2022 wrap and 2023 outlook

The year 2022 was a stinker. In financial terms at least.

The Russian invasion of Ukraine, leading to an energy crisis, resulting in rampant inflation, followed by central banks around the world realising that their zero interest rate policies needed to change, led us into a year most investors would rather forget.

Sure, there were some positives, we saw an end to most of the COVID restrictions and many people were able to sell real estate at prices that were unthinkable only a few years prior. Un-employment remained at all-time lows and real economy conditions remained strong.

Let’s dig into a some of the details of the year that was, what worked and what didn’t, and consider the outlook for 2023.

2022 – a sour year for traditional investments

Australian shares did exceptionally well all things considered. After dividends are included, the ASX200 was only down 1.1%. By comparison the US S&P500 Index fell by around 18% and the tech heavy NASDAQ was down 33%. It was a long time coming, but overpriced ‘growth’ companies led the losses, with Tesla down 65% and Meta (the old Facebook) down 64%. It was a good time for ‘home country bias’ and Buy Australian.

Fixed Income markets had their worst year in living memory. The last time losses were anywhere near as bad was 1994, a full 28 years ago. Australian fixed income was down 9.7%, taking the three year return down to -2.9% p.a. The five year historical return on Australian Fixed interest now sits at a measly 0.5% p.a.  Yes, you would have been better in simple term deposits. In the US, the broadest measure of bonds fell by 12.7% over the year.

With these returns, its not hard to see why the Vanguard Balanced ETF produced a -11.1% total return over the year, and that same index produced only 0.69% p.a. between December 2019 and December 2022.

What worked?

Energy. Of course, those greedy oil companies ramping up prices! Well, actually no. From start of January 2022 to end of December 2022, West Texas Intermediate crude was up only 2.74%. Sure, it did go up 65% between January and March as a result of the Russian invasion of Ukraine. But since then oil has spent the year in a choppy down trend. Energy equities on the other hand did very well. Seven of the top ten performers in the S&P500 were Energy companies. The best of those in the USA was Occidental petroleum which gained 117% in 2022. Warren Buffet loaded up on OXY in February, although Berkshire Hathaway lost more on Apple than it made on Occidental.

In the Australian energy space Santos was up 15.8% and Woodside was up 75%. The biggest gains were in the most hated sector – Coal. Whitehaven was up 265%, New Hope up 205% and Yancoal up 178% as both thermal and metallurgical coal prices soared.

Alternative assets had a banner year too. We include Private Equity, Managed Futures, and Equity Market Neutral in this subset, and some of the managed funds we use in this sector helped immensely in offsetting poor returns in more traditional assets.

In the Managed Futures space, Pimco Trends gained 16.7% and Winton Global Alpha was up 21.7%. Private equity saw the Partners Global Value fund eke out a positive return of around 2%, (waiting on final figures) and the Pengana Private Equity fund was up 3.5%. In Equity Market Neutral we had CC Sage up 7.0% and Apis Global Long short up 8.5%.

What will 2023 bring?

“Past performance is no indication of future returns”. That common warning is often ignored by investors who chase what was hot last year, and ditch what has underperformed, in the process ignoring wonderful opportunities. On the other hand we have to also consider Isaac Newton’s universal law of motion. He said;  “An object at rest stays at rest and an object in motion stays in motion with the same speed and the same direction unless acted upon by an unbalanced force”.

Investors who chased growth were rewarded handsomely until the end of 2021. The tailwind was ultra low interest rates. In 2022 global central banks unleashed the ‘unbalanced force’ of rising interest rates that changed the direction of the ‘object in motion’.

Right now, market participants are desperately trying to outguess each other as to when the ‘unbalanced force’ might swing back to an easier stance. The term ‘pivot’ is now the common parlance to describe the change in direction of for interest rates, particularly in the biggest market of all, the USA.

The first two weeks of January have brought a small reprieve to shares with the S&P 500 up 4%, and the ASX220 up 4.4%. Assisting the more buoyant mood was a small moderation in inflation, with the official US CPI for December coming in at 6.5%. This is down from 9.1% back in June. Hopes are high that we have seen the peak in inflation, and that this in turn will allow the Fed to ‘pivot’. In Australia the year on year inflation was 7.3% for November and the December figure is tipped to hit 8%.

