ETF Playbook: Tactical ideas for 2023

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2022 saw a rare bear market across both bonds and equities as central banks were forced to aggressively hike rates in the face of the highest inflation readings in decades. This resulted in some of the largest yield increases in the modern era across sovereign debt markets and a meaningful derating of equity multiples as they adjusted to higher discount rates. While inflation pressures are broadly expected to ease throughout 2023, the consequences of the tightening we’ve already had on growth and corporate earnings and the magnitude of any impending slowdown and potential recession, particularly in the US, are likely to drive the narrative for risk assets in the year ahead.

Below we look at some of these key investment themes and potential scenarios for 2023, and strategies which could help position portfolios for each.
Our Chief Economist, David Bassanese, has offered his thoughts on the macro-outlook for the year here.

Defending a US recession

With mixed signals from the U.S. economic data (PMIs continue to soften and are entering contractionary territory, while some components of the services basket remain sticky and the labour market remains strong) the market remains largely split over whether the Fed will be able to engineer a soft landing or whether the US is heading for a recession. Due to the historic magnitude of both the inflation breakout and the tightening already seen, it is our core view the that the US economy is unlikely not to be adversely affected, and a recession in 2023 remains our base case. As discussed by David, the key leading indicators appear to be signalling a deterioration in the economy. Arguably the most important sector, that of housing, has also essentially ground to a halt across housing starts, building permits and new home sales amid the surge in mortgage rates.

Importantly, despite being widely anticipated amongst economists, it doesn’t appear that a recession is being priced into US risk assets, with the S&P 500 still trading on optimistic forward EPS estimates and yet to price in any future earnings downgrades, and US high yield credit spreads also trading at levels inconsistent with recession.

For investors looking to position portfolios for a hard landing scenario, the typical playbook has called for defensive positioning amid a risk off environment – with high-quality bonds once again acting as a valuable portfolio diversifier to equities:

• Betashares U.S. Treasury Bond 20+ Year ETF – Currency Hedged (ASX: GGOV) – Currently offering their most attractive nominal and real yields in a decade, high grade bonds would be expected to regain their defensive attributes against equities in a recessionary environment as yields fall amid both a flight to quality from earnings downgrades and a pivot in central bank policy. A hard landing should be good for the longer end of the yield curve, given it would mean the Fed would likely be forced into a very aggressive cutting cycle and would be far behind the “curve” when the easing cycle commences. An alternative option domestically would be the Betashares Australian Government Bond ETF (ASX: AGVT) which invests in a portfolio of relatively long duration Australian government bonds with 7-12 years maturity.

Within equities, a typical recession would call for more defensive positioning on a sector and factor basis:

• Betashares Global Healthcare ETF – Currency Hedged (ASX: DRUG) – Traditionally one of the most defensive equity sectors, healthcare tends to fare well with resilient cashflow in recessionary environments. The largest global healthcare companies tend to be pharmaceutical companies, which are defensive by nature of having inelastic demand for their products and high pricing power in terms of their ability to pass on rising input costs to consumers. Eight of the top 10 holdings in DRUG are major pharmaceuticals companies.

• Betashares Global Quality Leaders ETF (ASX: QLTY) – As a factor, quality tends to regain favour once the market looks through concerns about inflation and starts to price in a slowdown, as investors once again place a premium on cash flow, balance sheet strength, and stability of earnings.

Positioning for a soft landing

Despite our core view that the most likely scenario from here is that the US falls into recession during 2023, there is of course a chance the Fed might be successful in engineering a soft landing, especially if geopolitical risks subside and supply chains are repaired. While this would likely be broadly risk on and see most equity sectors rally while credit spreads compress, the precise implications for risk assets remains somewhat unclear. On one hand, the market could take inflation unwinding as a signal that rates have peaked, and that the structural disinflationary forces of the low-rate era remain dominant. This could initiate a rates driven re-rating of out of favour growth and technology. On the other hand, there is also the possibility that a true soft landing – one defined by no contraction in real output, no meaningful rise in unemployment, and no crash in corporate profits – could be seen as evidence that the US economy is fundamentally strong enough to withstand the most aggressive policy tightening cycle in over 40 years. This could mean that the Fed does not indeed need to pivot and could actually lead to a repricing higher of the “neutral” real interest rate – which would imply higher long-term yields and lower multiples on growth stocks.

