The divergence of the economy and policy in 2023 wrong-footed many investors. The year started with the fastest pace of rate hikes in a generation and moved quickly to yield curve inversion and then banking stress, but it is ending with the U.S. economy proving more resilient than many expected.

As the fiscal impulse and surprisingly robust consumer activity of 2023 start to fade, growth will likely moderate. But it remains unclear whether the cycle, having slowed, can extend or whether the most widely anticipated recession in history finally materializes.

Cooling inflation, combined with slower but positive growth, probably keeps rates on hold for some time and gives few clear directional signals for markets. Such conditions favor carry trades, relative value positions, manager selection alpha and an emphasis on portfolio diversification much more than bold directional calls.

Convention dictates that restrictive rates for a prolonged period will eventually cause something in the economy to break. However, the imbalances that often help trigger recessions are notable by their absence or at least by their heterogeneity – stresses in one sector do not necessarily cause the dominoes to fall elsewhere.

The result is that, broadly, the economy is less interest rate sensitive than many had assumed. At a more granular level, various stresses pass sequentially from one sector or region to another, leading to divergences in margins, earnings and valuations. In turn, this is generating relative value opportunities across assets and across securities but failing to deliver the synchronized slump so many had feared.

Yields have risen to levels that have surprised many investors – especially as inflation began to reverse from mid-year. But with more evidence of moderating growth, the case for lower yields and lower rate volatility is building. This calls for a modest overweight to duration and diversifying a core U.S. Treasuries position with other regions. We favor UK Gilts and core European bonds – where the growth picture is distinctly less robust – and Australia, where curves are not inverted and the carry penalty to owning bonds is reduced.

Unusually, interest rate volatility jumped this year, while equity and credit volatility declined. Since firms had termed out their liabilities in the aftermath of the pandemic, the transmission of volatility from policy to credit and equity markets was weakened. Refinancing cliffs will eventually loom closer but remain manageable for much of next year. And with policy on hold, we see rate volatility declining. This creates a favorable environment for carry assets such as credit.

By and large, we play credit with an up-in-quality bias, but this is not a simple matter of investment grade over high yield. The differing impact of higher rates by sector and by country leads to a richer opportunity set in which to express our preference to be overweight credit. Credit may also be a preferable means of adding beta to a portfolio rather than adding equities, particularly for those with an income objective.

Although we continue to take a neutral view on stocks, the recent sell-off in equities is bringing market levels closer to a more attractive entry point. But for now within the asset class, we focus on increasing opportunity for relative value positions. Bulls and bears alike tend to agree that margins are elevated. We also note significant variance in margins – and in turn earnings – by sector and by region. At a regional level, we see further rerating potential in Japan, strong cash flow generation in the U.S. and cheap access to high dividends in the UK.

Meanwhile, Europe and emerging market (EM) ex-China equities are held back by continued slowing in the goods cycle. Chinese equities stand out as cheap and unloved, but while the potential for a short squeeze persists, the fundamental picture does not yet support a long position. Sector exposures add further nuance: U.S. cyclicals appear underheld in a region that could undergo an inventory restocking cycle, while European defensives look inexpensive in a region facing ongoing manufacturing weakness.

In sum, we believe that the sharp rise in rates has created asset market distortions that are more compelling to trade than simply trying to predict or time a recession. True, recession odds are modestly elevated, but not so elevated as to suggest an outsize defensive stance. Equally, the path toward an extension of the cycle is not yet sufficiently clear to call for a large risk-on tilt.

Instead, we believe that collecting carry in credit as volatility declines, leaning into the better earnings and cash flow outlook in the U.S. and Japan compared with Europe and emerging markets, and diversifying bond overweights into slower growth regions provide ingredients for a resilient portfolio in today’s less certain environment.

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