Q4 2022: "The Upside Down"

“You shouldn't like things because people tell you you're supposed to.”

Jonathan Byers (Charlie Heaton), Stranger Things, TV series by Netflix, 2016

What has happened?

Q4 2022 continued to keep investors on their toes and brought an end to what was clearly a challenging year for markets – let us hope it is not the new normal this decade! Despite the downward inflation trend being confirmed, the Fed continued to push forward with its rate-hiking schedule. In Europe, inflation may have peaked (although more data is needed to confirm that suspicion). The downward inflation trend in Europe has been helped by energy prices falling back to pre-war levels in a milder-than-expected winter. Unfortunately, the situation in Ukraine continues to remain perilous and has become even more entrenched, with no obvious resolution in sight. Adding further to these woes, the region remains well below average levels of economic growth and deep in recession territory when viewed through our macroeconomic cycle model. This position is not helped by the ECB raising rates and a hawkish president whose rhetoric continued to send peripheral spreads wider (Italian 10Y BTPs ended the year at 4.3% – the same level as the start of the Euro crisis in 2011). On an optimistic note, China continued to experience low inflation and is still a region of growth, even if that growth has not matched expectations. China’s main act, however, came at the end of the quarter when authorities finally dropped their zero COVID policy, just in time for the Chinese New Year – a change lauded by many despite mixed results.?

Markets finally broke their losing streak in Q4 2022, with a largely broad-based rally after gains in October and November were enough to offset December’s decline. Global equities rose by +7.6%, reducing 2022's loss to -15.5%. Asia and Europe led gains. Asia benefited from rumours that China would drop its zero-COVID policy and Europe reaped the benefits of a mild winter and lower commodity prices. The US also rallied, but to a lesser extent, with the S&P 500 Index ending the quarter up +7.6% (MSCI Europe Index: +9.6%; MSCI Asia Pacific: +12.5%) but experiencing a bumpy ride on the way as the “Upside Down” narrative (which takes bad news as good news in the hope of a more dovish Fed) continued. For fixed income, bonds rallied with equities as high yield (“HY”) outperformed investment grade (“IG”), taking YTD losses to -11.1% for HY (Q4 2022: +6.4%) and -11.2% for IG (+Q4 2022: +1.0%). Volatility sank -31.5% as the market’s appetite for risk returned, for now. Meanwhile, the USD lost -7.7% in Q4 2022 (2022: +8.2%), which helped gold rally +9.4% (2022: -0.3%).?

Our strategy performance

Our Tyrus Capital Global Convertible strategy returned +1.5% in Q4 2022 (SI USD acc. Class), with a 90-day volatility at 8.3%. This puts 2022 performance at -9.2%, meaning our Fund performed in the top decile in Bloomberg’s convertible bond fund ranking. In 2022, our strategy outperformed both equities (MSCI ACWI World Index, USD Hedged: -15.5%) and IG corporate bonds (Bloomberg Global Corporate Aggregate, USD Hedged: -14.1%). Although our annual return was down, we maintained our investment mandate and stayed invested with a delta always around 50%, an investment grade average credit quality, and strong focus on virtuous ESG issuers. Our top down focus, on which we founded our strategy, helped us navigate a macro-heavy 2022 and we believe it will serve us well in what we expect to be a macro-heavy 2023!?

Our summary view

Main focus: Stagflation is here to stay. While perhaps an unpopular opinion, we think the wave of market optimism felt in Q4 2022 is somewhat misplaced, with the notable exception of Asia. Stagflation cannot simply be wished away. While we have seen most of its first phase (see chart below) with the duration shock in 2022 and central banks hiking rates in an attempt to fend off inflation, 2023 will mostly be about the second phase of our three-phase stagflation process and the pain of higher rates finally propagating into the real economy. In this second phase, the duration pain stops.

