In a year that most investors would rather forget, will 2023 bring any respite? Or will the slings and arrows of US Federal Reserve rate hikes continue to undermine risk assets and bring an unceremonious end to the era of cheap money?
How will some of the riskiest assets fare in the year ahead and should investors be sticking their heads in the sand or looking for opportunity?
Investors who have until fairly recently, been punch drunk on a steady diet of risk assets are unlikely to reflect on 2022 with undiluted pleasure.
From the highest pace of inflation in over four decades, to the Russian invasion of Ukraine, there were few, if any, bright spots in the global economy.
Few investors, especially those who have entered the market in the past decade, have ever experienced such a challenging macroeconomic environment, and it’s safe to say that 2023 will likely be worse.
The unfortunate prognosis is that things are likely to get a lot worse before they get any better.
What happens when the Fed removes the punch bowl?
Prior to the 2008 Financial Crisis, the last precedent for massive infusions of cash into the economy was in the aftermath of the 1929 Great Depression, that precipitated the Second World War.
Whereas reservations around “moral hazard” may have weighed on Washington’s decision-making process in 2008, the global central bank response in the wake of the 2020 Covid-19 pandemic put to rest lingering doubts that central banks would intervene with easy money to shore up battered economies.
The result of prolonged loose monetary conditions over the past decade and especially in the aftermath of the pandemic led to a surge in asset prices, which post-pandemic, spilled over into price increases for living expenses.
And while central banks have raised interest rates, these hikes are still well short of inflation and real interest rates remain deeply negative.
By way of illustration, if the rate of inflation is 8 per cent and interest rates are at 4 per cent, real interest rates are -4 per cent, which is why markets have corrected, but not capitulated.
Negative real interest rates for multi-year periods have only occurred four times since the mid-1800s — during the two world wars, in the aftermath of the oil crisis from 1974 to 1980, and our current epoch.
In the previous three periods where negative real interest rates were prolonged, average US inflation ranged from 7 per cent to 15 per cent, with central bank intervention to restore positive real interest rates, part of an effort to tackle inflation.
Nowhere in history has negative real interest rates persisted for so long as in the present.
Compounding the problem facing policymakers looking to raise interest rates is that major central banks have purchased massive amounts of government (or government-guaranteed) debt, setting fresh peacetime records.
And while central bank balance sheets were pared down after the 2008 Financial Crisis, they remained historically higher than before that crisis, only to swell to new highs during the Covid-19 pandemic.
These unprecedented measures have stymied the ability of policymakers to respond to rising inflation, and helps explain why the US federal funds rate remains locked well below the 12-month inflation rate of about 7.1 per cent.
In Europe, interest rates remain well below the eurozone inflation rate, which is fast approaching double-digits and Japan’s negative interest rates are now only just approaching zero.
To be sure, the moves to hike interest rates in the US over the past year have helped to slow down inflation somewhat, but inflation remains well above central bank targets and policymakers will need to keep conditions tighter for much longer than the market appears to be pricing in.
But it is far from clear that policymakers, who in the US are political appointees, have the stomach to maintain their commitment to tighter monetary conditions in the face of weakening economic activity, especially as unemployment starts creeping up.
The persistence of inflation in the US in the 1970s can at least be partly explained by the Fed doing too little too late, or constantly vacillating in the tightening process, leading to the painful start-stop policymaking that was the hallmark of that era.
Because central bank independence has been more undermined than ever, officials now consider a much wider mix of variables when setting policy, weighing the broader consequences of policy, both on the economy and on their political masters.
And that increases the risk that the global economy is in for a prolonged period of heightened volatility against an extended period of elevated price pressures — inflation may not get out of control, but neither will it be brought back down to target.
At some point, a new equilibrium will be arrived at, with interest rates settling at a level higher than zero, but well short of the pace of inflation and when arrived at, will provide the indicative risk-free rate of return for investors.
Instead of a determined effort to tighten conditions to achieve an exit from negative real interest rates, policymakers are more likely to settle for an unsatisfactory and glacial path to reign in price pressures.
That policymakers don’t have the stomach to tackle inflation by the horns has been demonstrated by the Fed only hiking rates by 50 basis-points in December, which at the current pace, will still take almost a year to exceed the pace of inflation.
Nevertheless, the sheer threat of positive real interest rates already has businesses preparing for a central bank-induced recession, and the odds of one occurring are increasing by the day.
Not My Recession
Predicting a floor for risk assets is in many ways an exercise in futility mainly because the Fed stands at the ready to turn on the liquidity taps again should things get too bad.
And therein lies the main issue for investors.
Prior to 2008, there was never a guarantee that central banks would intervene to backstop markets in a crisis.
In 2020, while there may have been some sense central banks would step in to switch on the liquidity taps when markets needed them the most, there was no guarantee that would be the case either.