Although the headline rates of inflation might be moderating, inflation remains high enough to indicate that central banks will continue to raise interest rates in the first part of 2023. That much seems to be a given.

However we are unlikely to see cuts in interest rates without some kind of ‘breakage’ in financial markets, employment, or GDP growth that turns negative.

We expect more volatility as markets vacillate between pivot and no-pivot sentiment. If there is no pivot, but rather a pause, the higher rates of interest will gradually suck the oxygen out of the sickly enterprises and over leveraged investors and homeowners. This will likely lead to a recession late in 2023.

Opportunities

The poor returns from fixed interest last year have created one of this year’s opportunities.

Fixed Income

In the corporate bond market in Australia, you can buy five year Telstra bonds that yield a tad over 5%. You can buy Wesfarmers bonds with a 5.5% yield. To get a diversified exposure to this market, the Betashares Australian Investment Grade Corporate bond ETF had a yield to maturity of 6.03% at the end of November. Average bond maturity in this portfolio is around 7 years. In the Vanguard Australian Corporate Fixed Interest ETF the average maturity is shorter at 3.5 years, but the yield to maturity is still a healthy 5.06% with an average credit rating of A+.

In a mild soft landing scenario corporate fixed income should do quite well if interest rates pause or moderate. In a deeper recession scenario however, we could see a widening of credit spreads (the increased return investors demand over the government bond rate) and this could lead to a temporary fall in value.

Similar opportunities are also available with active managers in the managed funds we recommend in this sector, such as Daintree, Janus Henderson, Franklin Templeton and State Street.

Positioning for a deeper recession or a 2008 style financial crisis would dictate a move up the credit quality stack. The Vanguard Australian Government bond ETF had a terrible 3 year historical return of -3.36% per annum. But at current prices, the yield to maturity of their bond portfolio is 3.97% with a AAA credit rating. Average maturity of the underlying bonds are 6.6 years, but since this is a marketable security you can buy and sell immediately on any given day. In a recession, if interest rates fell by 1% over the next year, this ETF could make a total return of around 8%.

Energy

While we need to be cautious about chasing last year’s winners, there has been a perfect storm that has turned energy from being most hated (especially when crude prices went briefly negative in 2020) to now being recognised as an interest rate agnostic cash cow. For a deep dive into the how energy abundance has shaped the rise of our living standards, listen to the first fifteen minutes of this podcast from Erik Townsend. https://www.podbean.com/ep/pb-7rakk-1358d72

Due to ‘net zero’ emissions targets and outright hostility from governments against new oil developments there has been a shortfall of Capex to maintain current oil production. Why would oil company boards invest in new developments when it is easier to use cashflow to buy back shares and increase earnings per share. It is farcical that one of Joe Biden’s first executive orders in January 2021 was to halt new oil and gas leases on public lands and waters and yet now he has to go cap in hand to the Saudi’s and even Venezuela to beg for oil supplies!

Traditional energy, (coal, oil and gas) should continue to do well in the coming years.

New energy, in the form of generation and storage will also be in high demand. My concern is that there may be too much money chasing the generation side. Wind and Solar are in a growth phase, but there is a lot of large institutional money flooding into that sector and that will supress future rates of return. There is also the risk of producing too much solar energy at times when the market has no need for it. I have commented before on Nuclear energy and dabbled in a few shares of uranium producers like Lotus. If you are interested in the outlook for nuclear energy and investing then I highly recommend the above podcast from Eric Townsend.  

Energy storage. Given the above comments on production of too much natural energy at peak times I think that energy storage is one of the areas that is most interesting. Naturally this includes the lithium producers, and once again, it seems Australia is the ‘lucky country’ in this respect. We have lithium company research and a full list of names available on request.

Additionally there are many new developments in mediums of energy storage that are also very interesting. Hydrogen is one example. We also have some extensive research on listed companies in this market. Redox flow batteries that use liquid electrolytes, or silicon, and also vanadium. Many of these technologies have demonstration units but are some way off large scale adoption.

Equity Market Neutral, Dynamic Hedging, and Trend Following

When the zero interest rate tail winds were blowing it seemed that all stocks went up. Now that the wind has changed, there is a larger difference between the performance of the best and worst stocks. This is where equity market neutral funds can shine. The Sage Capital Absolute return fund is a good example of this. Up 7.06% in 2022, and up 10.82% per annum over the last 3 years versus 7.74% for the ASX200 provided a handy outperformance. More recently we have added the Apis Global Long/Short fund to our recommendations. Although only available in Australia since October 2020, the returns since April 2004 are 11.15% per annum. The one year return to 30 November 2022 was 11.35%.

