David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is our 2023 asset allocation draft, and has been recorded for institutional and professional investors.
 

I'm David Lebovitz, Global Market Strategist, and host of the Center for Investment Excellence. With me today is Jared Gross, Head of Institutional Portfolio Strategy at JPMorgan Asset Management. Welcome to the Center for Investment Excellence.
 

Jared Gross: Happy to be with you today. Thanks for having me, David.
 

David Lebovitz: Of course. Well, always good to have you on, Jared, and thanks for coming back. It's been an interesting year in 2022, and I know we're going to get to the meat and potatoes of today's conversation, which is another asset allocation draft as we look ahead to 2023, but when we think about where we started the year versus where we are today, really those places could not be more different.
 

We started the year with rates that were still sitting at the zero bound, a Fed cycle that was just beginning to move from accommodative to the early stages of restrictive. We had public market valuations across both equities and fixed income sitting at significantly elevated levels.
 

And you look at where we are today. Obviously, a significant repricing across both stocks and bonds, a Fed that is outright hawkish, rates at the highest level seen in a number of years. So, a very different starting point today than where we were at the beginning of 2022. But as I know we'll discuss, that has created a fair share of risks, but also a fair share of opportunities when we think about the year to come.
 

Just in terms of what we expect from a macro perspective over the course of the coming 12 months, inflation is still very much going to be the story. We think that it's going to take time for inflation to get to where the Fed would like it to be. But we do believe that inflation has peaked here in the United States, and should gradually move to more palatable levels by late 2023, if not early 2024.
 

A lot of that's going to have to do with the Fed. They are by no means done. We have a Fed meeting coming up next week to round out the year. We'll get a new set of projections. We are also expecting a 50-basis point increase in the Fed Funds Rate. And then frankly, my view is that they will hike by 25 basis points in February, another 25 basis points in March.
 

That'll bring the terminal rate north of 5%, and then they probably pause and hang on for dear life as long as they can, or until the inflation candle has truly been snuffed out. And there will be an impact on growth from all of this. I think we're already beginning to see an impact on growth from all of this.
 

And so, when we think about the probability of recession next year, we very much believe that in the United States, it's 50-50 with risks to the upside. We wouldn't be surprised if there was a recession next year.
 

We don't think it would be a terribly severe recession next year, but it's important to take stock of the amount of tightening that the Fed has done here and the impact that that will have, not only on controlling inflation, but also softening the labor market and leading to a slowdown in growth.
 

And so, that's where things are from a macro perspective. Jared, maybe I'll just tap you in here quickly to see if there's anything you would want to add.
 

Jared Gross: Yes. Thanks, David. I think you captured all the main points. The only thing I would reiterate here is, as we've learned a number of times over the last several years, beginning with COVID and repeatedly since, the economy is not the markets and the markets are not the economy.
 

And I think we may be in store for another reminder of what that means in 2023, which is, as you noted, we may be heading into a recession, but that does not necessarily mean it's going to be a bad environment for the markets.
 

We obviously want to be selective in how we approach taking risk, and we'll talk through that in a variety of ways today, but I think it's always helpful to come back to that key point, because as investors, the macro economy should obviously inform what we do, but it is not actually what we do. What we do is invest money, and we have to make sure that we do that as thoughtfully as we can.
 

David Lebovitz: Exactly. And, you know, to put it bluntly, the stock market has bottomed an average of six months before the unemployment has peaked during every recession since 1960. So, I think that that tells us what we need to know about a year that could be challenging for the economy, could well end up being, at a minimum, a better year for the markets than what we've dealt with here in 2022.
 

And so, speaking of markets, let's dive right into the draft. Taking a step back and just reminding you and all of our listeners of the process here, we're going to go through four rounds. Each round is going to focus on a particular sector of the markets.
 

We're going to cover both publics, as well as privates, and we'll talk a little bit about the various considerations around the investment opportunities in each sector. And then one of us will make the final selection.
 

And at the end of the conversation today, Jared, and I, will each make a final pick of what we think will do best in the coming year. Just as a reminder from last year, Jared's advice was on short-term bonds. I thought public markets would reprice, and private markets would be a bit safer.
 

