Asset class reviews and outlook from CFS Sector Specialists

Asset Allocations - Jujhar Tokai, Senior Investment Manager

What is the long term outlook for investment markets after a difficult 2022?

Many of the difficulties experienced in 2022 have created significant opportunities going forward for patient long term investors in 2023. Lower valuations, higher bond yields and the accompanying unwind of many policy dislocations mean that long term (20 years) forward looking returns are expected to be higher, especially for equities and fixed interest assets.

The forward looking returns for both global shares and hedged global shares is expected to increase by 0.8% and 0.5% respectively while expected risk (measured as standard deviation) is expected to decrease by 1.9% and 1.1% respectively. Higher inflation and hawkish central banks have pushed bond yields and cash rates higher. Given these better starting points, the forward looking returns for Australian and developed market fixed interest increase by 1.5% and 1.6% respectively. The expected risk for Australian fixed interest is expected to increase by 0.3%, while expected risk for developed market fixed interest is expected to decrease by 1.0% when compared to last year. 

What are the implications for diversified, multi-sector portfolios?

For a typical 60/40 portfolio, our updated asset class assumptions point to higher 20 years forward looking returns, increasing from 5.4% to 6.3%, while expected risk will decrease from 9.4% to 8.8%, effectively improving the reward to risk for the portfolio. Similarly, a typical 30/70 portfolio is also expected to have higher forward looking returns, increasing from 4.1% to 5.0% and a decrease in expected risk, from 5.0% to 4.6%, resulting in a higher reward to risk for the portfolio. 

Furthermore, the probability of a negative return (in any single year) over 20 years is expected to decrease, especially for portfolios that are more conservative in nature. The probability of a negative return for a typical 30/70 and 60/40 portfolio is expected to decrease by approximately 7.0% and 4.2% respectively.

Fixed Interests - Robert Graham-Smith, Senior Investment Manager 

In 2022, Global fixed interest and Australian fixed interest suffered their worst returns in over 40 years, as central banks aggressively pushed interest rates higher. Do you believe this is over and what are the expectations in 2023?

I believe that fixed interest is past its low point, and the sector should provide attractive returns and increasing portfolio diversification benefits in 2023.

Global yields have already risen from unprecedented low levels. Although further interest rate rises are likely, some element of this is already priced into markets. This mitigates further impact to fixed interest securities which suffer when rates rise. In fact, interest rate cuts are already being anticipated in some markets in late 2023 and 2024, as economies cool.

The fixed interest sector now provides higher yields to investors as well as diversification against other risk assets such as equities. These were two elements that were blunted in the extremely low interest rate environment of recent years. If a recession becomes more likely, central banks have the ability to cut rates, which is beneficial for bond prices.

However the other element of fixed interest investment is credit exposure through corporate and other higher yielding bonds. In a recessionary environment, as corporate earnings potentially decline, negative sentiment and credit spread widening can also work against fixed interest investors from this perspective. 

Are there any sub sectors which you prefer or try to avoid in 2023, and why?

In developed market sovereign bonds, performance is largely driven by interest rates and not credit risk. Given the elevated risk of recession and a potential peak in interest rates in 2023, this is likely a safer place to be positioned. For investors with greater risk appetite, there are some interesting opportunities. Corporate, higher yielding bond and asset-backed security spreads spent much of 2022 at very wide levels – essentially already pricing in some form of recession. In turn, this presents opportunities in these market segments for positive repricing. In addition, interest rate cycles in some emerging market economies have already peaked, which is a positive tailwind for the prices of their bonds, however some of these economies also inherently suffer from political and economic instability which present risks. 

Floating rate loans and private debt are also interesting areas – providing the benefit of rising returns that follow rising interest rates and are an active area of research for us.

Overall, higher grade companies with dependable earnings are likely to do better in a recession than cyclical companies or those with less reliable free cash-flow generation. In this uncertain environment, sector and security selection in fixed interest portfolio management remains paramount. 

What are the main risks in your sector in 2023 and why?

A key risk in fixed income in 2023 is a period of further persistent or rising inflation, accompanied by a recession or cooling growth. In this environment central banks could be forced to choose between their ambitions of cooling inflation (i.e. continuing to raise rates) at the expense of economic growth. In this environment fixed income securities may suffer. Conversely, if a global recession does eventuate and inflation cools, resulting interest rate cuts could potentially benefit fixed interest investors, although credit markets may suffer.

Another risk is Japan which is currently realising positive levels of inflation, something they have been trying to achieve for decades. Should the Bank of Japan follow the rest of the world and undertake a process of rate rises, this would be negative for the price of their government bonds as Japan accounts for around 8% of global aggregate bond index exposure.

Australian Equities - Ben Lam, Senior Investment Manager

Australian equities outperformed global equities in 2022, despite a small negative return on a total return basis. What is the outlook in 2023?

