Expect wide, volatile ranges in markets into early 2023

Tail risks from geopolitical events and concerns about market liquidity suggest an allocation to potentially safe assets in most portfolios. We added further to short-duration US Treasuries while reducing non-USD fixed income in Europe and Asia. This raised our US investment grade bond allocation to about 14% overweight.

Globally, fixed income is just 1% overweight owing to large underweights in Europe and Japan. Global equities remain 2% underweight, gold 2% overweight, and cash 1% underweight. (International fixed income assets are generally held on a currency-hedged basis, while equities are unhedged).

With a global recession or significant economic weakening highly likely in 2023, our asset allocation remains tilted toward defensive, higher-quality income generation. In global equities we overweight the most consistent US dividend growers by 3%. We also overweight global pharmaceuticals by 2%.

We remain underweight cyclical equities across Europe, Japan and smaller company shares globally. These underweight assets have weakened further this year in USD terms as the US dollar has surged against peers.

In fixed income, 1- to 3-year duration US Treasuries have seen yields jump nearly 75 basis points since our GIC meeting last month. At 4.5%, short-term Treasuries are among the safest investments with a yield that has risen 410 basis points in a single year.

These yields anticipate further Fed tightening of significant scope even into a likely US economic downturn that will stem inflation. While longer-term US Treasuries (which we overweight) are likely to rally in price if the US economy weakens, short maturities will provide higher income over our tactical return period of 12-18 months.

Equity markets will find a bottom in 2023

As markets have led turns in the economy in both 2020 and 2021, history suggests equity markets will find a bottom prior to the full extent of economic weakness in 2023. However, history also suggests it is premature to expect this bottom to be in place before the very first declines in US employment and corporate profits. We expect these in the first half of next year. As was the case in 2020, we would expect to use our US bond holdings as “dry powder” to reallocate into higher risk equities as potential opportunities arise.

A peak in US interest rates is likely to be generated by a weakening of the US economy. This will most likely favor rate-sensitive equities (high quality growth shares) over cyclical industries initially. As we outlined in last month’s Quadrant, we also believe the surge in the US dollar may continue into 2023.

However, there are reasons to believe this represents an overshoot that won’t be sustained in the longer run. A peak in the US dollar after very large declines in international asset prices may offer strong return opportunities. However, it also represents a performance risk for our current asset allocation, which is effectively overweight the US dollar.

In general, we would warn investors to expect wide, volatile ranges in markets into early 2023 at a minimum. While we anticipate economic recovery in 2024 (please see our August 2022 Quadrant), US and global monetary policy is proceeding in a “pro-cyclical” manner (restraining the economy heading into a period of weakness, rather than restraining it during a period of strength).

With hawkish monetary policy views expressed daily by policymakers, markets have braced for economic weakness in advance. Short positions have surged to historically high levels in equities, bonds and non-US currencies (see our October 9, 2022 CIO Bulletin).

With this surge in short interest, sizable rallies in asset prices should be expected, even if the economy faces deterioration ahead. Our tactical approach remains to focus on the broader business cycle, which continues to present market risks. The rewards for greater risk-taking lie ahead in the coming year, in our view.