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ChangeThe views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
This is an excerpt from our 2023 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come. This is a chapter in the Investment Strategy Outlook section.
iStrat is the investment strategy and solutions group within Wellington. We are allocators and investors, like our clients. So, where do we think the investment focus should be in the coming year? I’ll highlight three areas that are top of mind:
1. Seeking downside mitigation as the equity/bond correlation remains unstable
Over the last few decades, the negative correlation between equities and bonds has provided an excellent balance to many allocations. This last year saw both markets decline, and this positive correlation turned the equity/bond relationship from risk-mitigating to risk-additive.
As our team explained in a recent article, the shift in correlation was driven by the evolving economic environment. Over the past decade, markets came to assume that central banks would respond to any deterioration in macro conditions by cutting interest rates and doing, as former ECB President Mario Draghi once put it, “whatever it takes”. This helped maintain the negative correlation: a struggling economy is negative for equities but positive for duration when the response is lower rates. But now central banks face higher inflation, setting up the potential for a difficult choice: loosen monetary policy if the economic outlook worsens or hike rates to stem inflation. Bonds will struggle in this environment and especially if central banks are perceived to be behind the curve in the inflation fight.
We think inflation will remain a challenge (even if it’s not at current 40-year highs) and central banks and governments will be forced to wrestle with this growth/inflation trade-off. While bonds may still play an important role in portfolios given their potential for income, liquidity and total return enhancement, this high-inflation regime may limit their diversification and downside protection roles. To prepare, allocators may want to consider strategies that can complement the protective role of bonds, including:
- Defensive hedge fund allocations — Our Fundamental Factor Team has looked at how hedge funds can potentially help fill the same roles as traditional fixed income allocations. They found that macro hedge funds may be best aligned with the fixed income roles of diversification and downside protection in different rate environments (read their research here).
- Defensive equity allocations — As allocators consider ways to use their risk-seeking allocations to compensate for the reduced diversification and downside protection of fixed income, we are seeing renewed interest in defensive equity allocations to complement growth and value, many of which have done well in 2022.
- Active risk control — Another part of the solution may be taking more control of risk levels in a portfolio. One approach our Multi-Asset Team thinks is worth considering is actively adjusting portfolio hedges as the perceived probability of a market decline fluctuates. For example, if the probability of a near-term drawdown is elevated, various protective strategies (e.g., options, beta hedging, volatility-control mechanisms) may be implemented to potentially help mitigate some of the downside loss even if the correlation between equities and bonds remains positive.
2. Planning for cyclical uncertainty and macro volatility
In the new economic reality described above, where central banks can no longer focus exclusively on maintaining stable growth, our macro strategist team has argued that we will see a return to a traditional economic cycle with distinct and possibly more frequent moves from one phase to the next. We also expect more cyclical divergence between countries as policymakers make different decisions about the growth/inflation trade-off and as globalization is unwound. Cyclical volatility will likely translate to increased volatility in macro-driven assets, including rates and currencies. This may create challenges but also opportunities to consider:
- Take advantage of volatility and dispersion — We expect increased volatility and economic divergence between countries to contribute to greater asset price differentiation. We think this is a potentially attractive environment for active managers and especially for global macro strategies. It also reinforces the need to focus on liquidity in portfolios.
- Reduce exposure to the cycle — In our team’s research on sizing and evaluating thematic allocations, we have demonstrated their potential to reduce the importance of the cycle to portfolio returns. If thematic investments generate their returns by exploiting structural change, then including them in a portfolio could make the difficult task of timing the cycle less important. Thematic allocations could also enhance diversification, given how much cyclical exposure is found in a typical portfolio.
- Actively manage a portfolio’s beta profile — To help navigate cyclical uncertainty, this may be a time to consider a more active asset allocation process that seeks to adjust exposure to different asset classes over time. This process may benefit from the elevated cyclical divergence across regions and elevated volatility across asset classes.
3. Looking through the volatility: how should portfolios evolve for the longer term?
We believe that we are in the midst of regime change — that is, the economic shifts we’re witnessing are likely structural rather than cyclical (hear more on the subject from Macro Strategist John Butler). With this in mind, we think 2023 will be a year for allocators to ensure they are positioned for the change.
- Higher CMAs — In the wake of market declines in 2022, capital market assumptions (CMAs) over the medium to long term look more attractive, driven by lower valuations. This may be a good entry point for long-term investors, as well as a time to evaluate one’s strategic asset allocation in light of the opportunity. It’s also worth noting that our CMAs incorporate climate-related risks (physical and transition), which are expected to contribute to higher inflation.
- Source-driven inflation strategies — As noted, we believe inflation will remain higher than it has been in recent years, potentially for the next decade. To help build inflation resilience into a portfolio, we think allocators should consider the source of the inflation pressure, which can guide decisions about mitigation strategies. For instance, underinvestment in the production of various commodities has constrained supplies and driven up prices, making us more positive structurally on commodities. Read more in our paper, A source-based approach to managing inflation risk.
- Innovation and opportunity in secular trends — We see a variety of secular trends spurring innovation and disruption in the global economy, creating what we believe are attractive investment opportunities. For example, financial inclusion — the global push to ensure that individuals have access to useful and affordable financial products and services — has broad policy support around the world and has received a boost from the digitalisation of financial services and growing consumer acceptance of technology in the wake of the pandemic. These trends can lead to attractive investment opportunities in areas like consumer lending, microfinancing, insurance, capital markets access and savings/investments (read more here). Among other themes we find attractive are the rise of electric vehicles/advanced vehicle technology and the future of food (food security, agricultural innovation, etc.).
- Factor perspectives — In a more volatile regime, the risk levels of growth and value allocations may be less stable, potentially making dedicated defensive allocations all the more important for balancing risk through the cycle. In addition, as our Fundamental Factor Team has noted, they expect more volatility/less sustainability in margins, more focus on balance sheets, more opportunity for stock picking across the market-cap spectrum, and more opportunities for mean reversion. We would expect this to benefit fundamental bottom-up research and support active allocations.
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