Fund Return 2022-2023

Investment Commentary

Provided by Mercer - CERS Investment Adviser

Market Developments

In May, performance was mixed for US equities and mostly negative for non-US equities, bonds and real assets.

News flow during May focused predominantly on the debt ceiling deadline looming in early June. This led to volatility in Treasury bills at the very short end of the curve, which would be most affected if the US were to default.  Overall, the market impact has been fairly limited, although ratings agencies have placed US credit on watch for potential downgrades. 

The challenges facing regional banks in the US continued to be a major topic in early-May. Regulators brokered a deal for JP Morgan to purchase First Republic Bank. However, the sell-off in shares of other vulnerable banks continued along with sizable deposit outflows.

Economic data in general remained resilient. US unemployment fell back to the lowest level in over 50 years, although other indicators, such as wage growth, show that the labor market is gradually cooling. Forward-looking purchasing manager indices remain in expansion territory across most major regions, with strength in services outweighing weakness in manufacturing. In spite of economic resilience, headline inflation continued to decline in most major economies. It fell to just under 5% in the US.  Inflation in Japan rose to 3.5%, which is high by historical standards, but still lower than in other developed countries. In the UK and Eurozone, inflation remains more resilient, but also on a downward trajectory. Inflation in China remains low amid a slowly developing expected economic recovery. Central banks in the US, UK, Eurozone and Australia raised their respective benchmark rates by 25 basis points each. Declining inflation, an expected end of the monetary hiking cycle and decent economic data kept the soft landing narrative alive throughout the month.  

Equity returns ranged from mid-single digit increases for US growth stocks to declines for value stocks. US equities generally outperformed non-US equities, with emerging markets outperforming non-US developed markets. Bond returns were negative as the US yield curve moved higher over the month. US credit spreads generally moved modestly higher. Inflation expectations in the US, as measured by the 10-year inflation breakeven rate remained at 2.2%.

In terms of geopolitical developments, President Erdogan of Turkey was elected to another term in office. At the G7 summit in Japan, leaders discussed potential new sanctions against Russia due to the ongoing conflict in Ukraine.

US dollar strengthened against most major currencies over the month and gold fell amid rising real rates. Real assets declined over the month. Commodity prices generally fell during the month, with oil declining over 11% despite OPEC’s announcement of a production cut earlier in the month. 

Outlook

In the face of persistent inflation, in 2022, central banks were forced to start unwinding the financial repression of the post-global financial crisis and COVID era. The resulting reset of discount rates, particularly in real terms, led to a sea of red in equities and bonds.

However, the tide appears to have turned in 2023. Despite a series of negative headlines in the banking sector, the MSCI ACWI is up 9% and the Bloomberg Global Aggregate (hedged) index is up 3% (as of 30 April 2023) The question facing investors now is whether the robustness of markets is a sign valuations have fallen enough?

The challenges of the next decade may well place greater demands on portfolio construction than even the turbulent recent past. Rather than a naïve equity and bond portfolio, achieving the right balance of beta and intelligent diversification will require a forward-looking approach that incorporates this era of regime change rather than ignores it.

Fragility and inflation remain a key problem, both today and for the future. From a portfolio construction perspective, the reset in valuations has reopened some segments of investment that investors had dismissed in recent years as unattractive. The yields on offer in fixed income, especially in an environment fraught with uncertainty and regime changes, may appeal to many investors. However, fixed income and equities alone will not be enough to build a portfolio robust to the potential challenges of the coming years.

While future portfolios will be better able to utilize fixed income, they still need other diversifiers including hedge funds, real assets, and, if feasible, private markets to build a robust portfolio for what we believe will be a period challenged by regime change.

Notes