A year ago, we communicated that inflation and geopolitical risks would dominate 2022. Early in 2022, we predicted the recession would strike within 18 to 24 months. We now expect that the outlook for 2023 will be dominated by the following economic drivers: US and global recession, volatile inflation outcomes, and continuing geopolitical risks. This provides tremendous challenges to traditional equity and property-centric portfolios and great opportunities for unconstrained active management. Let us explore three ways we expect to benefit from this outlook to position and profit in 2023.

(1) Precious Metals and Other Commodities
Inflation has peaked for now. Demand is in decline, and recession is looming, with cooling inflation due to weakening economic growth and the delayed effects of a rapid monetary policy tightening cycle. Inflation is not a spent force, however, and increasing inflation will likely return post-recession due to policy and geopolitical settings. At the same time, given the large structural challenges, including huge debts and fiscal deficits, central banks are unlikely to continue with sufficient tightening for long enough to prevent inflation's eventual return. Mismanagement of energy and commodity policy, low workforce participation and China's reopening will likely see higher inflation, energy and commodity prices than has been the case in many prior recessions.

Geopolitical risks remain extreme, and war is a highly profitable business for some instrumental people and entities, with the Pentagon again being unable to pass an audit.

The war in Ukraine is at risk of escalation and is no closer to being resolved. The Middle East remains a risk, and China and Taiwan remain unresolved. Politically the world appears to be fracturing both regionally and ideologically, and many important countries are now openly flouting US hegemony and working on deepening and developing their own trading and financial relationships.

Precious metals was our favoured asset class for 2022 (and one of its top performers) and remains a must to own given the political and economic environment. Gold could easily reach new highs in 2023, offering diversification and some reasonable prospect of substantial gains. As part of a diversified portfolio, we also perceive opportunities in oil, uranium, speciality metals and food.

(2) Active Management, Hedging and Shorting
At the asset class and stock level we perceive numerous opportunities to preserve and add value in 2023. Equity markets are likely to be weak into an earnings recession in the first half of 2023 as decreasing earnings are not priced in and may hence provide opportunities for increased weightings as realism returns. Dynamic asset allocation enables meaningful asset class movements, such as taking advantage of the current rally to sell or hedge equities, hence owning low equity weightings today while being ready to buy equities or high-yield credit when they offer a sufficient risk premium and a better outlook.

Even bonds may provide opportunities. Convertible bonds currently appear attractive as equity substitutes and offer better downside protection. Government bonds with duration have two-sided risks albeit they may still suffer under structural inflation, capital withdrawals or central banks unexpectedly holding their nerve and keeping policy tight for longer. Nonetheless, they will likely provide tactical opportunities to own small weightings.

Liquid alternatives and trading strategies appear attractive for their low market sensitivity and their ability to protect capital. These include long/short approaches, relative value opportunities, contrarian trading, carbon trading and event-driven strategies. These strategies don't rely upon favourable equity markets to do well and provide a cash alternative, offering better capital preservation in weak markets. It is not necessary to lock up money for 7-10 years in illiquid alternatives to get the benefits of diversification, as liquid strategies provide attractive opportunities while so many stocks remain overvalued..

Investors in large commercial property managers like Blackstone are finding out that favourable published returns are not available to them when they want to redeem. Investors in some large Australian super funds could also potentially suffer similar issues, particularly if economic and financial market conditions further deteriorate.

Stock picking will likely offer good opportunities into 2023, both long and short and even among some very large market leaders. Tesla looks to be the gift that keeps on giving on the short side, with the reality of strong competition, insider sales and lower growth in a recession bringing the company's valuation back down to earth. (We have successfully shorted Tesla more than once in 2022 and will likely do so again). Numerous still highly priced growth stocks are likely to disappoint further and will provide good hedging opportunities during market weakness in the early part of 2023. Companies like Zoom still fall into this category. Numerous "high promise" but currently unprofitable companies have had a disastrous 2022 whilst diluting shareholder equity by issuing large share and option incentives to management. Many large quality companies and household names where investors are hiding also appear overvalued; companies like McDonalds and Coca-Cola are trading at greater than 30 times earnings with modest growth and consumer sensitivity. Blackrock provides an opportunity to short passive management. Many commercial property stocks will likely be strong shorting opportunities, given the sector's disastrous outlook.

