10 investment themes for 2023
The year 2022 saw the end of an era of low rates, low inflation and asset price growth. As we head into 2023, the world’s economies have changed dramatically, with an economic tightening under way.
Higher energy, food and consumer goods prices are fanning inflation without necessarily boosting productivity. Now, the spectre of recession is haunting many of the world’s economies, as central banks walk a tightrope between cooling rampant inflation without dampening demand and depressing wages.
Our investment teams of course need to navigate their way through these obstacles carefully – managing downside risks while positioning for upside gains. First Sentier Investors’ asset class experts share their ideas about what’s ahead in 2023.
Recession looms large
There’s a growing consensus many economies are likely to enter recession in 2023.
“Inflation in the US has recently seen a reversal in direction, signalling the peak may have passed and further softening could be on its way. There are concerns substantial policy tightening in the face of spiralling inflation will strangle growth and push major economies into recession,” Craig Morabito, Senior Portfolio Manager, Global Credit, said.
“Whilst the year that passed was largely characterised by higher interest rates responding to rising inflation, investors will need to factor in the actual impact of rising rates on the real economy and company earnings in the year ahead,” said Dushko Bajic, Head of Australian Growth Equity.
“As higher rates slow the economy, companies will be under pressure in terms of their ability to increase prices when consumers start consuming less, straining the cost structure of businesses and impacting profit margins.”
“Another pressure is that we’re living in a world of labour shortages and whilst companies usually shed labour when demand weakens we may be in an environment where companies choose to hold onto labour for longer potentially impacting margins,” Bajic continued.
“It will be imperative to identify companies with business models able to work through this versus companies more beholden to the environment. This may be the difference between investing in the companies with better earnings versus the ones that’ll be under pressure.”
Head of Australian Equities Growth
China’s challenges easing
Nigel Foo, Head of Asian Fixed Income, said the challenges facing China may ease in 2023, and concerns about the country’s property sector along with it.
Foo pointed to the possibility the three themes driving Asian credit market performance in the past 12 months are likely to have a more subdued impact in 2023. The three themes he highlighted are the Federal Reserve hiking interest rates to curb inflation, negative sentiment towards China, its retreat from zero COVID policy, and global recession fears.
“Government support aimed at boosting liquidity and reducing re-financing risks in the sector has strengthened in recent months. It now includes direct bond purchases and guarantees for specific developers. This is definitely a big positive for the sector,” he said.
Interest rate rises: time to take a breath?
While central banks aggressively raised rates in 2022, there is hope that they will slow down.
Kej Somaia, Co-head of Multi-Asset Solutions, said: “We expect central banks to continue to implement quantitative tightening measures, including increasing interest rates in 2023 – albeit in smaller increments than in 2022 – as evidence of inflation growth remains but continues to plateau.”
“While tightening has dampened equity valuations, corporate balance sheets have so far remained solid” he said.
Co-Head of Multi-Asset Solutions
Pockets of opportunity in equities
Given all the uncertainty, equity markets need to be navigated carefully, Somaia added.
“Repricing in equity markets in recent months has led to valuation opportunities emerging. However, these opportunities need to be considered in the context of ongoing volatility and the potential for deteriorating economic conditions,” Somaia said.
“Global markets have seen selloffs and while valuations are more attractive than they were this time last year, we are cautious about 2023. We view Australian equities as more attractive than global, following their outperformance in 2022,” he said.
Bajic added: Companies with high quality earnings growth and pricing power will be key for equities investors in the year ahead.
“It is important to fully research a company, the industry structure, whether it’s improving or deteriorating, understanding where they are on the cost curve and their pricing power. We focus on companies that can grow structurally and independent of the cycle, identified by looking at their return on invested capital, capital intensity and valuing cash flows. This mindset and focus will allow investors to eliminate the noise and identify the opportunities,” Bajic said.
“Elevated volatility in local equity markets since the pandemic and in recent months provides opportunities to find attractive income streams through careful use of options,” Rudi Minbatiwala, Head of Equity Income, said.
“Dividend cuts are on the cards in 2023, as companies become more conservative in the face of an economic slowdown, and the disappearance of off-market buybacks will impact the level of dividend income available to Australian shareholders. Harnessing volatility through stock by stock assessment can provide a pathway of opportunity for income-seeking investors during periods when dividend incomes may be reduced.”
The ‘value’ recovery set to continue
David Walsh, Head of Investments for Realindex, said rising interest rates have driven markets down, but this has meant a strong rebound in the relative performance of value stocks as growth stocks have sold off, albeit with bear market rallies in between.
“Looking into 2023, some resolution of these issues may lead to a reduction in uncertainty and a cyclical recovery in equities. This again speaks to the resurgence of value, this time in an absolute sense.”
If inflation stays high – or even drifts lower – this value rebound will probably be slower, as quality stocks, more inflation-proof, will be popular. This speaks to creating a portfolio of value stocks which are not “junk”, but are mispriced.
