In 2023, we believe central bank actions have reduced, though not eliminated, the risks of a recession. However, there are other risks in financial markets. Our focus is on building portfolios that are able to deliver risk-adjusted returns, but with appropriate downside protection.

2022: We kept our head

As 2022 wore on, we believed that we were seeing the classic signs of a market cycle reaching its final stages. Central banks’ radical rate hikes had ramped the cost of capital to levels not seen for a decade and a half, equity markets had repriced lower, and we fully expected the business cycle to turn down, followed by the credit cycle, which meant more downside for equities.

With experience of trading through the Global Financial Crisis, we were also sensitive to the ‘known unknowns’ at a systemic level. Fifteen years of zero interest rates had numbed perceptions of risk and incentivised unprecedented risk-taking. Much of that risk-taking was occurring in private markets and the so-called ‘shadow banking’ system, far beyond the view of bank regulators (see our previous articles here and here).

Given this grim confluence of cyclical and structural risk, we positioned our funds defensively through 2022, an approach which paid off handsomely over the first three quarters of the year. By October, having rebased at lower levels, equity markets turned the corner and started climbing a ‘wall of worry’. We were not convinced by the bullish narrative. Instead, we focused on the alarming first fruits of higher rates: a near-death experience for the UK pension system as gilts fell off a cliff, tech valuations crushed, special purpose acquisition companies friendless and Chinese property stocks struggling to find a bid.

March 2023: Rout, Rescue, Rebound

These effects were dwarfed by the events of March 2023, when the structural vulnerability of the banking system to a rapid rise in rates was revealed. There was a nasty interplay between bond portfolios crashing in value and nervous depositors voting with their feet. The result was a simultaneous solvency and liquidity crisis, which triggered the second- and third-largest bank failures in history and a wave of uncertainty which spelled the end of Credit Suisse (CS) as an independent entity.

Central banks responded by dusting off the 2008 playbook, quickly mobilising overwhelming force in the form of a $25 billion Bank Term Funding Programme to reassure nervous depositors. Meanwhile, in Europe the shotgun wedding of CS and UBS confirmed the European Central Bank (ECB)’s unqualified commitment to systemic stability, even at the cost of shareholders. Reassured, markets resumed their upward march. A new ‘risk on’ mood has revived some of the biggest losers of 2022 even as forward-looking interest rates have climbed back to their March highs. Bulls have been rewarded by robust economic data around the world which outperformed the expectations of almost all economists, including STANLIB’s own Jedi Master, Kevin Lings. Investor sentiment at the end of 2022 was characterised by fear rather than greed as inflation raged and rates marched higher. By the second quarter of 2023, the needle of sentiment had swung into more bullish territory, fed by a positive trifecta of resilient growth, the prospect of an end to the hiking cycle and proof that the authorities were alert to systemic issues and ready to act. Earnings have softened, but not as much as we had expected, and the market’s optimism has remained intact, as we have discussed in our commentary to date. Even with the European economy entering a technical recession, equities have stalled but not fallen.

We recognise that the actions of governments and monetary authorities around the world have extended the cycle and positively shifted the range of outcomes. As a result, the probability we ascribe to our ’hard landing’1 scenario has declined from over 50% in mid-2022 to 33% currently. But this is still higher than either ‘slowflation’ (31%) or ‘reacceleration’2 (26%) (see graphics below).

The bullish narrative is persuasive at first glance, but it is superficial if we are (as we suspect) facing a policy regime change. The extraordinary monetary and fiscal policies which kept the global economy alive during the Covid pandemic are now regarded as responsible for creating a mountain of government debt and a cost of living crisis which is crushing the world’s poor. An alternative approach (adjustment or removal of yield curve control or adjusting inflation targets by central banks) would have seismic consequences for markets. For us as asset allocators, this is the elephant in the room, and it casts a long shadow over simplistic bullish narratives.