Nuances Matter When Navigating the Markets in 2023, Say Natixis Affiliated Investment Managers
- Portfolio Managers, Strategists and Executives from Natixis Investment Managers Solutions, AEW Capital Management, AlphaSimplex, Flexstone Partners, Gateway Investment Advisers, Harris Associates, Loomis Sayles, Mirova, and Vaughan Nelson Investment Management Provide 2023 Outlooks
- Managers Anticipate Continued Macro Uncertainty, Equity Market Volatility, Increased Real Rates, Potential for a Recession, Growth in Outcome-Focused ETFs
BOSTON–(BUSINESS WIRE)–In 2022, things got ugly for both the equity and fixed income markets. As inflation grew and interest rates rose in response to monetary policy tightening, stocks registered their worst year since 2008 and bonds failed in their role as diversifiers in traditional 60/40 portfolios. As a result, investors faced disappointing returns from mainstay investment portfolios.
As the calendar shifts to 2023, many wonder what the new year will bring. A recent easing of inflationary pressures and looking out beyond a potential recessionary environment, some optimism has returned. However, caution remains the watchword for many professional investors. Here are the views of portfolio managers, strategists, and executives from Natixis Investment Managers and its affiliated investment firms about what they expect from the markets in 2023:
Lower for Longer No Longer: Changing Yields, Property Valuations, and Opportunities
by Michael Acton, managing director, director of research, AEW Capital Management
The rapid change in the global yield environment showed up quickly in the value of publicly traded risk assets with stock, bond and REIT prices typically declining 15%-25% during 2022. For its part, private market property valuations have not yet showed any meaningful valuation change as private market valuations typically lag the public market by 12 months or more. We expect 2023 to be a period of general re-pricing of currently held property, bringing metrics such as income yield in line with today’s higher borrowing costs as well as higher yields on other asset classes.
Following periods of re-pricing, U.S. core property typically produces outsized total return as post trough periods are generally characterized by economic recovery and loosening of credit market conditions supporting improving property market fundamentals and asset valuations. Today, maturing property loans originated in the years immediately preceding the pandemic will be particularly difficult to refinance during 2023 and 2024. Many of these properties will require some combination of so-called rescue capital – fresh equity, senior financing, or mezzanine lending – creating investment opportunities not seen since the period immediately following the financial crisis.
While the near term will be largely characterized by challenging capital structures requiring new debt and equity solutions with commensurately higher returns, the longer run investment environment following the current period may prove even more beneficial. Many investors, plan sponsors especially, have struggled over the past decade with an investment landscape defined by low or negative nominal and real yields. Following the financial crisis, central banks across the globe collectively distorted the cost of capital in pursuit of varying of financial system stabilization, economic growth, pandemic relief, etc. If today’s coordinated normalization of yields, ostensibly in pursuit of price stability, ultimately gives way to a new normal of positive real sovereign yields, most investors will benefit greatly. If so, it may once again be possible to deploy capital into safer credit assets that achieve most if not all of investors’ required return (e.g., senior loans) or equity investments that do not require most or all return in the form of residual equity (e.g., core property).
Past Peak Inflation but Not Out of The Woods
by Kathryn Kaminski, chief research strategist and portfolio manager, AlphaSimplex Group
Inflation and rising rates were the central focus of 2022. In retrospect, 2022 will be remembered as the year where central bankers finally had to react to raging inflation. In the first quarter of 2022, the need to fight inflation became clear as central bankers stepped up to raise rates despite the wave of concern around the Ukraine invasion by Russia. Supply chains, commodities, inflating prices, and general concern over geopolitical tension led to high macro uncertainty throughout the year.
The largest theme in 2022 was rising rates and the presence of high downside volatility in fixed income markets. Commodity trends, especially in metals and energies, were strong in the first half of the year while the US dollar’s relative strength was a key theme until early fall. The final quarter of 2022 was a period of consolidation as key themes reverted and risk-on sentiment raged back into markets as we began to see signs that peak inflation had passed.
Looking forward into 2023, markets are optimistic given that we seem to have gotten past peak inflation. Despite this optimism, there are still some concerns. First, inflation, although lower, is still high. There seem to be two trajectories for monetary policy: continue to act or tolerate high inflation for a longer period. Both options could have adverse consequences for equity markets in either the short or longer term. If central bankers continue to fight inflation with higher rates, they risk a recession or an overreaction in policy. On the other hand, if they step back and tolerate further inflation, this may be a short-term positive for equity markets but have more insidious and less clear longer-term impacts such as risk of a stagflationary environment. Either way, macro uncertainty will likely remain high, the trajectory for interest rates is still unclear, and many geopolitical issues remain unsolved.
