2022 Year in Review and Market Outlook

2022 Year in Review

2022 was a historic year in many ways. In the developed world, we saw a spike in inflation as pre-pandemic mobility and expenditure returned. Geopolitical risks escalated, with Russia’s invasion of Ukraine and an increasingly multi-polar world. For investors, this led to a tricky investment environment with little historic precedent, with both bonds and equities struggling in tandem.

If there is one factor that has driven markets over 2022 it is the US federal reserve’s historic interest rate rises. At the start of January 2022, with inflation stubbornly sticky, US Fed Reserve chairman Powell communicated an intention to shift aggressively away from stimulus and towards tackling excessive prices rises across the economy. This heralded a landmark shift not seen since prices last reared upwards in 2006. It also increased the discount rate for every financial asset, driving values dramatically downwards. The greater the interest rate sensitivity, the greater the fall: witness the horrendous returns in tech stocks (Nasdaq -28%), or global fixed income (Barclays Global Agg -13%).

Domestic markets were not entirely immune from the carnage but better protected. The RBA signalled a more patient approach with inflation driven by a more flexible inflation target of 2 to 3% (vs 2% in the US). Our equity market benefited from a more even composition of growth and value stocks (growth stocks notoriously sensitive to rising rates), and a healthy allocation to Energy and Mining. The local bourse finished the year in reasonable condition, down only 1.8% (S&P/ASX 300 Accumulation index). Australian bonds performed better than many foreign fixed income markets (-9.7%). Geopolitical tensions renewed with a bang: Russia’s land invasion of Ukraine caught many by surprise. This led to a meteoric initial rise in the Oil price as sanctions “took out” Russian supply, only for a dramatic fall as demand destruction started to occur. China and other emerging markets’ initial opportunistic support for Putin increased talk of Cold War 2 between “the West” and “the Rest “. The US Dollar predictably climbed as fear and uncertainty drove an aggressive unwind of the riskier business models and “investments”. The Cryptocurrency space’s epic Q4 2022 downfall more than negated its extraordinary rise over late 2020 and 2021.

Looking Ahead to 2023

The next twelve months look far from straightforward, though we remain broadly optimistic, even if the road travelled will likely be just as volatile and at times uncertain as 2022.

The first and most important call we make as we enter the new year is that the peak in inflation, in the US and domestically, has already occurred in Q4 2022. This has some definite repercussions for investors, not least of which a likely strong rally in government bonds, which have always delivered positive returns (and on 5 of the last 6 occasions better than cash) in the 12 months subsequent a peak in CPI back to 1970.

Inflation looks likely to fall dramatically in the short term as both arithmetic (base effects, e.g., growth on already high prices becomes harder to achieve), and demand for specific services falls (hard to imagine persistence on post pandemic demand for restaurants and travel). In the medium and long term however, certain issues may take a while longer to settle, particularly in the US where a shortage of labour continues to plague businesses.

Central bank actions thus far and the raising of interest rates globally will take some toll on the global economy which again will place downward pressure on inflation. We do not however see the slowdown in growth as being as pronounced as some commentators have suggested. The most likely scenario in our view is that initial fear and uncertainty in the first half of 2023 will provide investors a solid buying opportunity to increase our exposure to growth assets. The road however will be rocky, and timing will be of the essence. The markets most vulnerable in our view will be the US, where valuations remain high, and the central bank is most hawkish (determined to raise rates most aggressively). The local equity market looks fair value, and an attractive place to be relative to other markets.

Within the Australian Equity market, we see a balanced allocation across sectors and value/growth as the most effective strategy until a clearer path ahead materializes one way or another. We think tech will do better than in 2022 where the selling was indiscriminate and at times brutal. Consumer stocks will again be a volatile place to be given the household budget constraints on spending from increasing mortgages repayments (remember interest rate resets are likely to occur in 2023). In Resources we would favour diversified bulk metals over industrials or over-crowded battery metal specialists. Energy companies will likely perform over the course of the year though they are a tactical underweight until we see a rosier picture emerge for global growth.

While we see in the final analysis a rally in the Australian dollar, we do see some potential weakness in the short term; opportunities to hedge our international equities exposure are likely to arise in the second half. Geopolitics are likely to continue to influence markets in a way that is hard to predict though we expect a more cordial trade environment in the short term out of bare necessity for China’s vulnerable economy.

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