The A3 class is a new class, effective from 13 April 2023

A look back:
Markets arrived into 2022 with the notion that in the previous year, we had the luxury of witnessing S&P notch 70 new ATHs with only one 5% pull back along the way. On 1 Jan 2022, the rates market was only pricing in ~70bps of Fed hikes, there were pockets of exuberance (a CryptoPunk NFT reportedly sold for ~$22mn), the US 10yr sat at ~1.5%, the VIX was at 17 (low tick for 2022), while Software traded at ~14x EV/Sales; and with that, the market sprinted out of the gates closing on a fresh ATH of 4796 on January 3..., alas things got much more difficult (to put it lightly) from here (4796 still stands as the ATH almost a year later). During the year, the S&P has closed down by at least -1% on 60-plus trading sessions (the most since 2008 when it happened 75 times), and the year was remarkable not only for the severity of losses but also their breadth - the first year, since at least the 1870s, that both US stocks and long-term bonds fell by more than 10%. From a trading perspective the year was defined by depressed sentiment, poor liquidity, little conviction, light positioning and low turnover. Geopolitics were front and centre with Russia / Ukraine war beginning on February 24..

From a human perspective the tragic and senseless loss of life will is unfathomable. From a markets perspective this war fanned the flames of the commodities super cycle, cementing inflation as the most dominant market narrative of 2022 by a landslide. Not so transitory. In March, the FOMC hiked rates (by 25bps) for the first time since December of 2018, followed up with a 50bp hike at the May meeting, and then 75bps in June, July, September and November, only to close out the year with another 50bps in December, resulting in 425bps of hikes. And most institutional investors did NOT have a 5+% terminal rate in their valuation models until well into 4Q22 (in December 2021, the market was pricing a December '22 Fed Funds rate of 0.8%) . As money managers continuously tweaked their terminal rates, higher, growth exposed stocks suffered. In fact, the Big Tech cohort (AAPL, MSFT, GOOG, AMZN, TSLA, META & NVDA) has collectively shed ~$4.9tn of market cap during the course of 2022 - for comparison sake, that amount lost is larger than the current market cap of nearly every S&P GICS sector (Info Tech and Health Care the exceptions) - with this ~$4.9tn figure roughly matching the amount of value lost by the entire Nasdaq Composite back peak-to-trough in the dotcom bubble (~ $4.6tn). This sell growth to buy high quality value (cyclicals) rotation made 2022 also one of single worst years of performance in the history of Fundamental Long Short HFs in US., returning -12% on the year. Within the HF community we saw several high profile closures. The most consistent and noteworthy buyer of US stocks in 2022 were corporates with over $1tn in buyback executions (the most ever). But, buybacks should decline by at least 10% in 2023. Interestingly, an analysis from Goldman Sachs shows that during the four recessions since 1990, cash M&A typically fell by 60% and buybacks fell by 46%. As we closed the past year we also witnessed considerable easing across most jurisdictions: In the most vulnerable segment of the fixed income market (i.e., CCC or below debt), spreads have dropped from ~12%-13% in October to ~10%, while average high yield spread (dominated by BBs) eased from ~5.5%-6% to ~4.5%. In emerging markets, corporate HY spreads narrowed from 8.5% to ~6.5% and yields are down from ~12.5% to ~10%. Even China's HY yields have dropped, albeit to still high 20%. Volatility measures have become more placid, with MOVE (bond market) index down from highs of 135-140 to ~110, while VIX has once again flirted with 19-20 vs more elevated levels of 30+ two months ago. The same relatively placid environment was restored in FX vols for G7 and EMs. Market expectation of policy rate cuts and less intense tightening started to be reflected in the forward curve, while real 10Y yields dropped from 1.8% to as low as 1.3%. With this, US Financial Conditions Index had eased considerably, as did ECB's systemic stress and intra-EMU spreads. For now, economic data has been a reflection of moderating cyclical inflation, a still robust consumer and although we see strong signs of moderation in the goods economy, housing and pockets of manufacturing surveys there have been no sizeable increases in unemployment. Fed member Esther George views higher Household savings as a helping buffer for Households but points out that this might also mean that rates have to be higher to cool spending.
How to position?
A very soft landing has been priced in by markets, and so far, the combination of events has been as bullish as it could have been - inflation has been surprising to the downside while growth/hard data/labour market has looked like it has been incredibly resilient.