Cautious Outlook for Private Equity in 2023
by Eric Deram, managing partner, Flexstone Partners
After a year that saw relative buoyancy in the global private equity space, underpinned by the dominance of the ESG agenda, strength in fundraising, increasing prominence of co-investments and secondaries, our industry now faces a rapidly evolving and highly complex outlook. Flexstone Partners’ 2023 outlook is cautious.
We note, however, that Private Equity outperforms by a wider margin during periods of volatility and fund-raising contraction. As a global investor in mid-market private equity funds, co-investments and secondaries, we have five key predictions of what’s to come in the year ahead:
- Amounts raised in private equity will be substantially down in 2023.
- 2023 will be a buyers’ market for private equity secondaries.
- As funds take a more center stage in Private Equity, expect increased scrutiny from regulators and LPs.
- As inflation, global recession and increased interest expenses take their toll, private equity valuations will come down in 2023, just like they did in 2022 for public equities.
- Persistent inflation in 2023 and slowdown in China will further impact CAPEX and export-oriented businesses, especially in Europe.
Recession, Continued Equity Market Volatility Likely in 2023
by David Jilek, chief investment strategist, Gateway Investment Advisers
Chairman Powell announced seven rate increases during 2022, raising the target rate for the Fed Funds to 4.5% at the final meeting while indicating the likelihood of more increases in 2023. Keeping inflation at levels that would be easy on Americans’ wallets is an admirable goal, but achieving this without causing painful economic contraction, is looking increasingly difficult as real estate is starting to cool off, the employment picture looks more uncertain, and banks are starting to tighten lending standards (a historical foreshadow of recession).
While bond yields are higher than they have been since prior to the Great Financial Crisis, only time will tell if current nominal yields will be surpassed by persistently high inflation or be a large enough buffer to deliver positive total return if the Fed’s tightening cycle extends longer than investors currently anticipate, driving additional loss of principal in bond portfolios.
Historically, the equity market has delivered well-above-average returns after drawdowns that exceed 20%. On the other hand, investors who worry that stocks will have difficulty delivering enough near-term earnings growth to support still-lofty equity market valuations, can justify their concerns in more ways than one. In particular, supply chains and labor markets have yet to reach full repair and recent data has shown that Americans are spending down their COVID savings – consumer balance sheets could deteriorate, putting a damper on consumer demand and diminishing a key driver of economic growth.
Elevated equity market volatility and higher short-term interest rates increase index call option premiums like those utilized at Gateway. Higher index call option premiums potentially improve the net cash flow generated by our option writing strategies. If current levels of volatility and interest rates persist, or move higher, net cash flow may continue to be an attractive source of lower-risk participation in a potential equity market recovery as well as provide downside protection if there are additional losses between now and the ultimate recovery of the equity market.
Signs Point to a Shallow Recession, Bond Revival in 2023
by Adam Abbas, portfolio manager and co-head of Fixed Income at Harris Associates
The past year will be remembered as one of the most challenging years ever for fixed income markets in terms of returns and sheer unpredictability. One thing is certain, however: bear markets always do eventually come to an end, and in fixed income, the inevitable expiration occurs through the discounting transmission of price (valuation), time, and higher income.
In 2023, investors need to navigate a weaker demand backdrop but also calibrate for a Fed policy that will eventually signal a less restrictive stance as disinflation eventually gathers momentum. What we know today – and why our base case is a recessionary (albeit shallow) period for 2023 – is that a robust set of reliable signals point clearly to an upcoming economic contraction.
A much more interesting debate at this juncture is the magnitude of the slowdown in 2023. Although consumers are burning through their savings, households are in relatively good shape and corporate balance sheets are much more resilient than they were in the lead up to the global financial crisis. As expected, given the tighter conditions, the labor market is cooling but it has not collapsed. That leaves inflation as the major outstanding imbalance versus prior recessions. However, we think the market is underestimating the likelihood that prices could decline naturally and without the requirement of a major drop in demand.
To summarize, we expect a shallow recession with tight, but normalizing financial conditions. With this outlook in mind, we prefer to move deliberately, but also opportunistically. A shallow recession should isolate economic pain to the most fragile areas of the economy, meaning that the weakest companies that have been staying afloat for the last several years purely on the buoyancy provided by central bank and fiscal liquidity – commonly referred to as “zombie credits” – will indeed finally default this time around.
Active management and a bottom-up approach to fundamental research will help sort the survivors from the bankruptcies now more than ever. For investors with less risk appetite or those who are geared to a more passive approach, higher quality fixed income should finally offer high enough yields to generate both competitive total returns and strong relative protection (offered by higher recurring income) from losses versus most asset classes.
