The conventional wisdom about trying to time the market is that you shouldn’t. Catching the tops and bottoms with any degree of accuracy or consistency is near impossible and the cost of getting it wrong can take a heavy mental as well as financial toll.
But there is a difference between an all-in, all-out approach to investing and more subtle attempts to weight your portfolio to what you think will be the better performing assets at any point in time. It’s the equivalent of gentle nudges on the tiller to catch shifts in the wind direction as opposed to violent oversteering with the associated risk of a painful smack on the head from a swinging boom.
To labour the analogy, 2022 would actually have been a good year not to take the boat out at all. As the inflation and interest rate storm has blown through financial markets, cash has been the only safe harbour. Even after last week’s relief rally in both the US and China, shares and bonds have taken a beating this year. And the usual diversifiers like gold and property have generally been no help.
I think 2023 could be very different and I expect to look back in 12 months’ time on a much more satisfactory year in the markets. In my opinion, by the end of next year, stock markets will be looking through the ongoing recession to better times ahead. And bonds will have responded to falling interest rates as central banks shift their attention from overcoming inflation to supporting the economy.
But different assets will march to different drumbeats through 2023. In general, the more interest-rate sensitive an asset is, the sooner it will emerge blinking into the light at the end of the tunnel. The more economically sensitive assets will likely follow in due course but take longer to pass through the darkness. Sometimes it’s better to just sit on your hands. But next year I think it will pay to be more active and to ride the rotation into risk.
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I expect government bonds to be the first to move in 2023. These are the simplest of assets because there is almost no risk of default. The UK government may have ‘eye-wateringly’ difficult choices to make but these do not include whether or not to pay its debts. In the final analysis it will simply print more money to do so. This means a key consideration when deciding whether to lend to a government with the luxury of its own currency is whether interest rates are going to rise or fall.
At some point the central banks on either side of the Atlantic will realise they have done enough. Inflation will start a rapid return to target and they will take their foot off the brake. Because bond markets anticipate these moves, yields will likely peak some time before the actual turn in the interest rate cycle. The explosive response to last week’s lower than expected inflation print in America showed just how quickly this can happen.
At the moment there is no sign that the US Federal Reserve (Fed) is ready to change the direction of travel for US interest rates, but it is already hinting that it can slow the pace of hikes. We probably won’t see any more 0.75 percentage point hikes in this cycle and the likely peak in rates may only be two or three smaller increases in the future. Elsewhere, the European Central Bank (ECB) is already reaching the upper limit of its tightening cycle and the greater stability of the UK government means the Bank of England (BoE) can also start to look beyond this week’s 40-year inflation high.
The bonds issued by companies share some of the interest rate sensitivity of government bonds, but they also behave a bit like shares. They are a kind of hybrid investment with so-called investment-grade bonds sitting closer to government debts and high-yield or junk bonds closer to the stock market end of the risk spectrum.
Because of this, next year’s recession will likely exert a two way pull on corporate bonds. They may benefit from lower interest rates, but investors may demand a higher yield to compensate them for the greater risk that companies will fail to repay lenders what they owe them. To an extent this scenario has already been priced in as the gap between government and corporate bond yields has widened. But there is less hurry to increase the weighting to this riskier end of the bond market next year.
The final part of the rotation will be the recovery in share prices. As with corporate bonds, shares are impacted by both changes in interest rates (which affect companies’ borrowing costs and demand from their customers) and company-specific economic risks. The health of the economy and the profits cycle is more important for equity investors, so they tend to move later than bonds. The good news is that, as with bonds, shares discount the future. They don’t require the sun to shine, they just need a break in the clouds.
Described in this way, it all sounds very logical and easy to navigate. Government bonds, then corporate credit and finally shares. The reality, of course, is that this is an oversimplification and the exact timing of the turn in each cycle is unpredictable. Holding a balanced and diversified portfolio throughout remains sensible.
I expect to see positive returns from both bonds and shares next year, which may surprise an observer focused on the economic headlines. These will remain grim through much of 2023. Holding either asset will be more rewarding next year than this. But in my opinion rotating steadily from an overweight in government bonds at the start of the year to a preference for shares at the end could make a good year even better.
Originally published by Tom Stevenson, investment director at Fidelity International.