The Australian share market has performed well relative to Global Equities in 2022, supported by stronger earnings and dividends which was offset by multiples contracting leading to a small single digit fall for 2022.

Corporate earnings are likely to be more challenging in 2023, as the tailwinds from the reopening of economies in 2022 is replaced by a macroeconomic environment with high inflation, high interest rates, accompanied by a slowing economy. Whilst the market is pricing a slowdown in earnings, there remains risks that earnings might disappoint relative to expectations. The valuation of the market appears reasonable relative to history, however as always, averages can be misleading.

Weakness in the Australian economy is likely to lead to earnings disappointments, particularly if we enter into a deep recession. Banks have been a beneficiary of rising interest rates and may continue to benefit but will be impacted by any correction in the housing market and slowdown in economic activity. Resource stocks performed well in 2022 with higher commodity prices, expectations are that they should fall but certain commodities such as iron ore may benefit from the reopening of China. High interest rates and inflation will be headwinds to the consumer related companies. Stocks trading on high multiples remain most at risk as challenging conditions are likely to lead to further de-rating and disappointing earnings growth.

Global Equities - Andrew Howlett, Senior Investment Manager

After a difficult 2022 for global equities, what are your expectations for 2023?

I like to make a distinction between developed markets and emerging market (EM) equities.

I am cautious on the outlook for developed market equities in 2023. The prospect of sustained high inflation and interest rates are potential headwinds for macroeconomic growth and corporate earnings, although this may be partly offset by developed market equity valuations being at or below historical averages. The potentially challenged environment from a macroeconomic and corporate earnings perspective may also result in the market turning its focus toward company earnings durability and financial strength. Such an environment will be conducive to active funds management as it will lead to an increased focus on stock selection. 

The attractive valuation of EM equities, relative to developed market equities, is a feature which provides a supportive backdrop for EM equities in 2023. China is a key driver of EM’s outcome, due to the size of the economy and its weight in the benchmark. Chinese domestic political, regulatory and economic developments, as well as Sino-US relationship have weighed on China equity’s performance since 2020. There are some initial signs of more positive developments in each of these areas, thereby potentially providing a more supportive environment for local Chinese economy and companies. In addition, valuations for listed Chinese companies are generally below historical averages. 

What are the main risks in your sector in 2023?

The main risk for global equity markets is a prolonged period of high interest rates as a result of either persistent inflation or policy error.  This can lead to a deeper than expected global recession. Potential drivers of persistent inflation are consumption resilience, wage growth, increased energy prices or increased materials prices, with the latter two potentially being driven by continued Russia/Ukraine conflict or by the economic recovery of China. 

Key risks for EM equities are slowing global economic growth, a negative domestic political or economic development in China, or a negative geopolitical development.  

Listed Property and Listed Infrastructure - Leroy Qian, Investment Manager

After a torrid year, do you believe the worst is behind listed property (both Australian and Global) and infrastructure?

I am cautiously optimistic on the outlook for listed property securities, both Australian and global. The two markets face similar challenges and opportunities.

The poor performance of the Australian property securities sector in 2022 was primarily due to the market pricing in higher interest rates and the adverse effect of higher interest rates on property valuation and cost of debt. As the pace of interest rate rises slows in 2023, the dominant headwind against the sector will ease. On a valuation multiple basis, Australian property securities remain cheaper than broader Australian equities, as well as against the value of the underlying physical properties which these property trusts holds. Historically, such a valuation discount has led to subsequent outsized returns for property securities as valuation reverts back to their long-run average. In addition, property trusts can provide a hedge versus inflation, given the ability to raise rents on their property, with some property leases explicitly linked to inflation. 

My expectations on global property securities are similar.

What about global infrastructure securities sector?

The global infrastructure securities sector outperformed broader global equity markets in 2022, despite being a long duration asset class. The sector’s performance was supported by the strength of the energy pipeline sub-sector in the face of global energy disruptions and the perceived inflation protection characteristic of the asset class overall.  

The resilience of global infrastructure securities was also supported by sustained demand for assets from private infrastructure investors, with private infrastructure investors willing to pay a higher multiple to acquire infrastructure assets than the current multiples of corresponding infrastructure securities.

On a valuation multiple basis, the sector trades at a slight discount to its historic average but with wider valuation dispersion amongst infrastructure sub-sectors, therefore creating a rich environment for active stock selection in this asset class.

What are the main risks in your sectors in 2023 and why? 

For both Australian and global property securities, a prolonged and deep recession is the main risk. This would weigh on tenant demand and occupancy of the properties owned by listed property trusts. Mitigating this risk to some extent is that the sector has a more resilient balance sheet than at the last major downturn during the GFC.

For listed infrastructure, cost of living pressure and “populist” regulatory policies are potential risks. Such policies would impact on the future profitability of infrastructure assets, in favour of reducing costs for households (voters). On the positive side, the significant level of capital expenditure required to support de-carbonisation is an opportunity.