Bloomberg Línea — The effects of a restrictive monetary policy, high inflation, and slowing economic activity are expected to continue into 2023, requiring cautious portfolio positioning. However, once real interest rates peak in the United States, the economic cycle should create opportunities to increase allocations to risk assets. This is the assessment of Stéphane Monier, Chief Investment Officer (CIO) at Swiss bank Lombard Odier.
In a report exclusively disclosed to Bloomberg Línea, Monier comments on the main investment thesis for the coming year, in which a recession is the basic scenario of the bank. Among the main risks for investors, the bank highlights the excessively restrictive monetary policies, the war in Ukraine, and new geopolitical tensions over Taiwan.
Entering the year with more caution, the bank has privileged assets considered of quality in all classes. In equities, the focus is on companies with low volatility in earnings and a greater ability to maintain margins.
In fixed income, the bank prefers investment grade bonds (with better ratings and lower risk) to the detriment of high yield bonds (with higher risk but greater return potential) and, in currencies, risk shelters, such as the dollar and the Swiss franc, are the main choices.
For the first half of 2023, Lombard Odier has opted to maintain a portfolio with greater liquidity to “allow speed to seize investment opportunities as conditions improve”.
Check out Lombard Odier’s top investment theses for the year ahead:
1. Inflection point
The tightening of monetary policy to contain inflationary pressure translates into an unfavorable scenario for risk assets. In this context, expectations of recession and further cuts in corporate earnings projections act as headwinds for stocks and bonds. For Monier, however, a spike in real interest rates in the United States should provide a turning point for markets.
To do so, the Fed will need to interrupt its interest rate hike cycle as inflation slows and unemployment rises. When this occurs, the manager says he will gradually increase risk levels in portfolios, extending the duration (average return on investment) in government bonds, as well as adding some equities and private credit securities.
2. Underweight position in risky assets - for now
Given the uncertain macroeconomic scenario, Lombard Odier has maintained a cautious exposure to risk assets, focusing on those that can better withstand the impact of weaker growth and higher interest rates. In other words, this means keeping quality stocks, government bonds, and investment-grade private credit paper (with better ratings and lower risk) in the portfolio. The specialist has also kept a larger liquidity slice in the portfolio to be able to invest as soon as he sees opportunities.
3. Quality Assets
In the report, the Swiss bank said it expects further declines in the stock market as high borrowing costs limit the expansion of company multiples and earnings projections continue to be adjusted by recession fears.
“In this context, we look for quality companies with low earnings volatility and better ability to defend their margins. These stocks tend to outperform in recessions or when earnings decline,” he writes.
Among sectors, healthcare is preferred due to high margins, inflation insulation due to high pricing power, and attractive shareholder returns. “Valuations also remain historically undemanding compared to other defensive growth sectors,” the manager adds.
4. Asymmetry and hedge
Options strategies, such as put spreads on stock indices, can be interesting instruments to protect portfolios from possible declines, Monier points out. This “bearish lock” strategy consists of the simultaneous purchase and sale of two puts.
The house has used hedges throughout 2022 and intends to continue with the strategy in 2023, tactically and according to market conditions.
5. Alternative investments
As the investment environment is still challenging, Lombard Odier has favored allocating to mutual funds, such as global macro multi-markets, discretionary funds, and quantitative funds.
“These should provide diversification as they tend to benefit from performance dispersion across asset classes and regions. They are designed to perform in more extreme periods and should profit from the volatile environment,” writes the CIO.
6. Dollar Exposure
Dollar strength should remain during the “pre-pivot” phase, according to Monier, given rate differentials and liquidity tightening in the US. Another currency that also tends to gain in this scenario is the Swiss franc, for example.
7. Gold as a store of value
For much of 2022, gold prices have been caught between geopolitical and recession risks - which tend to appreciate the commodity - and pressures from falling real interest rates and a strong dollar. The expectation, according to Lombard Odier, is that low-interest rates, a weaker dollar, and a reopening of China will contribute to an appreciation in gold prices.
8. High-yield credit
As investor sentiment improves, appetite for risk assets should follow suit, he says. “Once high yield credit spreads [with higher risk and higher return potential] more fully price a recession and rates have stabilized, carrying these will be more attractive than investment grade and sovereign bonds.”
9. Shares as an opportunity
As inflation and the threat of higher rates begin to recede, equity valuations and multiples will benefit, according to the Swiss bank. “The easing of financial conditions will lead to improved investor sentiment and in turn expand price to earnings (P/E) ratios,” the report highlights.
“By mid-2023, earnings and sales expectations will be revised downwards and markets will begin to look towards 2024 and a recovery from the cyclical slowdown. This will present opportunities to add exposure to cyclical and growth names.”
10. Emerging stocks
Following a Fed pivot, Lombard Odier expects that emerging assets will recover. It will, however, require a change in sentiment and growth momentum. “If these catalysts materialize, we will see emerging equities outperforming developed markets and emerging local currency debt looking increasingly attractive,” the report said.
While the bank says it is more constructive on local emerging rates, given well-advanced monetary cycles, it expects emerging currencies to recover from depressed levels only when financial conditions improve.
“There will be room for appreciation in emerging assets after the pivot, with more appetite from international investors and greater confidence in the emerging market backdrop,” it says.
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