iShares 2023 year-ahead investor guide

• Rethinking the role of bonds – Recession is almost a certainty, but high and persistent inflation implies Federal Reserve easing is unlikely in 2023. Investors should consider adding high-quality fixed income to their portfolio at current yield levels.
• Pricing the damage – A higher real-rate regime favors value-style equities, a departure from a decade of growth leadership. For those willing to step out in equity risk, small-caps may present attractive risk-on fundamentals at favorable valuations.
• Living with inflation – Core inflation is unlikely to get back to pre-pandemic levels of below 2% in 2023. TIPS and infrastructure equities are historically attractive in a higher inflationary regime.

The investing regime we have long known has changed. Over the past fifteen years, accommodative central bank monetary policy had shaped asset allocation, encouraging investors to add risk in search of yield. The prolonged period of low, stable rates resulted in a fundamental shift away from fixed income and towards high-growth equities. We believe that the regime of “lower rates for longer” has transitioned to a regime of “higher rates for longer” – bringing with it profound implications for portfolio construction.

The post-pandemic inflationary shock brought a rapid rise in U.S. interest rates, with the Fed Funds rate moving from 0.25% to 4% in a span of just nine months, punishing equities and fixed income alike. In 2022, a portfolio comprised of 60% equities and 40% bonds returned -16.8% through the end of October¹ – the worst annualized performance since 1937.² The rapid normalization of monetary policy has brought about a reset across asset classes that has created incredible opportunities, particularly in fixed income markets. Today an investor can potentially earn over 5% coupon in a low-duration, high-quality fixed income bond, underscoring the enhanced role that bonds can play in an investors’ overall portfolio.³ Higher yields in fixed income also means that investors do not need their equity allocations to work as hard, and within their equity allocations they can focus on earnings resiliency in the face of an uncertain economic environment.

In this investor guide, we pair our macroeconomic views and market positioning insights to identify potential investment opportunities using exchange traded funds (ETFs). We consider fund flow trends and proprietary signals designed to capture crowded positioning and under-owned opportunities within each investment theme.

We are bound for the most well-advertised economic slowdown in recent memory. Given the speed and magnitude with which the Federal Reserve needs to drive down demand in the economy to tame inflation, a recession seems inevitable. Even as the Fed’s tightening begins to bite and economic activity begins to slow, we believe inflation will likely remain above the Fed’s 2% target due to the stickiness of prices within services and other key consumption basket components, like shelter. Elevated levels of inflation should prevent the Fed from easing aggressively, even if a recession takes hold. Although markets continue to trade on the possibility of a Fed “pivot,” we think central bank authorities will raise and then hold rates in restrictive territory throughout 2023 – waiting for the long and variable lags of monetary policy tightening to feed through into the economy. Put simply, the rate regime has shifted from one of “lower for longer” to “higher for longer.”

It is time to consider a new portfolio playbook.

• Put your cash to work. We believe investors can seek to generate income through ultra-short duration securities. The Federal Reserve has already delivered the bulk of rate increases pegged for this hiking cycle. Therefore, investors can look to earn a steady income stream in lieu of low-yielding cash in their portfolios.
• Bonds are back. During the last decade, investors largely moved away from fixed income in search of yield amid a lower-rate environment. Reaching a similar yield target today requires less equity risk, as fixed income yields have returned (Figure 1). This is likely to drive a shift back into fixed income, as it returns as an investable asset class.

The rapid shift higher in yields has created significant opportunities in high-quality, front-end fixed income exposures.

With yields at levels not seen since the Global Financial Crisis, the front end of the curve in both nominal U.S. Treasuries and investment grade credit offer the potential for attractive total returns (Figure 2). High quality corporations with strong balance sheets can weather a mild recession, especially as many of these companies have refinanced their debts at lower yields. We’ve already seen investors move in this direction, with front-end U.S. Treasury and investment grade credit ETFs adding $10.6 billion and $1.3 billion, respectively, in net assets year-to-date.⁴

We also see opportunity in agency mortgages. Mortgage-backed securities (MBS) have suffered this year from the sharp rise in mortgage rates and pressures from the Federal Reserve’s balance sheet runoff. However, U.S. mortgage-backed securities – including those issued by government-sponsored agencies such as Ginnie Mae, Fannie Mae, and Freddie Mac – have a current yield over 4.6%, a level not seen since the Global Financial Crisis.⁶ We believe the underlying mortgage market is healthier than during the crisis, while carrying very little prepayment risk due to the rate backdrop.⁷ For those looking to moderately extend duration, mortgage-backed securities can be a liquid way to access high quality income.

In assessing the damage from the sell-off that defined markets in 2022, the discussion for many investors often turns with surprising speed to “when do I buy the dip?” Given the sector weighting of broad equity indexes, “dip-buying” is often conflated with the question of “when do I buy tech again?” This implicit question fails to recognize the regime shift that has taken place: the accommodative monetary policy that drove the decade-long outperformance of growth (and large-cap technology in particular) is over.⁸ As a result, we remain broadly defensive on a tactical basis, favoring industries like health care and energy producers.

Stock prices are a function of earnings, interest rates, and risk sentiment. Equity valuations have mean-reverted to their pre-pandemic average of 17-18x earnings.⁹ But this isn’t necessarily cheap, especially headed into a slowing growth environment that should be very different than the past decade.