But post-pandemic, central banks, through their repeated interventions, may have created an expectation on the part of investors that policymakers will never let things get “too bad,” but what that looks like is debatable.
And that’s why assets in general, and risk assets in particular, have been making a gradual but progressive decline, as opposed to marking a sharp pullback, on expectations that policymakers will intervene in the face of market turmoil.
Investors taking such a view will still need to run the gauntlet of subjective expectations, because what does “too bad” look like?
How much must US unemployment meaningfully rise for the Fed to cave under popular pressure and intervene?
What does “bad” even look like?
Against this backdrop of subjective determinations, and with Fed officials leaving the door open for nuanced policymaking, investors will need to stomach far greater levels of volatility.
Depending on where interest rates end up, assets more sensitive to rate hikes will be the first to show signs of weakness and deleveraging, above and beyond what is currently being experienced.
Insofar as real interest rates remain negative, risk assets of every stripe will see correction but not capitulation, if and when rates real interest rates become positive though, previously viable investments will now become untenable.
The reality of course is that such a scenario, where policymakers usher in a period of positive real interest rates, is highly unlikely, because of the painful medicine that the economy and constituents must take in the process.
In the decades since 2001, in the aftermath of the dotcom bubble bursting, loose monetary conditions have been greasing the wheels of the global economy and it’s hard to see both policymakers and politicians reversing course.
The global economy appears to be stuck in a vicious cycle where loose monetary conditions build unsustainable bubbles which burst because of tightening, necessitating rate cuts to reignite the economy, rinse and repeat ad infinitum.
If, as expected, China’s re-entry and opening up help lessen inflationary pressures, easing supply-side constraints, policymakers may find the opportunity to declare an early victory against their fight against rising prices.
Whether central banks can achieve such a turnaround before their economies are plunged into recession though remains unlikely.
Recall that policymakers set rates with only the benefit of hindsight — indicators of inflation, employment and business activity are all lagging indicators.
And central bankers have repeatedly gotten it wrong, calling inflation “transitory” when it proved persistent, they are likely to get it wrong again, holding conditions for too tight too long, well after the economy will require a shift.
As such, a recession ought not be seen as something to be avoided, but the necessary rite of passage to get to more sustainable levels of economic growth.
While much of the leverage and excess in the global financial markets has subsided somewhat, for as long as rates remain negative, the economic incentive to borrow and invest, or speculate, will persist.
The durability of investment and speculative behaviours will ultimately still depend not so much on actual policy rates, but on expectations of where rates will end up.
A large proportion of portfolios remain in cash at the present moment simply because investors are unwilling to bet on where or when policymakers will call a halt to tightening.
But the minute that policymakers are viewed as unequivocally ushering a shift, from hawkishness to dovishness, asset prices can be expected to have found a possible inflection point.
Capital and Cryptocurrencies
With former crypto wunderkind Sam Bankman-Fried in house arrest and facing a slew of criminal charges that could see the former CEO of crypto exchange FTX serving as much as 115 years in prison grabbing headlines, major inroads into the crypto sector by some of the biggest players in the financial services sector may go unnoticed.
While prosecutors regale observers with tales of fraud, mismanagement, and gross negligence at FTX, some of the world’s biggest asset managers are preparing for a more institutionalised version of the cryptocurrency sector.
Fidelity, one of the world’s largest asset managers with over US$10 trillion in assets recently filed trademark applications for an NFT (non-fungible token) marketplace, even as the sector has seen prices fall substantially.
Meanwhile HSBC, one of the world’s largest banks, recently filed a slew of trademarks for a wide range of digital currency and metaverse products, including a cryptocurrency exchange.
As federal prosecutors weed out bad actors in the cryptocurrency space, the string of corporate failures, whether from fraud or interdependence, will leave open a void for the cabal of regulated financial institutions to fill.
While there is more than an outside chance the vast majority of cryptocurrencies eventually become valueless, the handful that does survive will command higher prices, especially as monetary conditions stabilise and eventually ease.
Investors looking for bargains in cryptocurrencies now will have their work cut out for them, bearing in mind that outside of Bitcoin, Ether and Tether, the majority of the top ten tokens by market cap today were either unheard of or didn’t exist in 2018.
For the keen cryptocurrency investor, patience may not just be a virtue, but a necessary prerequisite to survive this prolonged period of price declines, especially as the heady returns of 2021 will remain elusive.
Venture capital funding for cryptocurrency and Web3 projects will continue, but terms will be less generous and a clear path to profitability will need to be proffered before coffers are replenished.
Stocks and Sectors
In a recession, commodity stocks are likely to be hammered first as global demand for raw materials cools.
The same level of leverage-fueled speculation that helped fuel the recent run-up in commodity prices, will also facilitate a sharp correction.
