Outlook 2023: Value Emergence in Low Duration Assets

Market Review

Most equity market indices are ending the year in the red, with notable declines of over 30% in the Nasdaq 100 and the Hang Seng Index. We expect further deterioration in the Nasdaq if interest rates continue to surge and a possible recovery in the Hang Seng as China loosens its strict zero-Covid mandates. Factor performance was broadly in line with our expectations, with minimum volatility and value outperforming.

We have also seen aggressive monetary policy year-round as central banks hike policy rates to combat inflation. Surprisingly, China and Japan have maintained easy policies due to their lagging domestic economies. We expect to see the EU and UK play catch up with Canada and the US in the coming year. Government bond yields have moved in tandem with policy rates, with US bonds yielding the highest compared to other sovereigns. Market participants expect further hikes, with the Fed Fund Rate expected to peak around the 5% range in 1Q23. However, if inflationary pressures subside, the rate is expected to end near 2%. Commodities have outperformed in 2022 due to persistent inflation and OPEC+ intervention.

As for net fund flows, we see DM bond flows showing reversal as inflows return after a year of deteriorated liquidity. However, it is uncertain if these flows will be sustainable.

Uncertain Macro Environment

Multiple scenarios could potentially play out in 2023. A supply-side recovery could occur as workers are attracted back to the labour market, boosting growth and lowering inflation. However, there remain risks that stem from elevated levels of geopolitical tension. Prolonged tension in Europe and the decoupling of China from the United States could exacerbate supply-side inflation by pushing prices higher, forcing further tightening that chokes growth.

Global inflation has been sticky in 2022, but we are starting to see a reversal in inflation rates in the US. If rates continue in this trajectory, market expectations will likely play out. However, if inflation persists, market expectations might change, and terminal rates could surge past 5%. We expect sustainable inflation to persist due to five factors: unequal income distribution, deglobalization, ESG practices, elevated inflation expectations and a low nonaccelerating inflation rate of unemployment target.

In FX markets, quantitative tightening has made the greenback king but caused mayhem in the markets as the rate differential has caused other currencies, particularly in emerging markets, to fall drastically.

As inflationary pressures persist, we expect the dollar to continue strengthening, bringing consequences for many countries. Should the dollar’s strength persist, equities are expected to deteriorate as foreign profits get eroded. However, a key indicator we are watching out for is when the Fed eventually pivots, causing support for global equities. We expect fixed income rates to settle higher than any point in the past decade. For private markets and real estate, we expect default rates to grow if the dollar continues its rise.

We expect macro and alpha strategies to outperform in the uncertain macro environment, bringing elevated volatility for systematic strategies.

Fixed Income Makes A Comeback

In 2022, the US Treasury suffered one of the worst drawdowns in history, and US treasuries are currently trading at attractive levels.

While both HY and IG credit spreads widened in 2022, we are starting to see credit spreads recover, but it is uncertain if this recovery will be sustainable. Also, IG spreads in Europe widened at relatively higher rates due to its higher exposure to Russia, Ukraine, and the energy crisis. If the war does not improve, credit spreads will likely stay elevated.

Nevertheless, our analysis finds that spreads are mean-reverting and we believe the spread deterioration will not last, with US, EU and EM spreads already starting to recover. Investors interested in the high yield market can take up exposure in HY bonds (especially in EM) as current prices are still attractive while being aware of their high idiosyncratic risks.

Overall, the fixed income market is attractive relative to the past decade, offering a rare opportunity for investors to capitalize on. Investors who do not require short-term liquidity in the next 1 to 2 years can look at short-dated bonds, while risk-averse investors may consider treasuries.

Hiding in Low Duration Equities

Equity valuations have become attractive, primarily due to quantitative tightening and deteriorated growth expectations. However, we maintain our underweight position on equities and believe the time to be aggressive is when the Fed pivots away from its hawkish stance. Nevertheless, we believe value will outperform growth as the valuation spread remains high.

Geographically, Asian equities continue to trade at a discount to US equities, and we prefer APAC equities over US equities. Within Asia, we prefer HK and China equities as their markets have reached five-year lows and because of China’s surprise pivot from its zero-Covid policy.

Equity duration measures a company’s cash flow maturity and its sensitivity to interest rates and liquidity shocks. Lower equity duration companies tend to generate and pay out cash flows sooner. Historically, L/S strategies that favour low duration have moved in tandem with global rates. In periods of high volatility and rising interest rates, we have found that long/short and market-neutral strategies outperform. Specifically, long low equity duration and short high equity duration companies since higher rates diminish the relative appeal of high cash flow duration companies. Across global equities, US companies have the highest cash flow duration risk compared to the broader DM and EM markets. Investors with high exposure to US equities should diversify across other DM and EM markets, primarily due to their lower duration.

Overall, we are currently underweight on equity exposure. However, we prefer Asian equities over US equities primarily due to their cheaper valuations. Within Asia, we expect HK and China to outperform the other Asian markets. Finally, we do expect low duration factor to continue outperforming high duration.