Fund Return 2022-2023

Investment Commentary

Provided by Mercer - CERS Investment Adviser

Market Developments

Markets started 2023 on an optimistic note. Equities, bonds and alternatives generally rose. Rates and spreads declined and equity market volatility fell to its lowest level in almost a year.

Positive market sentiment was helped by US CPI inflation falling for the sixth month in a row. It also seems to have peaked in other developed countries. Investors are still hoping for an end to the monetary tightening cycle, even if central banks remain cautious. Consumer confidence also improved over the month, as the University of Michigan consumer sentiment index unexpectedly rose to the highest level since April 2022. Forward-looking purchasing manager indices rose in the US, although remained in contraction territory. In the UK and Eurozone, purchasing manager indices also edged higher, as a sharp decline in natural gas prices raised hopes that Europe will avoid a deep recession. Existing home-sales, car sales and retail sales on the other hand hinted at an ongoing economic slowdown.  Additionally, a number of high profile lay-offs were announced by large US companies.

Equity returns were strong on receding inflation and falling interest rates. Fundamentals were otherwise unfavorable. The first month of the 2022Q4 earnings season yielded disappointing results from a number of companies in a quarter that could see its first decrease in earnings since 2020Q3. Analysts still expect low digit positive earnings growth for 2023 as a whole.

10-year yields in developed countries fell by 20-30 basis points over the month which led to positive returns for defensive fixed income. Falling credit spreads, especially for high yield, were an additional return boost for credit. Inflation expectations in the US, as measured by the 10-year break-even rate, fell to 2.2%, now slightly below the Federal Reserve’s long-term target.  Falling yields and thus lower opportunity costs for holding gold were a tailwind for the metal which increased by over 6% during the month.

Downward momentum for the US dollar continued as it weakened against most major developed and emerging market currencies. Investors continued to price in falling US inflation and therefore a slower pace of monetary tightening in the US.

Commodities prices were mixed over the month with oil and some industrial metals slightly higher and wheat lower. The global slowdown is expected to be a headwind for commodities going into 2023. Some of this could be offset by China’s reopening, which could lead to stronger demand for commodities.

Outlook

Global economic activity is likely to remain weak in 2023, although downside risks to economic activity have perhaps diminished on the back of the decline in European natural gas prices and an imminent sharp recovery in China, as the government rolled out a package of measures to support the property sector and largely ended COVID restrictions.

As we have seen elsewhere, the end of COVID restrictions leads to a pickup in economic activity as consumers splash out on activities that have been restricted like tourism and retail/entertainment. Chinese economic activity will also be boosted by the property sector support and broad monetary and fiscal policy loosening. The recovery in China will support trade partners and especially Chinese tourism destinations, who would otherwise be under pressure from the ongoing weakness elsewhere. The Japanese economy should have a better 2023, boosted by its COVID reopening and the recovery in China.

Inflation should fall sharply as past rises in commodity prices fall out of YoY comparisons, although the Chinese re-opening creates some upside risks to commodities. It remains to be seen whether inflation will fall back to 2% targets and central banks will remain hawkish until they are confident it will remain moderated. Nonetheless we are expecting most central banks, including the US Fed to pause their hiking cycles in 2023H1 to assess what impact the past 12 months of tightening has had.

We made no material changes to our asset class preferences, continuing to prefer growth fixed income assets (high yield, loans and EMD) to defensive fixed income assets and cash. We remain neutral equities. While further declines in inflation should support equities, we think corporate profit growth will be flat or negative in the developed world in 2023 and into 2024 and that market expectations of the Fed cutting rates before the end of 2023 are premature. Within equities we moved overweight emerging market equities as we expect the recovery in China, the pullback in the US dollar and more favourable valuations to support the asset class.

Notes