A year ago, some mainstream investors cautioned that equities might face a tougher time in 2022.
Corporate resilience and supportive monetary policies in the wake of the pandemic had fired up investor optimism toward risk assets. But that had left valuations high, and inflation was already a concern. After back-to-back years of double-digit returns, shareholders were warned to dial down their hopes a little.
Directionally, this cautionary tone was correct. But it misread the force of the brewing trouble, and the scale of the resulting sell-off across multiple asset classes. The carnage included a 25 per cent correction in large-cap global equities and an even worse fall in UK gilts in the year to early October.
Even among the Cassandras and perma-bears, very few commentators were predicting the worst return for the classic 60/40 portfolio in a century.
To decry this as a failure of imagination misses the point. “Prediction,” as the Danish physicist Niels Bohr once said, “is very difficult, especially if it’s about the future.” But we all tend to anchor our expectations to what has just happened – the so-called recency bias – or assume that complex systems will correct in stable fashion.
Investors may be especially guilty of this. The assumption that markets are steered by self-interested decision-making, for example, won’t always give a clear account of historical events.
Take the year’s biggest geopolitical and economic news story, Russia’s invasion of Ukraine. As well as an international crime, Putin’s decision looks guaranteed to isolate and damage Russia’s economy for decades to come. But it also coheres with an ugly logic that suppresses dissent at home and allows the Kremlin to pursue an imperialist agenda abroad.
Because it seemed irrational, few expected the invasion to happen or recognised its implications. But the world is full of unexpected or unforeseeable feedback loops, meaning investors are forever bound to dealing in probabilities, rather than certainties. Thinking hard about the distribution of those probabilities – the tail-risks and extreme events that often matter most to portfolios – is therefore a useful exercise.
Our five wild market calls for 2023 stem from one mainstream forecast: that the coming year will be dominated by recession. Where that one contention leads in reality, if indeed it proves true, is anyone’s bet.
A bond market ‘flash rally’
While global equities may still look overvalued, there is a sound conventional reason to believe bonds could have a better time in 2023. If higher interest rates have put inflation on a fast track back towards central banks’ 2 per cent target, then two-year US Treasuries – currently yielding 4.3 per cent – look cheap. Fixed income might once again offer that dizzying prospect: a real return.
Is anticipation too fevered? As we have seen in recent years, investors can be herd-like in their market positioning, and 2023 could offer another extreme example. Here's one scenario: with everyone looking for any hint that the Federal Reserve will slow the pace of interest rate hikes, a dovish comment from governor Jay Powell is interpreted as a sign that a pivot is not only nailed on, but will arrive far sooner than expected.
With a wall of money waiting to buy into the trade, a dramatic flash rally in bonds ensues, exacerbated by a short squeeze in the market for long-dated Treasuries, where hedge funds are betting on continued inflation and falling bond prices. The 20-year Treasury yield briefly falls back below 1 per cent. With the yield curve inversion at its most extreme point in history and inflation still above 5 per cent, this leads to weeks of high volatility across financial markets, as fears rises of liquidity mismatches and other unexpected messes.
Cue much hand wringing by brokers and exchange operators, and fears about the vulnerability of algorithm-driven financial markets. In the melee, and with real yields on safer bonds once again negative, gold catches a big bid, hitting $2,500 an ounce.
Oil dips below $20
Windfall taxes aside, oil and gas companies were in the ascendancy in 2022. In 2023, the market thinks high margins and free cash flows for producers and refiners are again likely: according to FactSet-compiled consensus analyst forecasts, the near-term Brent futures contract will close next year at $92 a barrel.
Instead, investors’ rediscovered love of the black stuff proves short-lived, as a perfect storm of factors causes the international benchmark to fall steadily throughout the year, and to below $20 by the autumn.
Deep economic recessions on both sides of the Atlantic lead to a subdued summer driving season and reduced demand from the transportation and chemicals sectors. This, coupled with China’s failure to reignite industrial output, means demand falls below already modest expectations.
Supply dynamics do even greater damage. Concerned that curbing output will cripple fragile pipeline infrastructure in the permafrost, and desperate for funds to pay for its failing war in Ukraine, Russia shrugs off the EU-brokered $60 price cap and pumps as much oil as it can, providing a continuing boost to Chinese and Indian buyers able to command steep discounts.
