemic hit. The surviving companies were the strong ones—and they’ve managed their balance sheets and liquidity conservatively over the past two years, even as profitability recovered. Thus, we expect defaults and downgrades to rise only to average levels over the next year.
Meanwhile, today’s higher yields signal higher potential returns ahead. For example, the high-yield sector’s yield to worst has been a reliable indicator of high-yield return over the following five years.
In fact, high-yield bonds performed predictably through the global financial crisis, one of the most stressful periods of economic and market turmoil on record. During that period, the relationship between starting yield and future five-year returns held steady, thanks largely to bonds’ consistent income stream.
Four Strategies for Surviving and Thriving
Below are some tips on how active investors can rise to the challenge in today’s environment.
1. Be nimble: We expect heightened volatility and liquidity challenges to persist. Active managers should be ready to take advantage of quickly shifting valuations and fleeting windows of opportunity as other investors react to headlines.
2. Seek (inflation) protection: Because inflation is likely to remain elevated for some time before it falls back to target, explicit inflation protection, such as Treasury Inflation-Protected Securities and CPI swaps, can play a useful role in portfolios.
3. Lean into higher-yielding credit: Yields across risk assets are much higher today than they’ve been in years—an opportunity investors have been waiting a long time for. “Spread sectors” such as investment-grade corporates, high-yield corporates and securitized assets, including commercial mortgage-backed securities and credit risk–transfer securities, can also serve as a buffer against inflation by providing a bigger current income stream.
4. Choose a balanced approach: Global multi-sector approaches to investing are well suited to a quickly evolving landscape, as investors can closely monitor conditions and valuations and prepare to shift the portfolio mix as conditions warrant. Among the most effective active strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.
This approach can help managers get a handle on the interplay between rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.
For now, we encourage bond investors to fix their eyes on the horizon. By taking a longer view, investors can avoid overreacting to today’s headlines—even as they shift tactically to capture opportunities that arise when other investors overcorrect.
Source: AllianceBernstein, as of December 2022.
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Macro is back on centre stage
The current conditions of elevated inflation and higher interest rates have put macro back on centre stage. The overriding question facing investors over the coming months is when the global monetary tightening cycle ends. There will likely come a point when inflation eases sufficiently that policymakers can prioritize supporting slowing economic growth. In our view, developed-market central banks are expected to begin easing before the end of 2023.
What to watch in the coming months?
While the next few months may be challenging, there are several market events that could offer opportunities:
1. A rollover in U.S. dollar strength
2. Is now the time to return to emerging markets?
3. Value vs growth stocks? Which style will outperform?
Our asset allocation views
On a dynamic basis, we are relatively more positive towards U.S. dollar assets, Southeast Asian equities within Asia ex-Japan, and select sectors within US equities. High-quality equities can potentially offer capital appreciation and dividends and relative protection if earnings come under pressure. We see tactical opportunities in Chinese debt and in China and Hong Kong equities, given recent easing of COVID restrictions and property support measures. We believe US investment-grade credit is becoming increasingly attractive in terms of yield and capital appreciation and real assets can provide an inflation-hedge and diversification properties in portfolios.
On a strategic basis, we remain structurally overweight in EM debt although EM debt’s relative return profile is slightly lower for the time being. Income-oriented portfolios may benefit from exposures to alternatives/real assets and natural yields (the cash generated from invested income sources). We think REITs (Real Estate Investment Trusts) can generate stable and higher-yielding income over the long term, while offering traditionally less volatility than equities.
Capture opportunities with agility, diversification, and outcomes in mind
Having an agile investment approach is so important during times of uncertainty. Each sector of the economy or asset class can perform differently from another at any time in a market cycle. A multi-asset approach that focuses on a specific outcome with diversified sources of returns may hold the key to helping investors generate and protect income streams.
Given the downside risk to economic growth in the U.S. and Europe, and the determination of central banks to cool inflation, we maintain our focus on managing portfolio volatility and prefer fixed income over equities. This also calls for diversification1 across asset classes and different regions.
The negative correlation between bonds and stocks is yet to be fully restored, but with limited upside to bond yields, we believe the benefits of diversification1 should return, especially taking into account the relatively low volatility in fixed income, compared with equities.
Our emphasis on quality continues. Pricing power and ability to manage downside risk of profit margins will be valuable in weathering through a period of weak growth and elevated price rises. Following the risk rally in the summer, valuations in corporate bonds are reflecting a more benign growth outlook and low defaults.
There are still some near-term risks facing investors, such as weaker corporate earnings, the Fed raising rates beyond current market expectations and possible delay in China’s economic reopening. These could also all spoil market moods going into the holiday season. However, if we take a longer-term view (12 months and beyond) on the economic and policy cycles, we think the prospects for long-term investors are improving. Valuations are not particularly challenging for equities. Fixed income is even more attractive given the rise in yields this year brought by spread widening and higher risk-free rates. This is also reiterated by our 2023 Long-Term Capital Market Assumptions, where the painful correction of 2022 has improved the forecasted return for the next 10-15 years for both equities and fixed income, as well as a 60/40 stock-bond portfolio.
1 Diversification does not guarantee investment return and does not eliminate the risk of loss.
The information contained in this document does not constitute investment advice, or an offer to sell, or a solicitation of an offer to buy any security, investment product or service. Informational sources are considered reliable but you should conduct your own verification of information contained herein. Forecasts, projections and other forward looking statements are based upon current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecast, projections or other forward statements, actual events, results or performance may differ materially from those reflected or contemplated. The Strategy is actively managed; holdings, sector weights, allocations and leverage, as applicable are subject to change at the discretion of the Investment Manager without notice.
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1 Source: Multi-Asset Solutions Team (MAST), as of December 2022. Projections or other forward-looking statements regarding future events, targets, management discipline or other expectations are only current as of the date indicated. There is no assurance that such events will occur, and if they were to occur, the result may be significantly different than that shown here.
Disclaimer – Quarterly Asset Allocation Views
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