Later in 2023, there may be significant opportunities on the long side in small caps and selective growth companies to play a recovery. On the long side, selective resource stocks still offer good longer-term opportunities, but many managers need to be avoided in the space due to demonstrably poor risk management and track records. If 2022 has proven anything at all about many money managers, it is that too many are like passive funds and rely upon rising markets, offering little risk management or capital preservation on the downside. Poor downside risk management can reveal who to avoid and switch away from!

(3) Genuine Diversification and Differentiation
Uncorrelated assets and strategies combined provide superior risk-adjusted returns to any one of the underlying components. Investing in multiple assets across various strategies provides greater downside protection. A diversified portfolio provides the owner with the knowledge that their risk is substantially lowered in a precarious and uncertain world compared to betting on any one outcome such as in equity or property risk alone. No matter how experienced you are, you never know anything for sure in this crazy world full of bad actors, and hence it is prudent to be protected from concentrated risks.

We expect that markets will remain challenged in early 2023 as economic mismanagement, increased corruption and malfeasance, geopolitical, valuation, and volatile inflation and interest rate pressures continue haunting broad market outlooks. This will again prove highly challenging for passive management, which must wear all these factors to its detriment. Genuine active management, fundamental research, risk management and conservatism appear essential in this environment.

We still see the end of a previously favourable period of globalisation and peaceful prosperity. Wages pressure, demographic issues and greater protectionism, regionalism, autocracy and greater socialism, along with less workforce participation, mean the labour and capital balance is shifting. Higher structural inflation and volatile inflation outcomes in coming years, along with various tail risks, must be carefully considered when building a portfolio and mean that the portfolio of the 2020s should be fundamentally different from years past. It is essential to be more conservative and have better diversification in this environment rather than simply gambling on strong financial asset returns, as the latter approach is best suited to a period that has now gone. 2022 has shown that many bottom-up investors who ignored these crucial top-down factors have been severely punished, for example, by holding large allocations to growth stocks or investing in what were traditionally defensive investments such as government bonds.

Property prices continued to fall across the nation with values declining a further 1.00% throughout November. This brings an approximate 7.00% (average of $53,400) decline since national property prices peaked in April of this year. Whilst this marks the seventh month of decline, the rate at which prices are declining is beginning to soften, with the 1.00% reduction being the smallest since the 1.60% monthly decline in August. 

Queensland again recorded the most significant monthly reduction, along with Tasmania with a 2.00% reduction in the Home Value Index. New South Wales, Canberra, Victoria and South Australia also experienced a reduction in value with 1.30%, 1.20%, 0.80% and 0.30% respectively. 

Western Australia remained stable, and the Northern Territory actually saw a small increase of 0.20% for the month. 

Record low vacancy rates of 1.00% have allowed unit prices continue to remain somewhat resilient, recording a 0.60% reduction for the month, bringing 4.70% reduction since prices peaked. 

The number of auctions held in the last weekend of November remained considerably below that of last year, with 2,393 auctions taking place as opposed to 4,251 last year. Whilst well below that of last year, the number of auctions were up 4.10% on the previous weeks results and were in fact the highest since a weekend in mid-June recorded 2,528 auctions. 

Clearance rates across the nation were also down on last year's figures, with only 61.50% of auctions clearing (down from 68.50% last year) indicating that vendors may not yet have responded to market conditions. Adelaide again recorded the highest clearance rate for the weekend with 65.90%, followed by Sydney (64.20%), Canberra (62.80%), Melbourne (61.00%) and Brisbane (47.40%). 

Source: Article, Report

Equity markets globally were stronger in November. In the US, the S&P 500 was up +5.4%, the Nasdaq rose +4.4%, whilst in the UK, the FTSE 100 increased +6.7%, boosted by its heavy mining weighting. On the ASX, the All Ordinaries Accumulation Index rose +6.4%. Utilities were the best performing sector, boosted by the takeover bid for index heavyweight Origin Energy, which was up +41% in the month. Materials was the next best sector, driven by investor optimism around China loosening its covid lockdown measures. Telco's, financials and technology all underperformed in the month. 

