2022 Investment Strategy Conference | Navigating the uncertainty, reasons for optimism

Jeremy: This year, the market has had a myopic focus on one factor: inflation. Inflation has had a profound impact on the central bank's reactions, the breadth of its ability to respond to broader market conditions, and our daily lives. Several factors drive inflation: the hangover of Covid19 impacts, geopolitical challenges, Russia's invasion of Ukraine, and its knock-on effects. Overall, our research suggests that we are seeing and will continue to see a moderation in inflation over the coming year. Our US Macro strategist indicates that 2023 could be a year of disinflation in the US, and we might see an inflation rate of sub-4 % by the end of 2023.

There are three factors to consider when it comes to inflation: supply chains, energy prices, and wage inflation. The supply chain was constrained through 2021. However, we think the disruptions in supply chains are starting to ease, and you can see in the chart below that the inventory-to-sales ratios are picking up.

The other aspect to think about is the supply chain index. The chart shows that supply chains will continue to ease over 2022. Finally, we can also look at the cost of shipping. The cost of shipping has dropped dramatically. All these factors are beginning to or continuing to ease, and we foresee this continuing into 2023. The next thing to think about is energy. The chart below shows an example of the price of natural gas in Europe versus the US. Europe has had a very acute issue with accessing energy and natural gas. This shows greater dispersion in countries and different parts of the world's ability to mitigate inflationary pressures in the energy crisis.

Moreover, energy prices are still falling dramatically from their highs. In addition, European liquid natural gas storage is around 95%. Finally, new oil rigs are also picking up, thus again showing another factor mitigating some inflationary pressures.

Wage inflation also had a meaningful impact on inflationary pressures. We currently have very low unemployment rates, but forward-looking employment expectations show that those intentions have been mitigated significantly. From an employment perspective, the impact on wage-price inflation helps balance the supply and demand dynamic.

Jeremy: Looking into 2023 and the equity indices, we are in an environment where dispersion will be elevated. Investors think about which businesses have pricing power and consistent secular demand that is important to our daily lives. These businesses will continue to have very consistent, reliable earnings, grow their revenues meaningfully over the coming years, and be rewarded by the market. As we look into 2023, investors' appreciation of durability and stability in earnings will only increase.

Jeremy: We expect the economic cycle to bottom and begin to inflect over the next 3-6 months. We expect markets to be more volatile going forward – with less monetary support, greater dispersion between geographies, industries, and companies, and higher potential for tail risks to occur (geopolitical, for example). As such, we think investors should seek active investors with deep research platforms, where we can identify the best places to allocate capital. We can build flexibility into their portfolio, optionality, and consistent and steady income in the potential absence of meaningful growth.

Furthermore, valuations have come down meaningfully, especially in the US. As a result, valuations are much more compelling to think about allocating to risk assets. Additionally, the velocity of earnings revisions has been meaningful this year. As we enter 2023, we believe there's going to be a dispersion in earnings revision; thus, investors should own high-quality businesses with pricing power. Finally, profit margins are another important factor in the current market environment. Therefore, we think the US would continue to be an attractive place to invest, as they have entered the interest rate cycle earlier than other economies, and they're starting to see it dissipate.

Jeremy: We are in a unique environment of peak uncertainty; our view is that we are in a regime shift; what drove markets over the last decade could be very different, and so investors want flexibility, and you want to be able to move your portfolio to be fluid to the economic conditions.

What you can see on chart is what you should historically own in different economic regimes. However, we are currently shifting between regimes and will continue in 2023. Looking at the picture, high-quality equities that can generate a higher yield and has an element of inflationary protection are very compelling. Investors need to balance their portfolio in terms of where their returns are coming from while also owning some inflationary-protected assets. Investors should own high-quality companies with growth potential, income, consistency in cashflows, as well as optionality and differentiated streams of returns. We think having the flexibility to leave your capital with your manager, who can move your portfolio around to capitalize on these opportunities while generating a high-income level, is important under different economic regimes.

Jeremy: Build flexibility into Portfolios – We expect individual economies, markets, and industries to behave differently, creating greater dispersion in returns and relative value opportunities.

Selectively rebuilding defensive fixed income exposure amid higher volatility – High-quality fixed income looks more competitive versus equities from a yield perspective. It could offer upside and diversification once a slowing cycle gains traction. However, caution is warranted, as central banks are likely to continue raising rates given concerns that they are behind the curve.

Seeking inflation protection – While demand destruction is a headwind for industrial commodities, a continued supply/demand imbalance could push oil prices higher, as could output cuts signaled by OPEC. As a result, we think select commodity-linked exposures could continue to outperform.

Income will be an important part of total return – Look at total return and how you can extract more from your portfolio, and think about alternative ways to generate income. For example, option strategies are interesting ways to increase the yield of your portfolio and enhance the income stream.

Jeremy: Investors should think about where the most compelling income across asset classes is. Differentiated income should rely on more than just the dividends of a company. At Wellington, we use options within our equity portfolio to generate extra income in some strategies. We sell some optionality and generate income through option strategies. The income stream is consistent; we receive option premiums over a specific stock. This is an example of a differentiated way to generate income uncorrelated with traditional risk assets.

The other aspect is looking at which companies have high-quality earnings streams that are stable and consistent, paying healthy dividends that are higher than what they were 12 months ago. Finally, in terms of fixed income, high-quality fixed income today pays more reasonably and gives you the ballast from duration.