Recovering From the COVID-19 Fog
by Elaine Stokes, portfolio manager and co-head of the full discretion team, Loomis Sayles
For the last two years, markets have been primarily focused on a global pandemic, war, inflation and the actions governments and their central banks could take to mitigate economic uncertainty and market volatility. Now that we are likely past peak uncertainty, we as managers can start to focus on the strategies and long-term trends that could shape markets for years to come.
As the fog lifts, I believe this starting place for fixed income investors could help provide income, cushion and opportunity. In my view, portfolio focus should move from interest rate bets to credit selection. Carry is likely to become more important in the next few years as we see volatility come down from the extremes of the COVID era and the likelihood of severe tail risks subside. Investors are generally being paid for some level of volatility and risk. As we work though the slowdown in growth and the ramifications of aggressive central bank policy, I feel it is important to stay nimble, be active and know your credits.
Slower growth and stubborn inflation could be the backdrop for investors. Although growth is expected to take a hit from central bank policy actions, I think China’s reopening and its potential effect on global demand combined with a resilient, employed consumer will help create a floor. While inflation has likely peaked for this cycle, I believe it will remain stubborn given labor shortages and global reopening demand. Governments, faced with increasing costs due largely to the need to secure supply chains and increase spending for cybersecurity, defense, healthcare and climate change, will likely face deficits. I expect this to pressure rates, which could remain stubborn at near current levels – even after the rate increases stop.
A move toward moderation seems to have started across many political, geopolitical and economic factors. I believe default risk will now be in focus as we work to extract the central bank safety net and uncover where the potential excesses reside.
In my view, this could bode well for active managers who have the ability to return to analyzing cycles, credits and opportunities with more conviction than any of us could have had during the events of the last few years.
Three Questions for 2023
by Jack Janasiewicz, lead portfolio strategist, Natixis Investment Managers Solutions
Three key questions need answers. And these will be critical in how markets evolve over the course of 2023. First, the obvious one: inflation. The worst is certainly behind us, but the more important question is where the structural equilibrium rate settles in the US. Should it prove to be sticky well above the 2% target expect the US Federal Reserve to tighten further than is currently discounted. A more hawkish Fed certainly won’t help restore dampened risk appetite across the globe.
Secondly, where will earnings finally settle? The market seems to be split into two binary outcomes: earnings remaining largely unchanged by year end or down another 10-15%. While consensus views a 2023 recession as inevitable, we find ourselves contemplating the old adage: “Never bet against the US consumer.” We would add another: “Never underestimate the resiliency and flexibility of corporate America.” Corporates are aggressively cutting costs to preserve margins. With cost pressures easing and demand proving resilient might that be the missing piece to the earnings puzzle that leads to a better-than-expected Earnings Per Share outcome?
And lastly, after a year of synchronized global tightening, expect 2023 to be a year of policy divergence from global central banks that will certainly influence divergent regional growth outcomes. The end of the Fed tightening cycle appears within reach while the European Central Bank remains several quarters behind, having just recently adopted the Federal Reserve’s playbook. Heading into 2023, growth momentum appears to be inflecting higher in the US while incremental downside risks appear to be building further in Europe. And in the emerging market (EM) world, many EM central banks were first to tighten. Will they now be the first to ease policy as inflation rolls over and growth moderates? China has fully committed to reopening, and while this process will be non-linear, it does appear irreversible. And in doing so, the People’s Bank of China looks set to continue down a path of completely asynchronous monetary policy relative to the rest of the world – an easing one. Nuance will matter again in 2023 after a year that was one big one-way rates trade.
SECURE 2.0 Act Creates New Financial Planning Opportunities
by Curt Overway, portfolio manager and co-head of Natixis Investment Managers Solutions
After a very challenging 2022, most investors were probably not too focused on the tax liability generated within their portfolios. Thoughtful investors who could take advantage of techniques like tax loss harvesting, especially those using more tax efficient vehicles like separately managed accounts or direct indexing strategies, likely had few if any net realized gains. Many may even have banked up losses that can be carried forward to future years when they may have net realized gains.
On the legislative front, none of the Democrats’ goals of raising taxes on the wealthy and corporations came to fruition. With a divided Congress for the next two years the likelihood of any major changes to tax policy is very unlikely. That said, the tax rate reductions for individuals in the Tax Cuts and Jobs Act will expire in 2025 without further action from Congress and this will start to loom over the horizon as the 2024 presidential campaigns kick into gear.
Congress did pass the SECURE 2.0 Act and President Biden signed it into law just before year end. This legislation, a sequel to the original SECURE Act passed in 2019, primarily addresses several issues related to retirement plans and accounts. Key provisions of the new law include:
- Deferring Required Minimum Distributions (RMD) from traditional 401(k) and IRA accounts. The original SECURE Act increased the age at which RMDs apply to 72. The new law increases that to 73 in 2023 and to 75 in 2033.