Walsh said there is little chance of a Fed ‘pivot’, where interest rates could start to be lowered.
“Central banks are still hawkish, and lower interest rates are unlikely as the fight against inflation continues. The defensive or quality value story seems likely to be supported for some time to come.”
ESG at the forefront
“Energy transition remains one of the most prominent ESG issues in 2023, with the focus on energy pathways and power generation as coal fired power plants are closed, wound down or closed for maintenance,” Kristen Le Mesurier, Head of ESG for the Australian Equity Growth, highlighted.
“Gas is a controversial energy source but will be needed in the short to medium term supplementing renewables until there are scalable and reliable alternatives to coal-fired base load power,” Le Mesurier said.
Climate activists have challenged new gas projects in court in Australia, so we expect approvals to be extremely well scrutinised by investors and activists alike, she added.
“Biodiversity and nature-related issues are rising in prominence as companies are increasingly asked to consider the broader impact of their operations on the environment, work out how to measure these impacts, then report to investors.”
“Modern slavery remains a challenge. In fact recent data suggests modern slavery is more prevalent than we suspected several years ago1. We expect more sophisticated investor scrutiny of company’s supply chains and modern slavery statements, and more disclosures by companies of instances found. It’s clear that modern slavery exists in supply chains and if companies are not reporting examples, chances are their detection processes are not good enough.”
Kristen Le Mesurier
Head of ESG, Australian Equities Growth
Infrastructure in the box seat
“We expect public policy support for infrastructure investment to remain strong globally, especially where it relates to the replacement of ageing infrastructure assets, buildout of renewables to help decarbonise electricity generation, and globalisation of natural gas markets,” said Peter Meany, Head of Global Listed Infrastructure Securities.
“We also expect private sector funding of new infrastructure investment to remain strong in 2023 although rising interest rates will likely see M&A activity slow. We anticipate a robust pipeline of capital investment opportunities for the majority of global listed infrastructure companies for the year ahead.”
“Some sectors within infrastructure could be well positioned to benefit from structural growth drivers, with communications infrastructure being one of these,” Meany said.
“Consumers and businesses continue to move activities onto digital platforms which underpins demand for capacity on communications infrastructure such as cell towers and data centres. In 2023, we expect carriers and mobile network operators to continue the multi-year rollout of 5G mobile technology which will require tower leasing”, Meany highlighted.
Credit’s time to shine
“Credit fundamentals remain broadly supportive, particularly in the US and Europe. Meanwhile, interest coverage ratios – which measure how comfortably companies can service their debt obligations – remain favourable on the whole,” Morabito said.
Morabito added that many companies have already locked in lower borrowing costs, and credit agencies are reasonably optimistic.
“Ample capital has been raised over the past three years through new bond issuance, as companies took advantage of historically low borrowing costs. Many firms have issued bonds with relatively long maturities, thereby reducing refinancing risk.
“Encouragingly, we are still seeing more upgrades than downgrades from major credit rating agencies, although the rate of upgrades has been moderating recently.”
Foo echoed this sentiment in his case for Asian credit: “At a yield of close to 6% compared to a historical average of 4-5%, Asian investment grade bonds are looking very attractive, especially for long term investors. The fundamentals of this asset class have also been resilient through previous downturns, and companies with healthy cash balances providing a compelling reason to increase exposure into this asset class for the year ahead.”
Bonds set to recover
Stephen Cooper, Head of Australian Fixed Income, says that after a tough year, bonds are increasingly attractive.
“Some forecasters think interest rates could be lowered before the end of 2023 if key markets enter recession. Against this backdrop, it’s possible we may have already seen the cyclical highs in longer-dated bond yields.”
“The near-term path remains unclear, but value has undoubtedly returned to the bond market in general,” Cooper said. But with the long-running secular bull market in bonds finally over, he noted the contribution from active management should account for a greater proportion of total return.
Cooper said: “With increased policy and inflation uncertainty, longer duration now embedded in most benchmarks, and more volatile yield curves, there should be no shortage of opportunities to implement active strategies in portfolios.”
Housing and data: A bright spots for REITs
“We are positive on the residential-for-rent sector, which includes apartments, detached housing, pre-fab homes and student housing. The risk-adjusted returns currently offered by the sector are compelling as residential assets typically deliver stable cash flows through the cycle, said Stephen Hayes, Head of Global Property Securities.
“We are also positive on data centres as replacement values continue to rise, increasing barriers to entry which should support rental growth with tenant demand likely to show low economic sensitivity. The sector is well placed over the medium to long term as they are integral to supporting the growth of the digital economy.”
After a strong run during the pandemic, the team is more cautious on the short-term outlook for logistical warehousing.
“Risks of a recession in the short term could see tenant demand fall back from elevated levels. However, we still believe that any short term over-estimations of required supply are transitory, and will be outweighed in the longer term by strong structural tailwinds in the sector.”
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