According to the New York Times, the median one-year forecast for the S&P500 from 2000 through to year-end 2020 missed its target by an average of 12.9% – which was more than double the average actual annual performance of the stock market.

Not that we need a reminder, but this is another datapoint highlighting how futile the financial industry’s obsession with annual outlooks and seemingly precise price targets is. The production of vast amounts of research, which take many weeks to produce, is rarely read by anyone and almost always subsequently misses their targets by a wide margin. This is of little real value to the private or institutional investor. After all these years, I do wonder what the investment relevance of this exercise is and why it always happens in December? It is an arbitrary point in time relating to a solar year when trying to forecast the unforecastable over a similarly arbitrary time frame.

However, there are some areas in the market that stand out to us as being interesting and which offer good risk/reward opportunities for investors. In this edition, I discuss several themes that appear to offer better probabilities of success than others.

For investors, 2022 was an unusual year as there was almost no place to hide from the upheaval in financial markets. Other than energy and selected alternatives, most other asset classes and equity sectors delivered highly correlated and negative returns throughout the year. Diversification did not provide the protection that one would have hoped for and the only (relative) performance driver for a portfolio was the amount of assets not being exposed to declining markets.

2023 appears to potentially shape up differently, although negative selection or ‘investment by exclusion’ will still be key. This means that investors need to equally focus on what not to buy as well as what to invest into as we would expect certain areas to remain under pressure for the time being.

We are now almost one year into a new investment environment determined by higher interest rates and elevated inflation. It might be somewhat premature to call it a new era, but it certainly is distinctly different from the recent past. This new paradigm is based on structurally higher inflation, elevated interest rates and a reduced willingness of central banks to ease monetary conditions to extreme levels.

We are now on a path to interest rate normalisation, which on balance is a positive for global economies and societies as it effectively ends the misallocation of capital that we have been observing over the last decade. Whilst there are many positives, especially in terms of longer-term stability of the financial system, there are of course several areas and trends that require attention.

Interest rates are the most important price in the World – it is the price of money. As that price increases money will be harder to come by – in other words, global liquidity will shrink. Various efforts of quantitative tightening have already removed hundreds of billions of dollars from the global liquidity pool and 2023 is unlikely to see a reversal of that trend. In addition, earlier supply chain issues, followed by outright global conflicts and tensions kicked off a trend towards deglobalisation that is now also well underway.

These two developments effectively reverse the positive tailwinds of falling interest rates and the disinflation we have been experiencing and enjoying for so long. Unsurprisingly, the most hotly debated topic of the hour is how persistent these new trends may be.

This leads us to a current highly anticipated event; the so-called Fed pivot – the expectation that central banks will soon stop raising interest rates on the back of peaking inflation and slowing economies. Market expectations are to cut rates from the summer of next year. The underlying logic is that a global recession will ultimately force the central bankers’ hands, leading to lower interest rates to fight an incoming recession and maintain high employment rates.

Whilst this makes some sense, and there is evidence that at least Europe is set on a path to negative GDP growth, I would be somewhat hesitant to fully underwrite this thesis today. The tail risk to this outcome we are potentially facing is that the US does not appear to be close to a recession, employment levels are still very solid and consumer demand is not collapsing. Furthermore, whilst we may have seen peak levels of inflation, it is unclear what the ‘new normal’ will be. It is equally feasible to imagine outright deflationary trends in a year’s time as it is to settle at stable levels of around 3-4% annual CPI. Under the latter scenario, how likely is it that the Fed and others will start cutting rates anytime soon? At least theoretically, policy rates should exceed inflation, which would support a terminal rate well in excess of 4% in the US.

To frame our outlook and to highlight the key areas that pique our interest, two observations are important. Firstly, it is critical to recognise where the epicentre of this year’s market turmoil is located. Although we have seen substantial declines in some equity markets, bond markets are experiencing their worst correction in at least four decades. In equity market terms this is equivalent to the 1987, 2001 or 2008 corrections.