- Increasing the amount of catch-up contributions to retirement accounts for older workers.
- Increasing how much of retirement savings can be put into Qualified Life Annuity Contracts (QLACs).
- Requiring automatic enrollment of employees into 401(k) plans.
The new law did not address mega-IRAs, even though early drafts had included some provisions that would have limited the use of retirement accounts to shelter very large pools of assets. While this law doesn’t directly affect the tax rates applied to investment portfolios in taxable accounts, it does create some new opportunities from a financial planning perspective.
Uncertainties Remain but Select Sustainable Equities Look Attractive
By the Mirova Global Sustainable Equity Fund portfolio management team
Looking ahead, we expect continued volatility in equity markets in 2023, driven by many of the same issues markets faced in 2022. We expect a significant slowdown in economic activity in the first half of the year driven by central banks increasing interest rates to fight inflation. We continue to work under the assumption of higher inflation for longer, which is likely to lead to recession in both Europe and in the U.S. The situation in Asia is a bit different and, however fragile, the reopening of China’s economy may help ease global supply chain constraints and support economic growth.
We think many central banks will continue to raise interest rates to fight inflation at least in the beginning of the year, impacting short-term interest rates. The good news is we believe we may have already seen an inflation peak in the U.S. at the end of 2022 and may be nearing the peak in Europe and other regions, meaning the probability of higher long-term interest rates is quite low. That said, as a fallout of the Russia/Ukraine war and the pandemic, we believe that inflation will be higher than it has been historically and for longer, buoyed in part by shifting supply chain practices.
Here are several sustainable investment themes in 2023:
- Shifting global supply chains should lead to more opportunities related to industrial automation and optimization of industrial processes across industries.
- Energy and energy security – Short-term solutions such as importing liquid natural gas from other countries will likely be used in response to the Russia/Ukraine conflict and the potential for Russia to leverage its oil and gas supplies to apply political pressure. But, longer term, renewable energy – such as wind, solar, and large-scale solutions such as hydrogen – is the only solution for Europe’s energy security and can make the region truly energy independent, although it will take time.
- Passage of the Inflation Reduction Act in the U.S. – The path ahead for an environmental transition in the U.S. seems clearer for the time being and should strengthen the growth tailwinds for companies that are well exposed to these themes.
- Biodiversity and food systems – In December at the COP15 United Nations Biodiversity Conference in Montreal, more than 190 nations adopted a landmark agreement to protect and restore biodiversity, including a pledge to protect 30% of land and oceans by 2030. We expect this to lead to greater awareness of biodiversity-related risks and opportunities across industries, in particular solutions for sustainable land management and food production, ingredients and bioscience, water technology and sustainable packaging.
Three ETF Trends May Emerge in 2023
by Nick Elward, head of institutional product and ETFs, Natixis Investment Managers
As we move into the new year, three ETF trends may emerge:
- Moderate to higher-risk investors may return to equity ETFs – As the stock market is typically a leading indicator as an economy emerges from recession, renewed interest in equity ETFs may be sparked by investors hoping to position their portfolios to take advantage of a potential run-up in stocks. Asset allocation rebalancing may also contribute to an uptick in allocations to equity ETFs as investors rebalance portfolios back to target levels after 2022’s sharp equity losses.
- Conservative investors may increasingly buy fixed income ETFs – There is newfound excitement for fixed income ETFs due to bond yields that are higher than they’ve been in years. Enthusiasm for nominal yields in the 4%-5% range on investment grade fixed income could drive increased flows into fixed income ETFs.
- Outcome-oriented ETFs may attract more assets than ever before – There has been significant ETF product development in investment options that limit equity market downside in recent years. After 2022, investors who still want equity market exposure may be even more willing to give up some upside performance in return for equity market downside protection. We expect to see more launches and growing sales into these types of ETFs as the year progresses.
Multiple Challenges Face Equity Markets
by Chris Wallis, CEO and CIO, Vaughan Nelson Investment Management
The 2022 equity bear market reflects the impact of higher interest rates increasing the cost of capital and therefore decreasing equity valuations. The next challenge for markets will be digesting the reduced earnings expectations for 2023. The largest reduction in earnings expectations should occur during the first two quarters of 2023.
A second half recovery for 2023 will be contingent on the interplay between the rapid deceleration in inflation and whether higher interest rates lead to excessive economic and market weakness. With the current level of interest rates and expiring monetary and fiscal stimulus, we anticipate that by the third quarter of 2023 the trajectory of inflation will be on pace to meet the Federal Reserve’s inflation target.
Contacts
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Harris Associates
Anne O’Reilly
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AOReilly@harrisassoc.com
Loomis Sayles
Kate Sheehan Tel: 617-960-4447
KSheehan@loomissayles.com