With the war in Ukraine plodding along towards an unsatisfactory stalemate, stocks of defense contractors, which had languished for so long, look particularly attractive as countries start to pay more attention to defense spending.
Outside of Europe’s rearming, geopolitical tensions rising in the Pacific, with China’s increasing assertiveness over the waters of the South China Sea and its goal to retake Taiwan will also see defense spending rise in the region.
Even before the Russian invasion of Ukraine, the Trump administration had provided Europe with plenty of food for thought in its defense posture and assumptions about American largesse with respect to the region.
Now Europe and Asia will be in for a long period of rearmament that will benefit not just high-profile defense contractors, but lesser-known component and service suppliers that are able to provide maintenance, training, spares, and technical expertise.
The war in Ukraine also highlighted the optimised supply chains when it came to food and feed production, and companies either focused on increasing crop and livestock yields or developing homegrown alternatives, will likely do well.
Investment themes to look out for in the coming year will revolve around water and food security, as well as the companies, including logistics companies, that are able to provide them.
Luxury real estate which financed at lower rates will likely retain value in many key markets, but weakness can be expected in prices in cities that experienced more speculative run-ups.
Australia’s real estate market looks particularly vulnerable, with soaring property prices in Sydney and Melbourne, fueled both by the pandemic and permissive credit conditions, likely to see the sharpest pullback.
Hong Kong could see a bottoming out as Chinese money is allowed to move again, but a return to the halcyon days may be elusive as the long-term prospects for the territory grow increasingly uncertain as Beijing tightens its grip.
In the US, the shift towards remote work is likely to prove durable, regardless of what Elon Musk may prefer and Americans may decamp from cities which have seen the sharpest rise in real estate prices for more affordable regions.
Cities like Phoenix, Miami, San Francisco, Seattle, San Diego, and Las Vegas are most at risk of seeing prices plateau, and if layoffs become more persistent, especially in the lucrative tech sector, prices could correct more sharply.
Tech talent and companies have already been shifting eastwards from the Bay Area over to new hubs like Austin, where real estate prices are far more affordable.
Rising interest rates will help to put a lid on real estate prices, but given that globally, the lessons of the 2008 Financial Crisis have helped reduce household mortgage debt, another crisis sparked from the real estate market appears unlikely.
Volatility is the New Normal
Despite sabre rattling by the Fed, it seems as though a start-stop approach to dealing with inflation is almost inevitable as policymakers grapple with conflicting needs and in a likely repeat of the 1970s.
Against this backdrop, volatility will likely increase instead of decrease and investors looking for returns greater than inflation will need to be able to stomach bigger swings for longer periods.
Investors accustomed to straightforward portfolios of 60/40 stock and bond allocations will need to relook at the approach that has served them well for the past three decades.
Indices which have become far more reliant on tech over the past decade will now act as a drag on passive investing, lowering the benchmark hurdle rate.
Hedge funds are particularly suited for this new macro environment in their ability to take more risks and perform more deftly in an increasingly dynamic and challenging operating environment.
2023 is a Time for Planting
Our current decade will be marked by a departure from the old way of investing and our approach and attitude towards risk and assets.
Even as the current fallout from the collapse of FTX continues to reverberate through the cryptocurrency industry, the continued institutional participation and development of digital assets and tokenisation mean that assets will take on a different look.
Tokenisation could help to reduce friction and costs, improve access and increase the velocity of assets.
Investors accustomed to a more laid-back approach to managing their portfolios will now be forced to take on a more active role, if not, one that is far more engaged than in the past to prevent themselves from getting caught flatfooted.
The biggest and most powerful companies for the next decade are likely to resemble nothing of this present decade as disruptive technology, including artificial intelligence, blockchain, virtual reality, augmented reality, cloud computing and the metaverse upend legacy systems.
As with all advancements in technology, the timeline and the impact of these new technologies will only be obvious with the benefit of hindsight.
Unfortunately, 2023 looks set to be the year that interest rates will peak and not plateau, which means that the quick gains and hard charging returns of the past several years are likely over.
As rates rise, investors will need to take a far more long-term view than they had in the past, while remaining cognizant that innovation isn’t instantaneous.
Balancing the need for regular receipts, bonds are likely to be a good buffer in a high interest rate environment while value could be had in the stock of companies whose valuations have come back to earth, but whose technology could be revolutionary in the years to come.
If 2022 was a year many investors would rather soon forget, then 2023 is a year for introspection.
By Patrick Tan, CEO & General Counsel of Novum Alpha
Novum Alpha is the quantitative digital asset trading arm of the Novum Group, a vertically integrated group of blockchain development and digital asset companies. For more information about Novum Alpha and its products, please go to https://novumalpha.com/ or email: email@example.com
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