The post-Global Financial Crisis interest rate paradigm was one of historically “low for long” interest rates. With real rates at or below zero, valuation multiples expanded broadly, but the decline in the discount rate was felt most keenly in sectors where expected future earnings growth was the highest. Consequently, high-growth segments like technology saw the largest gains.¹⁰

Instead, the regime has changed to one in which investors should be prepared for a positive real rate environment for the foreseeable future. Therefore, multiple expansion may not be the sustained driver of equity returns as it was during the last market cycle, as price-to-earnings (P/E) sensitivity to real rates decreases in a positive real rate environment (Figure 3). In other words, because the rates regime has changed during “the dip”, the most beaten-down stocks may not rebound as convincingly.

This shifts the focus in equities back to earnings, which ties closely with our fundamental economic outlook. There is further downside risk to household balance sheets as the cumulative effects of inflation and interest rates materialize in lower home prices, decreased spending power, and layoffs. Growth-style equity earnings-per-share (EPS) correlate more with retails sales than value-style equity EPS, presenting greater downside earnings risk in the case of a consumer-led slowdown.¹¹

However, value-style equities tend to provide exposures to the “real economy,” as evidenced by high correlations with industrial production and durable goods orders.¹² This means value embodies a mature segment of the overall market – one that is more defensive in nature with higher earnings yields and less sensitivity to the U.S. consumer.¹³ We believe infrastructure and agricultural producers are two sub-sectors that embody this type of value exposure. Furthermore, the equity risk premium attached to value segments of the market is solidly positive, meaning investors potentially would be compensated for taking on equity risk in an otherwise bleak economic environment (Figure 4).

For investors who believe that the Fed will be able to engineer a soft landing and are willing to extend equity risk, it may make more sense to look towards small-cap equities rather than growth. Not only do small-caps represent a general post-recession risk-on investment, but they are trading at the largest discount relative to large-cap equities since 2001.¹⁴ Furthermore, the shift back towards consumer spending on services and away from goods provides a strong fundamental backdrop to the services economy, to which small-caps tout higher exposure.¹⁵ In this context, small-cap equities are better set up from a valuation and fundamental perspective to benefit from the upside risk of a resilient U.S. consumer.

The single most important driver of financial markets in 2022 was the trajectory of inflation. This is because persistently above-target levels of inflation pushed the Fed towards a path of significantly higher rates, which drove asset prices down for stocks and bonds alike. While U.S. CPI inflation has decelerated from the 9.1% level seen this summer, we are still far away from Fed’s target of 2%. 

In the near term, we believe there are some reasons to expect further normalization in the path of inflation. We expect to see a continued easing of supply chain constraints in the goods sector of the economy. Indeed, the cost of shipping a 40 cubic foot container from Shanghai to LA has declined by 78% from the highs seen in the fall of 2021.¹⁶ Additionally, as interest rates continue to rise, the interest rate-sensitive sectors of the economy, such as autos, can continue to see decelerating demand. A rising U.S. dollar can continue to push inflation lower via import prices moving lower.

Yet even in the most optimistic scenario (where inflation only rises on average by 0.2% m/m for the next 12 months), inflation is unlikely to get back to the Fed’s target of 2% y/y, given the continued strength coming from the services category of the CPI market (Figure 5). Shelter inflation, comprising nearly 40% of core CPI,¹⁷ will remain high as demand for housing continues to remain elevated and rental prices in the economy are reflected in CPI with a lag. Longer term, geopolitical tensions, deglobalization, and the impact of onshoring production can drive a secular boost to inflation.

For investors, a higher inflationary regime favors owning inflation-linked bonds. After spending a few years in negative territory, TIPS real rates have repriced higher and have regained their role of providing a potential ballast in a multi-asset portfolio (Figure 6). As this paper outlines, TIPS pay investors a principal and a coupon that are tied to CPI inflation. Given our view of higher inflation and stable rates in the months ahead, allocation to TIPS can be a hedge against inflation and a ballast to equities in a portfolio. Flows have recently turned negative in TIPS with investors fleeing the asset class as real rates have risen. After inflows of $40bn in 2021, TIPS ETFs have been in outflow mode in 2022 but we believe that the positive real rate environment will entice investors back in the space in 2023.¹⁸

Investors can also capitalize on the higher inflation theme in equity markets by focusing on infrastructure stocks, which tend to hail from value-oriented sectors like utilities, industrials, and materials. The Infrastructure and Jobs Act directs $1.2 trillion to U.S. infrastructure, which includes 4300 projects that have been announced for 2023. Nationwide, infrastructure enablers from construction to materials could benefit from the spending boom in this space. A higher-inflation regime could lead to the relative outperformance of infrastructure owners, as they often have 10- to 20-year contracts that reset their pricing in parallel with changes in inflation. In addition, they are more often funded by long-term fixed debt that erodes in relative cost as inflation rises. Finally, the services they provide, such as lights, water, and trash collection, are typically less sensitive to recession.

For global investors, increased geopolitical risks and slower structural growth in China suggest taking a modular, flexible approach to EM investing over the medium- to long-term. EM ex-China is well-positioned to benefit from 1) peak Fed expectations and the potential reversal in dollar strength; 2) higher commodity exposures and 3) historically cheap valuations.¹⁹