For investors with the HUB24 wrap accounts the Watershed Group managed accounts provide a combination of direct equity exposure with active hedging using inverse ETF’s like BBUS and BBOZ which rise in value if share markets fall. Watershed have used this tool very well in 2022, managing to maintain a positive return for their Balanced Multi Asset managed account in 2022 outperforming the Vanguard Balanced ETF by 9.15% up to the end of November.

Another option with dynamic hedging is the Milford Absolute Growth Fund. Don’t be confused by the name. The ‘Growth’ moniker doesn’t refer to the growth/value difference between stocks with high P/E multiples and low P/E multiples. It is a style agnostic fund that focuses on capital preservation and as a corollary, ‘growth’ of your wealth. Milford managed to get through 2022 with a gain of 0.28% by judicious use of hedging options while the ‘growthy’ Bennelong Australian Equities fund produced a -28.89% number.

Within the Managed Futures / Trend Following segment we have traditionally used Winton, before that AHL, and at times the Aspect Diversified Futures fund. In the last three years our go-to fund has been the Pimco Trends fund.  All of these use a systemised futures trading system to trade a wide range of futures contracts and can benefit from prices either rising or falling as long as they are on the right side of the trade. In the month of March 2020 our conviction in the Pimco Trends fund was enhanced as it rose by 7.5% in a month when the S&P500 fell 12.5%. This proved to be a good diversifier in the portfolios, and the performance continued in 2022. These funds need continued strong trends either up or down to do well.

Relative Value trades

One of the relative value trades that has opened up is the divergence between the prices of listed property and unlisted property. There are still direct property transactions taking place in the industrial markets around a 4% yield. The prices of listed property has come down by 20% or so in the last year, implying cap rates that are 1 to 1.5% above the price being used for unlisted valuations. Where investors have a liquidity option we are selectively recommending the exit from un-listed property. This won’t be available in all cases, as some funds have a fixed term lock up. Listed property may have further to fall in a recessionary scenario, but the valuations and yields look very good if you believe we will manage a soft landing. Relative to unlisted property, listed property looks cheap.

In the world of closed end, listed investment products there are a few that are now trading at levels that warrant closer inspection. Closed end funds have a captive amount of capital under management, and in one way that is good since it means the manager can invest for the longer term. Warren Buffet’s Berkshire Hathaway is the biggest example of a closed end fund. At times though, when more people want out than those who want in, a closed end fund can trade at a discount to the net asset value. This is typical during panics and is the time when maximum opportunity presents itself. In this space the Partners Group Global Income fund qualifies as an example. Trading under the code PGG on the ASX, the fund holds a portfolio of loans to over 300 different small and medium sized companies. The senior secured loans are further up the capital stack than a bond as they generally have direct security over the assets of the business. At the moment though, thanks to the widening in credit spreads, the value of the loans have been marked down and the units in PGG are trading at a 14% discount to the marked down net asset value (NAV) of the loans. If all the loans were paid off in full over the next 3 years and the discount to NAV was closed then the total return would be around 17% per annum. Relative to the probable return from Equities this is a situation in fixed income which could easily outperform by a large margin. While the internal gearing adds some extra risk, this fund could be viewed as a substitute for some equity exposure. The 9% p.a. dividend yield, paid monthly, is a short term sweetener.

Conclusion

It is widely anticipated that a global recession may be just around the corner. The wide expectation of something is however often a contrarian indicator, so maybe it won’t play out as we expect. That said, we remain very cautious as the unwinding of excesses may only be in the early stage. Investors are nursing losses, but the general mentality on display is ‘buy the dip’ rather than capitulation.

Diversify and be willing to take non-consensus bets. Liquidity may be your best friend during 2023, so don’t be ‘all in’ on your positions. It will be a tug of war between inflation and recession. There is an ‘un-balanced’ force in play now that central banks are determined to tighten financial conditions. That which appears cheap on a historical fundamental basis can continue on a downward trajectory until a new ‘un-balanced force’ comes into play. Central bankers are unlikely to reverse course on interest rates down any time soon, and when they do it will be because of an untidy unravelling of some significant parts of the economy. Remain on a cautious footing.