First quarter (Q1) 2023 outlook: Summary
We expect the first half of 2023 to be choppy as markets process inflation data. Later in the year, central banks should moderate interest-rate hikes, inducing a sustainable risk-asset rally. With the timing of these events being fluid, the volatility of volatility should be high, and market moves fleeting in duration early in the year. We believe such a market environment presents a rich opportunity set for tactical managers focused on security selection.
- Discretionary global macro: We expect macro factors to remain in focus, with investors closely watching inflation and growth data to set expectations for future policy shifts.
- Commodities: The shape of China’s reopening will likely have an outsized impact on global commodities with a potential increase in COVID cases pushing back the full recovery.
- Insurance-linked securities (ILS): The current market offers one of the most attractive entry points for ILS investors since asset class inception. Total yields are higher following Hurricane Ian, tighter reinsurance capital, and an increase in money market rates.
Macro themes we are discussing
The most important factor for the markets over the next 12 months will unequivocally be inflation and inflation expectations. The forward paths of both are highly uncertain being they are the aggregate result of many disparate inputs. Global central banks are attempting to quell price pressures with aggressive monetary policy and tightening financial conditions, while admitting that it is very difficult for them to manage inflation. The resulting market environment, which we believe will persist for the foreseeable future, is one of high uncertainty as the market prices forward expectations of when and how inflation will be tamed. Major price and liquidity dislocations typically accompany such regimes.
Given the complexities of the aggregate inputs to inflation, we find it highly unlikely that central banks will accomplish their goal. The most likely scenario is a policy error. Either they overstay on the tightening pedal too hard and too long causing major economic destruction. Or, they are too light on the pedal, causing inflation to run too hot for too long and eventually cause the markets to lose confidence in central banks.
Accordingly, we are prioritizing capital preservation with a strong preference toward managers that can capture long versus short alpha in shifting environments via nimble portfolios. Our high-conviction area in hedge funds is discretionary global macro managers, given the opportunity set for directional and relative value themes. We favor market neutral alpha-driven managers in equity long/short and fixed income. Rising cash rates in the fixed income markets could provide a ballast to strategies.
First quarter 2023 outlook: Strategy highlights
Discretionary global macro
The US dollar staged a strong rally in 2022 until reversing itself in the fourth quarter. The re-emergence of large moves in currency markets is a reflection of heightened dispersion between regional fundamentals and policy paths. Discretionary macro managers, who often focus on such factors, may be well-placed to capture the opportunities these moves create. Significant momentum shifts in major markets like the US dollar can also have broad implications for other global markets, such as emerging markets and other asset classes. The persistence of these large, macro-driven moves can help create a robust opportunity set for macro managers.
The beginning of 2023 picked up where 2022 left off as it relates to European energy, with a strong cushion of natural gas held in storage following a milder-than-normal start to the winter. A freezing start to December drained stockpiles of the fuel rapidly, wiping out about a third of capacity in the United Kingdom. But mild, wet and windy weather over the Christmas period curbed gas demand and actually allowed inventories to be refilled. At the beginning of 2023 Europe’s gas stocks were 14 percentage points above the five-year average. This is the largest gap since 2020, when most forms of energy were in major surplus due to the pandemic. More significantly, Germany was able to add about eight terawatt-hours, which is the equivalent to all the UK storage volumes, to its stockpiles in the last 10 days of December. Europe’s ample gas supplies, combined with forecasts for continued mild weather, have pushed the TTF natural gas contract to near the lowest level since before Russia’s invasion of Ukraine.
Insurance-linked securities (ILS)
Historically, following heavy years of event activity, the ILS market sees risk-adjusted rate increases as investors demand higher rates to assume the risk. The Swiss Re Cat Bond TR Index saw its first year of negative annual performance because of markdowns in the immediate aftermath of Hurricane Ian. Previously, after years of substantial loss impact, the cat bond market has posted strong returns in the following years. The initial loss reports from underlying sponsors and insurance companies have been lower than anticipated, leading to some price recovery through the fourth quarter. Further buoying our positive outlook toward the ILS asset class is its floating-rate structure. ILS instruments are priced as a spread above the risk-free rate. With a sizable increase in money market rates, the forward-looking total yield expectations are near the highest since the inception of the asset class.
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