Fund Return 2022-2023

Investment Commentary

Provided by Mercer - CERS Investment Adviser

Market Developments

Both risk and duration assets sold off in February as pessimism over the monetary policy outlook took hold.

The US economy is showing few signs of a material slowdown in spite of almost a year of monetary tightening. Even though more large companies announced layoffs in February, the labor market as a whole remains exceptionally strong, attested by another strong nonfarm payroll report that saw the unemployment rate plummet to the lowest level in more than half a century. Consumer confidence strengthened to the highest level in over a year, retail spending came in much stronger than expected and one of the forward-looking purchasing manager composite indices returned into expansionary territory. Outside the US, economic data also indicated stronger growth momentum.

Consumer inflation continued to come down from high levels in the US, UK and Eurozone, although increased in Japan and China.  US producer inflation, however, came in stronger than expected. The combination of a resilient economy and mixed signals on inflation turned sentiment for the worse. Markets once again priced in the possibility of more inflationary growth momentum that could force central banks to continue with monetary tightening.

Equity returns were negative in February for most countries and sectors. The 2022Q4 earnings season continues to be disappointing. Earnings appear set to decrease for the first time since mid-20201.  Earnings aside, increased concerns over more monetary tightening than was priced in at the beginning of 2023 added to negative sentiment.

10-year yields in developed countries rose by 25-50 basis points over the month as markets priced more monetary tightening, which led to negative returns for fixed income. Rising credit spreads were an additional headwind for investment grade bonds during the month, while high yield spreads declined slightly. Inflation expectations in the US, as measured by the 10-year break-even rate, rose to 2.4% amid doubts whether downward momentum would continue.

The US dollar had its first positive month since September of 2022.  This was driven by both safe haven demand in a risk-off month and expectations of an extension of the US monetary tightening cycle.

Commodities had a weak month even as economic indicators painted a picture of resilience. The focus was once again on monetary tightening ultimately forcing a more material slowdown further down the road. Rising real yields and a strong dollar led to a sell-off in gold.

Outlook

After the 2021-2022 inflation shock, we enter 2023 with signs that cyclical inflation is easing, especially in the US. We anticipate inflation stabilizing near central bank target levels over the next one to three years, but recognize there are risks to this outcome.

Higher inflation and greater inflation volatility, for example, remain long-term risks driven by structural factors, including globalization slowing as the world is factionalizing, inadequate investment in the commodities supply chain and potential public debt monetization.

As a result, portfolios should remain positioned to weather various economic and inflationary scenarios by including a diversified mix of inflation-sensitive asset classes, while being conscious of current valuations.

Investors should evaluate the assets currently held in their portfolios and add exposure, at the right price, to those missing. The good news is that market dislocations have led to more attractive entry opportunities for many asset classes.

Furthermore, investors whose governance structures allow them to react opportunistically may find opportunities to make their portfolios more robust against the risk that inflation pressures do not settle down as the market expects.

To that end, asset classes with inflation-sensitive cash-flows such as listed or unlisted real assets, natural resource equities and inflation linked bonds could play an important role in building more robust portfolios.

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