2022 Wrap Up and 2023 Outlook
I have a feeling we are all somewhat relieved to be putting 2022 behind us. Regardless of who your asset manager was, including the global brand names, 2022 was a very challenging year, testing long-held fundamental assumptions about asset allocation and money management. If you rely exclusively on past statistics, you can be optimistic about 2023 as, statistcally, almost always, a positive year follows a negative year regardless of macro considerations. The macro considerations are complex but lets hope that history does repeat itself.
Without sounding like we lack empathy for the negative values in clients' portfolios, we hold a lot of pride in our process and in our risk management, as our portfolios did better than most competitors and benchmark indexes. From an advisory and wealth management point of view, I firmly believe in how Pioneer approaches wealth and manages money. So while the lessons of 2022 will be front of mind, we are not changing our process significantly and will continue to manage money professionally, using tried and tested approaches to asset allocation and risk management.
Now our heads turn towards 2023, and we are trying to position our portfolios to deliver the returns clients want without compromising the relavant risk profile - more on that below.
As communicated in previous bullitens, the clear positive correlation between stocks and bonds made 2022 unique and painful. Usually, when stocks go down so aggressively, bonds go up as money goes towards higher quality investments – the "flight to quality". This year that did not happen as the source of the pain was higher than expected, with rising interest rates. Please note that it almost didn’t matter what your asset allocation was, as the losses on stocks and bonds were similar. Conservative investors were thrown into the fire with aggressive investors. The only difference is that conservative investors should do better in 2023 if they don’t sell out. It looks to us that bonds will do much better in 2023 than in 2022 as some, if not all, of the 2022 bonds losses will be recouped in the short term, especially as the shorter bonds approach their maturities.
Recession Proof Investing
Over the last few years, in our letters and webinars, we have been saying how difficult it has been to make money from investing in bonds due to ultra-low interest rates. In such an environment, the risk-return profile was tilted to the downside – too much risk for insufficient return. Investors had to make difficult choices between higher-risk equities or lower yielding bonds. Look at the table above and you will see that the three-year returns for the primary bond indices are insanely low numbers (in contrast to equities), and most of the damage was in 2022. Ironically, bonds are used in portfolios because, generally speaking, they are more predictable than equities. We held them because of their historic predictability; investors and regulators use them to express low-risk objectives. How did we manage the risk? We had significantly shorter bonds than our strategic benchmarks, and this active decision meaningfully protected our portfolios. It should be stated that across the professional world- being short duration was not a consensus view. In retrospect, we should have been even shorter, and those asset managers who were long-duration have paid an even more painful price this year.
The bottom line is that, unfortunately, we were not short enough in duration to avoid any bond losses, but there is a some comfort for me to say that it could have been a lot worse.
The good news is that as we advance, we can finally expect to earn the type of returns we have traditionally expected from bonds, i.e. 4% to 7%, depending on risk level. Conservative USD and Shekel bond investors can now finally, after nearly 13 years, earn a decent yield in bonds. That is recession-proof investing - decent returns & low risk. In our opinion, investment-grade companies are going to survive the upcoming recession and will not go bankrupt; therefore, this is an excellent place to be. USD investors have a new dilemma as fixed deposit cash rates have gone up significantly, especially at the Israeli banks. These rates are attractive now but we cannot say how long they will last. For example, if you buy a 3-year quality bond portfolio yielding 5.5%, you can realistically expect to earn 5.5% per year for three years. If you put your money in a USD fixed deposit at, say, 5% for 12 months, then when the time comes to renew it - in 12 months - you do not know what interest rates will be one year from now. The currenct consensus view is that rates will be heading down again in a year as the recession bites and inflation comes down. That gives bonds an advantage over fixed deposits in terms of yields. Furtheremore, in a deposit, you will also lock up the money at the bank for the duration of the fixed deposit and will not have the daily liquidity offered by the bond market. That makes high qualitiy bonds the best place to ride out the current short term uncertainty.
As I have written before, predicting the stock market is somewhat of a fool's errand. We know it's volatlie. Reading the tea leaves tells us that there will be some sort of recession ahead of us, but in our opinion it will not be too bad as the USA consumer has a lot of resilience, savings and credit access. However, a recession does mean in general that companies will be stretched to make the money they did in the past. We believe its fair to say a lot of this view has already been priced into the the forward-looking stock market. It will be a bumpy ride as the equity market will jump on every possible positive piece of news and react if the trend reverses. Israeli investors should be aware that as the stock market settles down and recovers, there is a strong chance that the Shekel will strengthen again back to the 3.1 to 3.3 range to the USD.
