Interview, Fireside Chat, Podcast
Asset Allocation Outlook for 2023: Greater Diversification and Divergence
- Volatility is expected to persist in 60-40 portfolios next year, though the primary driver may shift from inflation and rate uncertainty to growth volatility.
- Inflation normalization is a key expectation, yet concerns remain regarding future unpredictability; inflation divergence is anticipated where the U.S. faces services-driven inflation while Europe and other regions deal with energy-linked inflation.
- Equity markets face headwinds from growth slowing below trend, with a 90% recession probability implied by the yield curve model against a 80% inverted curve, although economists forecast lower probabilities.
- Equity valuations have reset, yet current levels offer little cushion against potential drawdowns if growth shocks occur, particularly given that equity risk premiums appear low and cyclical assets may have priced in an unsustainable recovery.
- Fixed income is projected to play a dual role in portfolio construction, offering 6% to 7% yields for investment-grade U.S. credit with one-third to one-quarter the volatility of equities, though its traditional diversification benefits may take time to fully restore.
- A shift from TINA to TARA is underway, prompting considerations for increased allocations to real assets and alternatives, despite the slow-moving nature of such processes due to liquidity constraints.
- Market divergence is likely as the U.S. moves below trend while China reopens and Europe risks recession; the dollar is expected to peak in 2023, potentially creating opportunities in non-U.S. markets trading at significant discounts.
- Risks include negative convexity and VIX levels exceeding 40 if a growth shock occurs, with central banks unlikely to provide reliable support due to persistent headline and core inflation.
- Corporate sectors face challenging macro variables including peak margins, low unemployment, and slowing demand, which may cause further damage not yet fully reflected in market prices.
- Bond markets may fail to provide sufficient hedging during equity stress as they have already rallied significantly, and investors are cautioned against overpaying for growth before the full extent of economic slowdown is evident.