There will therefore be no more risk-premium led multiple compression, implying an end of positive correlation between bond and equities that poisoned risk-parity and 60:40 strategies in 2022. The issue now is that we are moving towards earning compression typically seen in a recessionary environment as household consumption contracts and refinancing starts to hurt. In short, we do not expect 2023 to be easy for the US or Europe. Looking at recent data, we expect to gauge more clearly the effect of this propagation phase in the US by the end of Q1 2023 and expect the Fed’s rate hiking schedule to plateau around 5.25% sometime in Q2 2023 (late Q1 2023 at the earliest). It is all about how the economy will slow down, not if. A soft landing will require progressive but controlled pressure on the job market, a clear relief trend for inflation, and a moderate slowdown of consumption. Given that many pieces are already in motion, it will be difficult to manage a soft landing.?If the stars align,?a pivot away from being defensive could be warranted in Q2 2023. If not, that defensive bias should remain in place as equities on current valuations will not fare well if low earnings extend more than 6 months. Europe seems to be our contrarian call—we remain wary. We feel investors have not been listening to the same ECB press conferences that we have. Our regional indicator firmly signals a European recession in 2023. Yes, investors received reprieve from mild temperatures, but we are left with massive structural issues to solve, and a wall of small businesses sandwiched between very high energy prices (even after they dropped) and fiscal support expected to vanish soon. The only thing bolstering our view of Europe in 2023 is slightly lower equity valuations versus the US. We would hide in IG credit and avoid the rest (e.g., HY and peripheral sovereigns). We can only hope the war in Ukraine concludes before next winter.?

The rest: We see China’s reopening as the only real upside scenario going into 2023—an event we have been waiting for. We think the way out will be bumpy and contentious as the virus spreads to the entire country from the Chinese New Year celebrations in January, which will be the first real test in seeing whether zero-COVID policies are really a fixture of the past. Perhaps, then, this year of the rabbit could welcome in significant upside for regional stocks given the pent-up demand. Some things we will be watching are how China’s reopening impacts western inflation numbers and how the economic slowdown in the West affects Asia. We will also watch the US dollar very closely given the large moves in 2022. A persistent drop in the USD could give significant tailwinds to Asia Pacific and EMEA, a scenario that does not appear to currently be priced in. We expect this to add its weight in earnings and inflation volatility in our globalised world. Lastly, credit contagion is a potential tail risk in 2023. Spreads are quite tight given the risk environment, and a market looking for a victim after several years of fiscally and monetary policy, which supported low default rates, would not have to look very far for an easy target to attack. This is also true for countries

Our investment themes and how we are positioned

Taking the above foundational views into account, we formulate our key investment themes and portfolio positioning as follows:

Where does this leave convertibles?

Our asset class remains discounted despite valuations having gained some ground by the end of Q4 2022. As 2022 demonstrated, we think a more macro-centric approach is likely to navigate 2023 well. We think valuation in both stocks and spreads in the West do not reflect the 50:50 odds of a US recession our model indicates.

However, the pain for asset allocators should ease in 2023 as we should see decorrelation come back by Q2 2023, a necessary pillar for the traditional 60-40 to work again. In that context, we place our strategy as an attractive low volatility equity-factor/ equity income solution. Valuation in equities coupled with the earning headwinds generated by the macro slowdown are making plain equities very timing-dependent in the near term, with the exception of Asia which enjoys a very specific reopening dynamic. As such, finding alternative ways to play the equity factor offers a safer path for at least part of that 60-40 construction, be it through call-overwriting, dividend-based strategies or convertibles (“CBs”) whose inherent asymmetry offers what market timing does not.

Turning to credit, the acclaimed consensus long for 2023 is not as benign as it seems. We think that spread levels are too tight and that the market is over-confident on how the flow picture is going to shift (central banks will not be our friends from either an interest rate or quantitative easing perspective – the latter is often forgotten in the fixed income debate). We feel that treasuries, IG corporate, and emerging markets selectively should all be key elements within an allocation pot. We recommend caution on HY (particularly sub BB) as liquidity is tricky and yield is very back-ended. In our view, IG convertibles are a better and cheaper alternative.

Finally, our entire Tyrus Capital Global Convertible team and I extend our best wishes to our readers and their families for 2023. 2022 was tough. 2023 will also likely not be easy.

Best wishes,

D. Regnier