Avoiding The Most Common Mistake
Behavioral finance lessons loom large. Human nature forces people to feel like they need to do something when their portfolio is not doing well. They either sell in panic and then miss the rebounds, fire their portfolio manager, or significantly change their asset allocation. These actions in isolation and without a well-thought -out process are all bad ideas. We see clients move around a lot only to have one manager sell everything and a new manager re-buy over 90% of the same assets that were just sold. Be sure not to make any of these mistakes.
One of the clear victims of 2022 was the Crypto space. An astounding number of more than 90% of Crypto investors have lost money since they started, and the profits are reserved only for the early adaptors. Over the last few years, many product providers have tried to sell us their Crypto strategy. Watching the exceptional rise did make us all jealous of the crazy performance. However, most of our professional investment team could not get their heads around the space, so we kept it out of the Pioneer portfolios. In Q4, we saw the implosion of one of the Crypto platforms- FTX, with money going missing and allegations of fraud and even arrests. I find it ironic that one of the selling points of Crytpo was that it was supposed to be transparent and self-regulated by the community of users, and therefore, safer from fraud than fiat (traditional) currency investments. The difference is that fiat currency has had a few hundred years to develop regulation against fraud and protect investors while Crypto is still in its infancy. Crypto's here to stay, but it will be long before the platforms are safe enough to say that they are better than traditional platforms.
Inflation is complex, and we all are guilty for looking for that one magic number. When it comes to inflation, that one-number metric does not really exist. Even the Fed, with all their data, tools and experts in the world, got it hopelessly wrong in 2022. In 2021 we spoke about covid driven transitory inflation. This inflation is essentially over. Durable goods inflation which was a significant component of Covid inflation, peaked at around 18% year on year in February. It was 4.7% year on year in October, a truly dramatic disinflation and at least in part supporting the thesis that inflation was temporary. Then came the commodity-driven inflation due to the Ukraine war; this, too, has slowed. The next source of inflation is profit inflation, as profits have grown faster than wages for seven of the past eight quarters, and even if salaries went up in nominal terms, they are down in real terms. Consumer demand remained very strong, which allowed firms to charge more, and consumers believe it's due to inflation, so they are willing to pay more. We believe that this is all temporary, and inflation will come down, especially now that the Fed has begun serioulsy to tighten the conditions through higher rates and reducing its balance sheet. However, it will be a very slow process. Don’t expect inflation to come down to 2% in 2023, perhaps not even in 2024, but the downward trend will continue in our opinion.
The Israeli economy grew exceptionally during Covid, much more than most developed nations. One of the drivers/results was a substantial increase in household credit, including mortgages. Average monthly mortgage payments are higher in shekel amounts because the property is so expensive and consumers are now paying higher interest rates too. The average Israeli family's total spending on their home (rental or mortgage) is higher than ever before as a percentage of their total earnings. The effect of this will be a drag on growth in the future.
On the positive side for the Israeli economy there is a significant global trend of increased military spending, domestically and for export. In addition, the new government is likley to assist low earners more than other developed countries, and therefore, the overall growth picture is not too bad. I do not believe there is a bubble in property (bubble implies 50% overvalued); however, we may see 10% to 20% reductions in prices as new developments come online. Already on my way to work in the morning, as I pass the famous IDC University in Herzliya, I see a noticeable increase in "for sale" and "for rent" signs which I have never seen before. This means to me that they must be asking too high a price and the growth story on property has slowed. In terms of Israeli Shekel Inflation, while currently high at around 5%, we think that it will slowly come down similar to USA inflation. We believe the Bank of Israel will increase rates slightly from the current level, but we don’t expect it to exceed 4%. As with global asset allocation, the opportunity in Shekels is to find quality bonds giving 4% to 6% in Shekels.
The aforementioned information is not a substitute for personal Investment marketing, which takes into account the particular circumstances and special needs of each person. The views expressed in this Review should be considered as market comment for the short term for information purposes only. As such the views herein may be subject to frequent change, are indicative only and no reliance should be placed thereon. This Review does not constitute legal, tax or accounting advice, or any investment recommendation, or any offer to buy or sell financial instruments of any kind, and does not take into account the investment objectives or needs of specific investors. Although this Review has been produced with all reasonable care, based on sources believed to be reliable, reflecting opinions at the time of its writing and subject to change at any time without prior notice, neither Pioneer Wealth Management nor any other entity or segment within the Pioneer International Group makes any representations or warranties as to the accuracy or completeness hereof and accepts no liability for any loss or damage which may arise from its use. The writer and the company are unaware of any conflict of interest at the time of publishing the above commentary.