Asset allocation outlook: The case for greater portfolio diversification in 2024

Asset Allocation Shift for 2024:

• Goldman Sachs Research advocates shifting optimal asset mix toward more equity compared to the last 20 years, though the immediate priority is returning to a 60-40 portfolio after many investors abandoned it.
• The optimal risk-adjusted portfolio (Sharpe ratio) over the last 20 years was actually a 40-60 equity-bond split (risk parity), suggesting the historical 60-40 benchmark was underperforming.
• Cash remains an underweight allocation in the view of investment research, given its $8 trillion in assets under management in money market funds, with investors advised to rotate into equities and bonds.
• Equities and bonds are expected to regain diversification benefits in 2024 as inflation and interest rate volatility normalize, reversing the correlation seen in recent years.

Macroeconomic Outlook and Cycle Position:

• Global Cycle Status: The U.S. economy is in a "late cycle" phase characterized by low unemployment and elevated profit margins, but not an imminent recession.
• Regional Divergence: While the U.S. is late cycle, China is in an early cycle fighting low inflation and weak growth, while Europe shows weak growth and Japan is early cycle due to structural factors.
• Sector Split: A significant divergence exists where the global services sector remains strong while the manufacturing sector has been in contraction for 13 consecutive months.
• Recession Probability: Goldman Sachs Asset Management projects a 30% probability of recession in 2024, significantly higher than the historical average of 12-15%, representing a divergence from the Research team's lower probability stance.
• Growth Forecast: Both teams project positive, albeit below-trend, growth for the first several quarters of 2024, targeting a "soft landing" (full employment with disinflation).
• Consumer Weakness: Leading indicators of recession risk include rising auto loan delinquencies (approaching 2008 levels) and increasing credit card defaults, exacerbated by high interest rates near 20%.

Fixed Income and Rate Strategy:

• Investors are advised to extend duration and add interest rate risk to portfolios, moving capital from money markets toward the "belly of the curve" in the yield curve.
• U.S. Treasury supply is expected to be 20% higher in 2024, which will be absorbed gradually to manage potential supply pressure.
• Goldman Sachs Asset Management underweights corporate credit bonds relative to other assets due to rich valuations, despite strong fundamentals.
• The strategy assumes a "central bank put" will remain active, with the Fed capable of reacting to tighten financial conditions if the economy slows.

Risk Management and Hedging:

• Equity put options are currently considered attractive due to low volatility and low skew, offering effective and reactive downside protection.
• Robust portfolio construction via diversification is cited as the primary defense, with real assets gaining importance as a hedge against potential inflation volatility.
• Structural safeguards include buying options on forward rate curves to cap losses while maintaining equity exposure.
• FX overlays are utilized to go long safe-haven assets (e.g., Yen) and short cyclical assets to provide diversification against geopolitical and economic shocks.

Alternatives and Private Markets:

• Private markets and hedge funds are increasingly viewed as vehicles for alpha generation rather than just risk reduction, as cash returns become less attractive.
• Private debt is favored as an alternative to public credit for investors seeking higher yields in a "higher-for-longer" rate environment.
• Private markets offer access to infrastructure and the full life cycle of companies (including early-stage ventures), providing acyclical returns and potential value extraction through active management.
• The valuation gap between public and private markets has narrowed, reducing the risk of private market valuations catching down to public levels.

Long-Term Structural Shifts:

• Inflation Volatility: Structural factors (de-globalization, decarbonization, demographics) may cause inflation volatility to remain higher than the low levels seen in previous decades, necessitating a portfolio shift toward real assets.
• Productivity and AI: Artificial Intelligence is expected to drive potential GDP growth of 1.5% and significant engineering productivity gains, creating a divergence between winners and losers.
• Strategic Allocation: Investors are advised to maintain optionality in venture capital or growth equity to capture productivity gains, while balancing inflation protection against deflationary productivity forces.
• Interest Rate Environment: The era of zero interest rates is not expected to return; portfolios will need to adjust to higher average rates and increased deficit-driven issuance.
• Active Management: The divergence driven by AI and other structural shifts (e.g., GLP-1 healthcare revolution) increases the value of active management over passive beta strategies.