Asset Allocation Outlook for 2023: Greater Diversification and Divergence

2022 Market Performance & Drivers

• High-growth technology stocks and "FANG" equities performed as the worst-performing asset class due to a sharp increase in real yields reversing the negative real yield environment of 2021.
• Bitcoin and cryptocurrencies with duration correlations to growth stocks suffered significant declines alongside equities.
• Commodities emerged as the brightest spot for portfolios, driven by the Russia-Ukraine invasion, energy crisis, and reopening momentum.
• The US dollar cash asset delivered remarkable performance, benefiting from the US being less impacted by the global energy crisis.
• Equity volatility in 2022 was characterized as a "slow tear" rather than the sharp, short drawdowns seen in previous cycles, primarily triggered by trending inflation rather than sudden growth shocks.

Volatility Outlook for 2023

• Goldman Sachs forecasts that 60-40 portfolios will likely remain volatile and not return to the robust regime experienced over the last 20 years.
• Market drivers are expected to shift from inflation and rate volatility toward growth volatility in the coming year.
• There is a higher probability of VIX spikes above 40 and significant drawdowns if growth shocks trigger negative convexity and second-round effects.
• Bond market tail events were the primary outlier in 2022, spilling over into equity markets due to autocorrelated inflation trends.

Equity Valuations and Risk

• Equity valuations have reset below 1990s averages but may not provide sufficient cushion given current macro conditions and potential corporate margin compression.
• Goldman Sachs models indicate a "decent probability" of another equity drawdown in the coming months despite recent relief rallies.
• Investors are currently "prepaying" for a recovery before the full extent of growth damage is realized, suggesting cyclical assets are overvalued.
• The equity risk premium remains low, indicating limited expected excess returns from equities relative to bonds given current risks.

Multi-Asset Strategy Shifts

• Traditional diversification failed in 2022 as positive correlations across assets challenged the efficacy of multi-asset portfolios.
• Fixed income is increasingly viewed as a return generator rather than a pure diversifier, with investment-grade US credit offering 6% to 7% yields at one-third to one-fourth the volatility of equities.
• The "TINA" (There Is No Alternative) narrative has shifted to "TARA" (There Are Reasonable Alternatives), allowing investors to stay up the risk curve with safer fixed income.
• Bonds may not immediately resume their historical negative correlation role with equities due to persistent high inflation levels and central bank credibility questions.

Diversification and Alternative Allocations

• Investors are increasing allocations to real assets (e.g., infrastructure) to hedge against unpredictable inflation volatility and contract-linked real cash flows.
• Trend-following strategies (CTAs) and hedge funds have become critical diversifiers, capitalizing on macro momentum and persistent price trends during high-inflation periods.
• Accessing alternatives via private markets is noted as a strategic move, though implementation is slow due to liquidity constraints.

Yield Curve and Recession Signals

• The inverted yield curve (approximately 80% inverted) signals deep recession risk, with the firm's model assigning a 90% probability of a recession within the next 12 months.
• Economists forecasting a US recession-free path disagree with the 90% market-implied probability, suggesting the curve heavily prices in late-cycle slowdown.
• The yield curve reflects both a pricing-in of a reversal in Fed tightening and anchored breakeven inflation expectations for the long run.

Global and Regional Diversification Opportunities

• US assets outperformed in 2022 due to dollar strength and short-duration equity bias, but opportunities are expected to shift internationally in 2023.
• The US dollar is forecast to peak in 2023, potentially unlocking regional diversification benefits for US investors.
• European, Japanese, and emerging market equities trade at significant valuation discounts, with Japan having been the strongest local currency equity market in 2022.
• Divergence is expected to widen globally, with the US facing services-led inflation, Europe facing energy-driven inflation and potential recession, and China offering a "reopening trade" story amidst zero-COVID policies.

Key Mispricing and Strategic Leaning

• Cyclical risky assets broadly are identified as the most mispriced, having recovered too far on optimism regarding "peak inflation" and "peak hawkishness."
• Goldman Sachs recommends leaning against cyclical optimism in equity breadth and avoiding overpaying for growth before a slowdown is confirmed.
• Specific opportunities are noted in China reopening trades and sectors with pricing power or demand resilience.