As the new year approaches, inflation is high, interest rates are still rising, and economic growth expectations are falling, with geopolitical tensions and the legacy of COVID-19 adding to uncertainty. (UBS)

As the new year approaches, inflation is high, interest rates are still rising, and economic growth expectations are falling, with geopolitical tensions, financial stresses, and the legacy of COVID-19 adding to uncertainty.

But inflection points for inflation, interest rates, and growth are all likely in the year ahead—and navigating them will be key to investing success in 2023. History tells us that durable turning points for markets tend to arrive once investors begin to anticipate interest rate cuts, and a trough in economic activity and corporate earnings.

So, investors with the discipline and patience to stay invested in line with longer-term goals should be rewarded. And those currently sheltering from volatility will need to plan when, and how, to head back into riskier assets.

Markets have been rallying in recent weeks, helped by softer US inflation data. Yet, as we enter 2023, the combination of still-high inflation, rate hikes, and falling earnings expectations makes for a challenging backdrop, and we think the risk-reward for markets over the next three to six months is unfavorable. That's why our investment ideas are focused on defensives, value, income, safety, and diversification:

Add defensives and value. Defensive sectors such as consumer staples and healthcare should prove relatively insulated from lower economic growth expectations, while value stocks tend to perform well in environments of high inflation. More attractive opportunities to buy cyclicals and growth stocks may emerge later in the year as markets start to anticipate lower inflation and stronger economic growth.

In foreign exchange, we also favor more defensive choices, with the US dollar and Swiss franc our favorite safe-haven currencies. Relatively high US rates and slowing global economic growth should help keep the dollar strong in the coming months, and the Swiss franc’s safe-haven appeal is likely to attract inflows. Over the next year, investors will need to prepare for dollar weakness as expectations for Federal Reserve policy shift.

Seek income opportunities. The opportunity to earn more predictable returns from income strategies is appealing against an uncertain backdrop, while high market volatility can itself also offer a means of generating income. We will start the new year with a focus on higher-quality credit issuers, but note that lower-rated issuers could present an opportunity once interest rates and growth stabilize.

Seek uncorrelated hedge fund strategies. Swings in monetary policy expectations are likely to remain an important market driver in 2023, meaning that equity-bond correlations will be periodically elevated. In this context, uncorrelated hedge fund strategies such as macro, equity market neutral, and multi-strategy funds should continue to help diversify portfolios.

Looking beyond 2023, this “Decade of Transformation” has already brought significant changes in the global economic, political, societal, and environmental landscape. But we think a more positive secular backdrop remains possible. Lower asset class valuations should favor stronger longer-term returns for diversified investors, with a transition to greener energy, the era of security, and digitalization remaining key drivers.

So, for investors who are able to look past short-term noise, the challenges of 2022 should give way to longer-term opportunities in the years ahead.

We hope that the Year Ahead 2023 brings you the perspective, insight, and ideas to navigate a Year of Inflections.

Main contributors - Mark Haefele, Thomas Flury, Giovanni Staunovo, Daisy Tseng, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Looking ahead to a Year of Inflections, 17 November 2022.