Investing.com – European markets are higher on Wednesday in a transitional session awaiting US CPI data on Thursday.
In the meantime, investors continue to closely watch the experts’ outlook for the investment landscape this year.
Natasha Brook-Walters, co-head of investment strategy at Wellington Management, discusses the 3 areas she believes investors should focus on in 2023.
Here is the full analysis:
1. Mitigating losses, as the correlation between equities and bonds remains unstable.
Over the past few decades, the negative correlation between stocks and bonds has been an excellent balance for many investors. Last year, when both markets fell, this positive correlation shifted the relationship between stocks and bonds from risk-mitigating to risk-increasing.
The change in correlation is due to changes in the economic environment. Over the past decade, markets have come to assume that central banks would react to any deterioration in macroeconomic conditions by cutting interest rates and doing, as the former ECB President once said, Mario Draghi, “everything you need”. This has helped keep the correlation negative: a struggling economy is negative for equities, but positive for sustainability when the response is to cut rates. But central banks are now faced with rising inflation, raising the possibility of a stark choice: ease monetary policy if the economic outlook deteriorates or raise rates to curb inflation. Bonds will struggle in this environment, especially if central banks are seen to be lagging in the fight against inflation.
We believe that inflation will remain a challenge (even if it does not reach the current highs of the past 40 years) and that central banks and governments will be forced to manage this growth/inflation trade-off. While bonds may continue to play an important role in portfolios due to their potential to increase income, liquidity and total return, this high inflation regime may limit their function of diversification and downside protection. . To prepare for this, managers can consider strategies that complement the protective role of bonds, for example:
- Defensive allocations of hedge funds – Our fundamental factors team studied how the hedge funds can potentially help perform the same functions as traditional fixed income allocations. They found that macro hedge funds can be better aligned with the diversification and downside protection functions of fixed income securities in different rate environments.
- Defensive Equity Allocations – As managers look for ways to use their investments to compensate for reduced diversification and downside protection in fixed income, there is renewed interest in defensive equity investments as a complement to growth and value , many of which performed well in 2022.
- Active risk control – Another part of the solution may be to better control the risk levels of a portfolio. One approach that our multi-asset team believes is worth considering is to actively adjust portfolio hedges based on the perceived likelihood of a market decline. For example, if the probability of a near-term decline is high, various hedging strategies (e.g. options, beta hedging, volatility controls) can be applied to help potentially mitigate some of the downside losses, although the correlation between equities and bonds remains positive.
2. Plan for Cyclical Uncertainty and Macroeconomic Volatility
In the new economic reality described above, where central banks can no longer focus exclusively on maintaining stable growth, our team of macroeconomic strategists argued that we will once again see a traditional economic cycle with distinct movements. and perhaps more frequent from one phase to another. We also expect greater cyclical divergence across countries as policymakers make different decisions on the balance between growth and inflation and globalization unravels. Cyclical volatility is likely to result in increased volatility of macroeconomic assets, including rates and currencies. This can create challenges, but also opportunities that need to be taken into account:
- Exploiting volatility and dispersion – We believe that the increase in volatility and economic divergence between countries will contribute to greater asset price differentiation. We believe 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 cycle exposure – As part of our team’s research on the sizing and valuation of thematic allocations, we have demonstrated their potential to reduce the importance of the cycle in portfolio returns. If thematic investments generate their returns by taking advantage of structural changes, their inclusion in a portfolio could make the difficult task of measuring the timing of the cycle less important. Thematic allocations could also improve diversification, given the high cyclical exposure of a typical portfolio.
- Actively manage a portfolio’s beta profile – To help navigate cyclical uncertainty, now may be a good time to consider a more active asset allocation process, which aims to adjust exposure to different asset classes over time . This process can benefit from strong cyclical divergence between regions and high volatility between asset classes.
Looking Through Volatility: How Should Portfolios Move Over the Long Term?
We believe we are in the midst of regime change, meaning that the economic changes we are witnessing are likely structural rather than cyclical. With that in mind, we believe 2023 will be a year where managers need to ensure they are positioned for change.
- Higher CMAs – Following the decline of markets in 2022, medium to long-term capital market assumptions (CMAs) look more attractive, due to falling valuations. This can be a good entry point for long-term investors, as well as a good time to assess strategic asset allocation in light of this opportunity. It’s also worth noting that our AMCs (NYSE:) incorporate weather-related risks (both physical and transient), which are expected to contribute to higher inflation.
- Source-Based Inflation Strategies – As we have indicated, we believe that inflation will remain higher than in recent years and even for the next decade. To help build a portfolio’s inflation resistance, we believe managers should consider the source of inflationary pressure, which can guide decisions on mitigation strategies. For example, the lack of investment in the production of several commodities has limited supply and pushed up prices, which makes us structurally more positive on commodities.
- Innovation and opportunity in secular trends – We see a variety of secular trends driving innovation and disruption in the global economy, creating what we believe are attractive investment opportunities. For example, financial inclusion – the global campaign to ensure people have access to useful and affordable financial products and services – enjoys broad political support around the world and has been boosted by the digitalization of financial services. and growing consumer acceptance of technology in the wake of the pandemic. These trends may give rise to attractive investment opportunities in areas such as consumer lending, microfinance, insurance, access to capital markets and savings/investment. Other topics we find attractive are the rise of electric vehicles/advanced automotive technology and the future of food (food safety, agricultural innovation, etc.).
- Factor Outlook – In a more volatile regime, the risk levels of growth and value allocations could be less stable, which could make defensive allocations even more important to balance risk over the cycle. In addition, as our fundamental team has pointed out, expect more volatility and less sustainability in margins, more focus on balance sheets, more stock picking opportunities in the across market capitalizations and more opportunities for mean reversion. We believe this will benefit bottom-up fundamental analysis and support active management.
By Laura Sanchez