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We expect the first half of 2023 to be turbulent as markets process inflation data. Later in the year, central banks are expected to moderate interest rate hikes, leading to a sustained recovery in risk assets.
Because the timing of these events is fluid, volatility is likely to be high and market movements short-lived early in the year. We believe this market environment offers a rich set of opportunities for tactical managers focused on stock selection.
Strategy Highlights
- Global discretionary macro: We expect macro factors to remain in focus, with investors closely monitoring inflation and growth data to gauge expectations for future policy changes.
- Raw material: The shape of China's reopening will likely have a huge impact on global commodities, with a potential surge in COVID cases delaying a full recovery.
- Linked Insurance Titles (ILS): The current market offers one of the most attractive entry points for ILS investors since the asset class's inception. Total returns are higher following Hurricane Ian, tighter reinsurance capital, and a rise in money market rates.
Macro themes we are discussing
The biggest factor for markets over the next 12 months will undoubtedly be inflation and inflation expectations. The future paths of both are highly uncertain, as they are the aggregate result of many disparate inputs.
Global central banks are trying to contain price pressures with aggressive monetary policies and tightening financial conditions, although they admit that it is very difficult for them to manage inflation.
The resulting market environment, which we believe will persist for the foreseeable future, is characterized by high uncertainty, as market prices drive expectations about when and how inflation will be controlled. Typically, such regimes are accompanied by significant price and liquidity dislocations.
Given the complexity of aggregate inflation data, we believe it is highly unlikely that central banks will achieve their target. The most likely scenario is a policy error.
Either they hold the pedal too hard and for too long, causing massive economic destruction. Or they are too light on the pedal, causing inflation to rise too high for too long and eventually causing markets to lose faith in central banks.
As a result, we prioritize capital preservation, with a strong preference for managers capable of capturing long versus short alpha in changing environments through agile portfolios.
Our high-conviction hedge fund portfolio is discretionary global macro managers, given the opportunity presented by directional and relative value themes. We favor alpha-oriented market-neutral managers in long/short equities and fixed income. Rising liquidity rates in fixed income markets can provide leverage for these strategies.
Outlook for the first quarter of 2023: Strategy highlights
Global discretionary macro
The US dollar rose sharply in 2022 before reversing course in the fourth quarter. The resurgence of large movements in foreign exchange markets reflects the greater dispersion between regional fundamentals and political trajectories.
Discretionary macro managers, who typically focus on these factors, may be well-positioned to capitalize on the opportunities created by these movements. Significant momentum shifts in major markets, such as the US dollar, can also have broad implications for other global markets, such as emerging markets and other asset classes. The persistence of these large macro-driven movements can help create a robust set of opportunities for macro managers.
Goods
The beginning of 2023 began where 2022 left off in terms of European energy, with a strong cushion of natural gas in storage after a milder-than-normal start to the winter.
An early freeze in December quickly dried up fuel stocks, destroying about a third of the UK's capacity. But mild, wet, and windy weather over the Christmas period reduced gas demand and effectively allowed stocks to be replenished.
At the beginning of 2023, gas inventories in Europe were 14 percentage points above the five-year average. This is the largest gap since 2020, when most forms of energy were in large surplus due to the pandemic.
Most significantly, Germany managed to add around eight terawatt-hours, the equivalent of the entire UK storage volumes, to its stockpiles in the last 10 days of December.
Europe's ample gas supplies, combined with forecasts of continued mild weather, have pushed the FTT natural gas contract close to its lowest level since before Russia's invasion of Ukraine.
Linked Insurance Securities (ILS)
Historically, after years of intense event activity, the ILS market sees increases in risk-adjusted rates as investors demand higher rates to bear the risk. The Swiss Re Cat Bond TR Index experienced its first year of negative annual performance due to declines in the aftermath of Hurricane Ian.
Previously, after years of notable losses, the category bond market posted strong returns in subsequent years. Initial loss reports from sponsors and underlying insurers were smaller than expected, leading to some price recovery during the fourth quarter.
Further supporting our positive outlook on the ILS asset class is its floating-rate structure. ILS instruments are priced at a spread above the risk-free rate. With a significant increase in money market rates, prospective total return expectations are nearly the highest since the asset class's inception.
What are the risks?
All investments involve risk, including possible loss or principal. Investments in alternative investment strategies and hedge funds (collectively, “Alternative Investments”) are complex and speculative investments, involve significant risk, and should not be considered a complete investment program. Derivative financial instruments are frequently used in alternative investment strategies and involve costs and may create economic leverage in the fund's portfolio, which may result in significant volatility and cause the fund to participate in losses (as well as gains) significantly exceeding the fund's initial investment. Depending on the product invested in, an investment in Alternative Investments may only provide limited liquidity and is suitable only for individuals who can afford to lose the full value of their investment. There is no guarantee that the investment strategies employed by K2 or the managers of investment entities selected by K2 will be successful.
Identifying attractive investment opportunities is difficult and involves a significant degree of uncertainty. The returns generated by alternative investments may not adequately compensate investors for the commercial and financial risks they assume. An investment in alternative investments is subject to market risks common to entities investing in all types of securities, including market volatility. Furthermore, certain trading techniques employed by Alternative Investments, such as leverage and hedging, may increase the adverse impact to which an investment portfolio may be subject.
Depending on the structure of the invested product, alternative investments may not be required to provide investors with periodic pricing or valuations, and there may be a lack of transparency regarding the underlying assets. Investing in alternative investments may also involve tax consequences, and a potential investor should consult a tax advisor before investing. In addition to direct asset-based fees and expenses, certain alternative investments, such as funds of hedge funds, are subject to additional fees, expenses, and indirect activity-based compensation from the investment funds in which these alternative investments invest.
Editor's note: The summary points in this article were chosen by Seeking Alpha editors.
This article was written by
Franklin Resources, Inc. (NYSE: BEN) is a global investment management organization operating as Franklin Templeton Investments. Franklin Templeton Investments provides global and domestic investment management solutions managed by its Franklin, Templeton, Mutual Series, Bissett, Fiduciary Trust, Darby, Balanced Equity Management, and K2 investment teams. The San Mateo, California-based firm has over 65 years of investment experience and over $1,040,000 in assets under management as of May 31, 2014. For more information, call 1-800/DIAL BEN® or visit franklinresources.com.