Going forward there are equal downside risks to inflation and growth while corporate margins could be under substantial pressure in what could be modest revenue dis-inflation yet a still tight labour market. At least in part the economy has proven resilient because post pandemic the magnitude of pent-up demand from constrained supply chains has made the economy's ability to respond to external stimuli (i.e. the Fed rising rates, fiscal contraction, housing market, geopolitics) limited. On the back of Sentio's data and macro models, our baseline is for a recession to occur in the US, probably by latest mid-year, while its severity is somewhat uncertain, given still conflicting data sets. It is likely though, that unless the recession is severe, any rebound will be mild, potentially setting the macro environment up for stagflationary conditions, as economic growth might stay weakish, while inflationary pressures persist.

We anticipate a consumer- and investment-led recession. We see headwinds for consumer spending from inflation, higher borrowing costs, tighter credit conditions, softer labour market conditions and declines in net financial and net real estate wealth. That said, households still have abundant liquid resources and a projected rise in the unemployment rate to 5.5% in 1Q24 would still leave the rate below its average over the past two decades (6.0%). Consumer spending is likely to soften, but not by much. Business investment should also lead activity meaningfully lower. The risks to our expectations are skewed towards a more prolonged expansion, additional Fed tightening, a later but larger downturn and more persistent inflation. Spending in some services categories remains below pre-pandemic trends, suggesting the rotation back to services has further room to run. This is important since expanding services output should come with robust employment gains given the low-productivity nature of the sector. The risk here is that we enter a virtuous cycle of employment begetting income growth and vice versa. Consumer spending should also be supported by excess savings, which we estimate at about $1.1tn. Based on recent trends, this should provide about 10-12 more months of additional spending support. A prolonged expansion likely means additional rate hikes will be needed to slow the economy down and eliminate demand and supply imbalances. This could mean a terminal target range closer to 6.0% and a longer lag between prior tightening and changes in economic activity. For markets, this scenario will paint a difficult backdrop: the recent FOMC Minutes cautioned against "unwarranted easing in financial conditions".

We believe that financial conditions are still too easy, reflecting a misperception among investors of the Fed's reaction function. Policymakers want to err on the side of being too restrictive, and as long as financial conditions are misaligned with the Fed's goals, we can expect additional tightening. The growth/ inflation mix also remains unfavourable - inflation is likely to normalise over time, but global growth is slowing and central banks are still tightening, albeit at a slower pace. The valuation starting point has improved but risky asset valuations are well above recessionary levels and earnings are skewed to the downside. Equity risk premia appear low considering elevated recession risk and uncertainty on the growth/inflation mix. Weak growth and volatility coupled with relatively high valuations keeps equity drawdown risk elevated. Financial stability concerns have equally picked up alongside market stress indicators.

Fixed income broadly offers a more attractive risk/reward for multi-asset portfolios. Bonds should be less positively correlated with equities later in 2023 and provide some diversification benefit - but until central banks stop hiking and inflation normalises bonds are unlikely to be a reliable diversifier for risky assets. We expect more regional diversification benefits, supported by an eventual peak in the US Dollar in 2023. With low expected returns and limited diversification benefits from traditional assets, the case for larger allocations to alternatives and focus on alpha rather than beta remains strong.

Given all of the above, we remain tactically constructive over the next 3 months or so, as the bear market rally continues to be driven by a drop off in inflation, still resilient (while softening) data from production and labour markets, as well as a relatively swift reopening in China, which will likely see some stimulus to kick-start the economy following fall-out from the restrictive Covid-Zero policy. However, we will continue to monitor, scrutinise and analyse the incoming data, as an increasing number of flags point to risks of an impending recession.