Bond yields declined in November as investors started to become more positive that the pace of interest rate hikes from central banks will moderate along with some signs that inflation has potentially peaked. In the US, the 10 year bond yield fell -30 basis points (bp) to close at 3.74%, whilst in Australia, the 10 year rate fell -23bp to 3.53%. During the month, the RBA increased interest rates by 25bp for the seventh month in a row, taking the official cash rate to 2.85%. The A$/US$ rallied in the month, up +6.0% to close at US$0.68. 

Commodity prices were broadly higher. Nickel rose +23%, whilst copper, aluminium and lead also rose between +6-8%. Thermal coal rebounded +11.4% after an -18% decline in October. Also of note, iron ore was up +25.6% after falling for seven months in a row. Brent crude oil fell -10.0%. 

As we look back on 2022, to describe the year as eventful seems an absurd understatement. So many events have dominated the news, each individually significant, and in aggregate almost overwhelming in consequence, both politically and economically.

Here's a reminder of just a few of those events:

• The invasion of Ukraine by Russia and the continuation of a war that many people thought would be short-lived.
• The sustained rise in inflation expectations to a 40-year high, ending the hope that inflationary conditions would be 'transitory'.
• The turmoil in the UK gilts, or government bond, market following the country's 'mini budget' in September that triggered a spike in long-term interest rates and havoc in pension funds that use a liability-driven investment approach.
• An escalation in geopolitical tension between the United States and its allies, with China.
• A global cost-of-living crisis with rising mortgage costs and unprecedented fiscal support measures for energy and food targeted at the most vulnerable in many countries.
• A slowdown in, or reversal of, growth expectations with regards to key tech companies leading to a significant loss of shareholder value and job cuts.

Climate crisis uncertainty

Yet all these things will be relatively short-lived in their impact (and manageable) when compared to the existential threat that continues to grow relatively unabated from our failure to make progress on constraining global warming to the agreed target of 1.5°C.

COP 27, the climate change conference held this year in Egypt, largely failed to expand on commitments made a year earlier with regards to phasing out fossil fuels, despite all the strong statements made around the necessity to do so.

The one major step forward was the agreement of a deal that has been sought for over 30 years to launch a fund for 'loss and damage' to support those nations most exposed to the consequences of climate change. But details and financial funding have not been agreed.

We can already observe more extreme weather events - notably the recent floods in Pakistan - which have devastating effects on impacted economies and contribute to the risk of a steady but dramatically expanded flow of migrants to other countries.

Don't give up

But, as the old saying goes, where there are challenges, there are also opportunities.

Here's where we see them:

• Tackling climate change, both in terms of mitigation and solution, will require trillions of dollars of investment each year for the next three decades at least;
• Reconfiguring supply chains (to shorten and make them more secure);
• Building security of energy and food supplies to rely less on a single supplier;
• Replacing inefficient infrastructure for transportation, energy supply and distribution;
• Funding the science and applied research needed to create the solutions not available today;
• Rebuilding Ukraine.

Reasons to be optimistic

It's easy to be overwhelmed by all the uncertainty. That said, we've also seen steady progress in many places that may offer an antidote to the gloom:

1. The investment industry is better equipped than ever to steward capital into productive assets that meet society's expectations of it.
2. Policy makers are finally seeking to unblock obstacles that constrain investment flows from long-term savings pools into infrastructure and patient-capital science-based assets.
3. Industry leaders are, at last, prioritising capital investment over share buybacks, particularly in Europe.
4. Employment prospects are strong, particularly for younger workers as many older workers who were close to retirement brought plans forward during the pandemic.
5. Many of the big trends that have caused concern are forecast to improve in 2023 - the inflation and interest rate outlooks will likely moderate next year; fiscal conditions are expected to remain supportive with major elections scheduled in 2024; China is expected to gradually remove Covid restrictions and re-open its economy.

2023 may well be a pivotal year for markets amid the economic challenges that remain. While these are clearly important, we mustn't take our eyes off potentially existential long-term issues.

Author: Sir Douglas Flint, Chairman of abrdn