Secondly, it is likely that earnings growth in 2023 will be lower than 2022 with the possibility of being negative. This raises the spectre of further multiple compression in equity markets. Whilst this does not mean that a universal earnings decline is on the cards, in conjunction with lower stock prices some sectors will be more acutely affected than others.

As a result, the market environment is unlikely to be straightforward and the winners of the past era are probably not going to be winners of the next. The transition phase from rising interest rates and high inflation to potentially lower inflation and peaking interest rates, necessitates a somewhat more defensive and active approach as major directional price moves appear unlikely under such a scenario.

Following this year’s double-digit selloff, government bonds have regained an important attribute they had lost many moons ago: their value as a hedging instrument. Whilst the widespread belief in a typically negative correlation between equities and interest rates stands on shaky foundations, it is true that government bonds tend to act as a countercyclical stabiliser in times of market stress. This is especially the case when prevailing interest rates are meaningfully high to begin with. We have frequently used government bonds in the past to introduce an element of portfolio hedging whilst effectively getting paid to wait.

At current interest rate levels, we are positioned within an attractive range across USD, GBP and EUR enabling us to consider such instruments and earn some yield in the meantime. For instance, the current US 10-year Treasury bond (4 1/8% 15 Nov 2032), has a duration of over 8 years, resulting in a >8% price increase should 10-year yields drop by 100bps (less than the 140bps drop during Feb/Mar 2020).

It is obviously a moot point trying to predict exactly what could derail risk markets, but I believe there is always a fairly constant number of tail risks that could trigger a sell off. In terms of hedging, in addition to government bonds we also occasionally use index put options to protect the equity portion of portfolios from downward moves. To minimise the cost of the portfolio insurance, we would typically look to implement these strategies when market volatility is very low, and index levels are elevated.

For the reasons outlined above, fixed income markets appear attractive to us from a risk/return perspective. More generally, as yields have moved substantially higher, the outright return prospects have materially improved. The choice investors face boils down to duration, credit risk and tax aspects.

As a result of the unprecedented volatility in fixed income markets, liquidity conditions have deteriorated resulting in bid/ask spreads widening. Furthermore, even only slightly complex bonds are now more mispriced than before as they are largely shunned by investors compared to the more vanilla options. The reasons for such mispricings are manifold, but just to mention a few examples: (1) bonds of issuers denominated in a ‘non-home’ currency, (2) bonds that are exposed to forced selling pressure from certain types of institutions (because of static risk limits being hit or currency hedging related liquidity requirements) and (3) uncertainty over whether callable bonds will be called at the next call date. For fundamentally oriented and flexible investors like us, this is a near-perfect environment for bond picking.

(1) In my view, the upside in rates is capped for many reasons.

• Mortgage rates have reached levels that make real estate highly unaffordable in many developed countries (see section 6), which in itself could kick-off a very serious recession.

• Higher interest rates in the US: if they were to remain at these high levels for several years, it would put a serious burden on the government’s budget. At the level of rates in 2019 the US government’s interest expense today would be circa USD900bn but would have been over USD1.5trn if the terminal rate reached 5%, rivalling the size of the healthcare budget. A terminal rate level of nearer 8% would be equivalent to the size of the healthcare and defence budget combined – a situation that is clearly not feasible.

• Furthermore, as we approach US presidential elections in November 2024, the Fed has realistically only twelve more months to run a strong policy approach.

• Globally, private and public indebtedness limits the upside on rates, especially when we consider the very low pain threshold of governments to inflict pressure on their respective economies.

2) Whilst credit spreads have not rallied much and are nearer March 2020 levels, cash prices in many cases are substantially lower, moving them closer to potential recovery values. This acts like a floor for some bonds. The reason for the high price sensitivity is that coupon payments have become negligible in recent years, putting the burden of yield adjustment on the bond price. As investors focus on duration, this also means that for constant-duration portfolios, the average maturity of such a portfolio has decreased over the last few years. What makes this interesting from a tax perspective is that most of the prospective return in a credit portfolio today stems from capital gains and not from coupon income.