However, the effect is multiplied by a historically quiet hurricane season in the Gulf of Mexico, where output comes in above the long-term trend. To make things worse for price takers, America’s loosening of restrictions on Venezuelan crude adds far more barrels to international markets than forecast.
Spooked by falling prices and a growing consensus that global oil consumption has peaked, OPEC members lose quota discipline, and the cartel comes close to disbanding. The price fall’s deflationary effects provide some relief to a contracting global economy, and a White House struggling to contain rising public anger at the cost of living.
A run on private equity
As an asset class, private equity proved resilient in both the dotcom crash and the 2008-09 financial crisis. But a dramatic reckoning unfolds in 2023: after years of above-average returns, the wheels come off, as increasingly suspect and opaque self-dealing and an inability to cope with higher interest rates collide in ugly and spectacular fashion.
Like many crises, things at first happen gradually. As recession bites in the first months of the year, a spate of high-profile private equity-backed businesses go to the wall, after bondholders take a hard line on covenant renegotiations. Then a bank calls in a loan to a major fund, after discovering massive off-balance sheet liabilities.
The watchdogs are forced to step in. Tasked with identifying potential sources of systemic risk to the financial system and concerned with reports on the growing use of securitisation within the shadow banking world, regulators in the US and Europe launch investigations into private funds’ use of leverage and off-balance sheet vehicles.
Their findings are partial but point to a sector creaking with debt. Major private equity investors from the world of pensions and insurance, spooked by reports of hidden leverage, start to pull cash wherever they can. Amid an otherwise benign summer for the public equity market, an effort by one fund to list a high-profile portfolio company flops as investors baulk at its debt. The asset is eventually sold to another private equity shop, for a huge loss.
Despite the casualties, the year again ends with many funds announcing better reported returns than the public markets. But with faith in the asset class shot to pieces, the discount on listed private equity funds increases to 70 per cent, and the fundraising environment becomes untenable for even some of the largest private equity houses for much of the decade.
The UK government collapses
Given the state of Westminster for much of 2022, betting against the government might not seem like the wildest of calls.
But the brief honeymoon for prime minister Rishi Sunak ends abruptly in early 2023, as he is forced to meet striking public sector workers’ demands and settle for a 15 per cent pay rise. Not only does this cost him the support of several dozen MPs, who resign in protest, but it creates a big headache for chancellor Jeremy Hunt, who must find the extra cash from the public purse.
With the Conservatives’ parliamentary majority hanging by a thread, the government stumbles on. A fresh crisis is already brewing. Another prolonged drought across England and Wales, exacerbated by cost pressures on the domestic food industry and another record heatwave, leads to the lowest agricultural output in decades.
Forced to foot a £50bn bill to bail out the nations' farmers, demands on state borrowing ratchet up once more. But an otherwise asset-hungry bond market baulks at a series of debt auctions, leading to a fresh crisis in the gilt market. A humbled Sunak resigns, parliament is dissolved, and the pound resumes its slide against the dollar as investors digest the scale of the task facing a hastily elected Labour government.
UK merger madness
Amid dour sentiment to UK equities, the year starts on a glum note for investment bankers. With investors unable to price anything with certainty and nervy issuers unwilling to take a haircut, the markets for initial public offerings and secondary issuance grind to a halt.
But come next Christmas’s bonus season, City dealmakers are toasting an excellent 12 months, after a combination of three factors lead to a record year for merger activity.
First is the view from the c-suite. With recession biting down on margins, the pressure on companies in cyclical sectors to look for efficiency savings becomes intense. Second, investment committees realise that lower equity valuations are a market feature, rather than a problem specific to their companies’ shares. Third, several prominent activist investors lead a rebellion against the booming market for share buybacks and make the case for consolidation.
Quickly, the three constituencies realise that all-share mergers (while riskier for shareholders all-cash deals) provide a neat solution to boost near-term earnings and see out the global recession, while avoiding fickle or overly expensive capital markets. And although several deals are viewed as a cynical way to covertly cut jobs, investors are soon won over, as rampant speculation around the next potential all-share candidates creates speculative merger premia in a raft of stocks in otherwise beaten-up sectors.