Investors inclined to align with the latter view could consider barbelling high grade bonds for a hard landing “base case” with more cyclical equity exposures which can withstand higher real rates and would be more likely to carry marketing leadership in that scenario.

• Betashares S&P 500 Equal Weight ETF (ASX: QUS) – When compared to the market-cap weighted S&P 500 Index, the S&P 500 equal weight index has a natural underweight to the still relatively high-multiple growth and technology names that dominate the top 10 and are arguably more vulnerable to multiple contractions. By virtue of this, QUS has a greater weighting to shorter duration equities, the value factor and more cyclical sectors of the market which have tended to outperform in periods of real economy resilience like financials, energy and dividend payers – many of which are now more reasonably priced relative to history. QUS outperformed the broader S&P 500 index by over 7% in 2022 and if you feel large cap technology and growth is likely to remain out of favour for some time, then a switch in US equities allocation from a cap weighted to equal weighted strategy to maintain market exposure could be an option.

• Betashares Interest Rate Hedged Australian Investment Grade Corporate Bond ETF (ASX: HCRD) – With opinions somewhat mixed over what a soft landing would mean for the yield curve, one potential way to get exposure to the scenario without the associated interest rate risk is via rate hedged investment grade corporate bonds. While credit spreads have widened out substantially over the past 12 months (especially AUD spreads), measures of the equity risk premium (e.g. spread between the S&P 500 earnings yield and real risk-free 10y yield) appear little changed over the period, making IG credit arguably more attractive from a relative valuation standpoint, with arguably more potential for mean reversion, than equities. At the time of writing, the yield-to-worst on HCRD is 5.63%*.

Getting paid for patience

Since the GFC, lower yields have forced investors up the risk curve and into higher risk assets to achieve their return targets. 2022 marked a step change from the last cycle which had been dominated by the TINA (there is no alternative) narrative to TARA, as reasonable alternatives with relatively high nominal yields and comparably lower risk once again became viable asset allocation instruments. As we move into 2023 and the potential for volatility in equities remains elevated, meaningfully higher risk-free rates on cash and lower volatility instruments, like senior floating rate debt, mean investors can now be ‘paid to wait’ in relatively risk-free liquid assets with the optionality to take advantage of opportunities in risk assets should they materialise.

• Betashares Australian High Interest Cash ETF (ASX: AAA) – Currently paying an interest rate 3.20% p.a. net of fee (effective 7th December 2022) AAA aims to provide exposure to Australian cash deposits, with monthly income distributions that exceed the 30-day Bank bill swap rate (after fees and expenses) and since inception, has consistently paid a higher net of fee rate than the RBA cash rate. Assets in AAA are simply invested in cash deposit accounts with selected banks regulated in Australia by APRA, unlike some other ‘cash’ exposures which utilise cash-like instruments. AAA distributes cash interest monthly and has the added benefit of being exchange traded, generally with T+2 liquidity – providing investors with a potentially attractive alternative to TD’s that preserves the optionality of that cash to take advantage of opportunities in other asset classes should they arise in the short term.

• Betashares Australian Bank Senior Floating Rate Bond ETF (ASX: QPON) – Credit spreads have widened out substantially over the past 12 months and senior bank FRNs are now offering some of the most generous risk premiums we’ve seen in years (at the time of writing QPON has a discount margin of 100bps and yield-to-worst of 4.64%*), with a benchmark BBSW that should continue to rise further.

* As at 17 January 2023.