Following this year’s double-digit selloff, government bonds have regained an important attribute they had lost many moons ago: their value as a hedging instrument. Whilst the widespread belief in a typically negative correlation between equities and interest rates stands on shaky foundations, it is true that government bonds tend to act as a countercyclical stabiliser in times of market stress. This is especially the case when prevailing interest rates are meaningfully high to begin with. We have frequently used government bonds in the past to introduce an element of portfolio hedging whilst effectively getting paid to wait. At current interest rate levels, we are positioned within an attractive range across USD, GBP and EUR enabling us to consider such instruments and earn some yield in the meantime. For instance, the current US 10-year Treasury bond (4 1/8% 15 Nov 2032), has a duration of over 8 years, resulting in a >8% price increase should 10-year yields drop by 100bps (less than the 140bps drop during Feb/Mar 2020).

It is obviously a moot point trying to predict exactly what could derail risk markets, but I believe there is always a fairly constant number of tail risks that could trigger a sell off. In terms of hedging, in addition to government bonds we also occasionally use index put options to protect the equity portion of portfolios from downward moves. To minimise the cost of the portfolio insurance, we would typically look to implement these strategies when market volatility is very low, and index levels are elevated.

Equity investors have always been attracted to growth and momentum stories but tend to pay less attention to the more boring corners of the stock market. This is not surprising as these stories tend to dominate the headlines and can create a more exciting short-term narrative. However, when one analyses equity factor performance over a longer time horizon, their attractiveness tends to fade quickly, giving way to companies with better quality balance sheets, higher profitability and more stable long-term growth. As a result, equities that are categorised as quality growth or value still outperform over long time horizons. We have been focusing on these areas and keep ‘pounding the table’ on companies that are known as ‘low beta’ names. Beta is a factor that expresses a stock’s return sensitivity compared to an index. Example: a beta > 1 means the stock’s performance (positive and negative) is higher than that of the underlying market index, and a beta < 1 implies the opposite. In an environment of rising interest rates, companies that are profitable and pay meaningful dividends tend to outperform most other areas in equity markets.

The superiority in performance of lower beta stocks can be seen below. Whilst there are certain periods where higher beta names outperform, these tend to be limited and can typically only be found during the most speculative phases of equity bull markets such as in 1999/2000, pre 2008 or during 2021. In the long run, however, the underperformance of high-beta strategies is evident.

From a sector perspective, this implies a focus on more defensive sectors, such as consumer staples, healthcare/pharma, food and beverage at the expense of high-beta areas such as software, information technology and consumer discretionary. Unsurprisingly, because of the crowded nature of investor interest in the latter, the valuation discount of the former is attractive for fundamental investors.

From a sector perspective, this implies a focus on more defensive sectors, such as consumer staples, healthcare/pharma, food and beverage at the expense of high-beta areas such as software, information technology and consumer discretionary. Unsurprisingly, because of the crowded nature of investor interest in the latter, the valuation discount of the former is attractive for fundamental investors.

Professional portfolio management does not only involve holding equities and bonds, betting on prices rising over time but also involves the use of option strategies. We use them primarily for two reasons: (1) to hedge a portfolio against adverse price moves and (2) to enhance returns.

Here, I would like to focus on the latter aspect: return enhancement by selling covered call options as well as put options. Without delving too deeply into the mechanics of derivative markets, what is important in this context is that the price of selling an option (put) or to purchase a stock (call) is primarily driven by the volatility of that underlying stock. The logic is simply that the more a stock fluctuates, the more likely the price will move away from its current price , either up or down.

Provided a stock is volatile enough, this has two interesting consequences: (1) it enables the holder of a stock to sell call options at a level substantially higher than the current share price and thus pocket the premium as a price for potentially selling the stock at a fixed price in the future and (2) allows us to sell put options on stocks we would like to own at a lower price and thus collecting a premium from the buyer of said put option for committing to buy a stock at a fixed price in the future.

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