You know, I'm not going to say that we can forecast with 100% certainty, but that feels pretty good with hindsight, which is obviously 2020. So, let's dive in and let's start with bonds because I think that those are front of mind for pretty much all the clients that I'm speaking with.
 

Jared, can you talk a little bit about how you're thinking about fixed income and where you're seeing opportunities as we look ahead to 2023?
 

Jared Gross: Absolutely. And I think I'll just take a brief step back since, as you noted, so much has happened in 2022 that has gotten us to where we are, that it's worth just a very quick recap. So, I sort of will divide the year into three periods, what I will call the pre-Jackson Hole period, where the Fed may have been slow out of the starting gate with respect to its hiking cycle, but I think the markets remained far too optimistic over the degree of hiking that was going to be necessary, and the Fed's commitment to that hiking.
 

And so, everything up until kind of mid-summer and ultimately the Jackson Hole announcement, was failing to price in the level of inflation and the Fed cycle that we have seen since. And obviously, with the Jackson Hole announcement, and with a lot of the subsequent Fed conversations around how they expected policy to evolve, the market has been forced to sort of get back on size, and that has been a painful process.
 

We have seen bond yields spike and significant negative returns across most fixed-income asset classes. And now, I would say we are at kind of a plateau where the market is more or less fairly assessing the Fed's policy pass.
 

We may still learn more information from data that comes out in the next few weeks and months, but it's hard to look at the market's pricing right now and see that it's clearly missing something that the Fed is trying to convey, certainly in the front and sort of medium part of the curve.
 

And so, what we're really looking at now is almost a recession betting environment where we're trying to figure out, will there be a recession? How severe will it be? How long will it last? Because that's going to ripple through a lot of these markets as we head into 2023. But as you evaluate the fixed income opportunity set, I think what you can start from is a much more favorable position that the markets are priced fairly well.
 

And so, that means you can start to think about moving out the yield curve a little bit. How far is a subject of some debate, and we can certainly talk about that. You may want to layer on a little bit of credit spread risk, probably in a diversified way, as opposed to in a very concentrated way.
 

And you certainly want to be selective and use active management in that respect, because if we do head into a recession, that would be the main concern, which is that while the Fed Funds Rate and the terminal rate and the duration that's implied in the sort of path of Fed Funds, is probably pretty close to the best information we have right now.
 

Credit spreads have not widened all that much over the course of 2022. And although the yields are attractive, you certainly have to be mindful that if we went into a severe recession and a credit downturn, you could see some material weakness in the credit sectors. And so, I think the response to that is generally speaking to stay up in quality.
 

Quality tends to outperform in this period of a Fed cycle. As volatility starts to come off the boil, you look at the MOVE Index, which is the interest rate volatility equivalent of the VIX for equities, generally speaking, investment-grade credit spreads tend to track the level of volatility in rates with the MOVE Index.
 

And so, as you noted, we expect the Fed to taper the increases in the Fed Funds Rate to 50 basis points in December, and then most likely 25, and again probably 25 in the early parts of 2023. And so, if that's the case, we probably expect rate volatility to come down a little bit, and that should be good for credit at the margin.
 

So, the fixed-income markets still has not kind of fully resolved itself, but we would say there are lots of opportunities to at least start taking some risk, treasuries, mortgages, where you get very high quality, particularly in the agency backspace, asset-backed securities, where they tend to be fairly short in maturity.
 

They tend to be self-amortizing. They're fairly resilient to a modest recession. And I said, investment grade. As you start to get into some of the more plus sectors of fixed income, things like high yield or EM, obviously the risks to a either extended period of elevated rates, and/or an outright recession, those risks grow.
 

And so, you do have to be a little careful, but given the inversion of the curve, given the level of yields, moving out a little bit into short duration or even core fixed income, is probably a pretty sensible call.
 

David Lebovitz: Excellent. Certainly makes sense to me, a little bit more duration, relatively high quality, that seems like a pretty good setup, given that we do see recession risk as having risen relative to start of this year. So, that's the view on fixed income. 
 

Shifting gears to equities, when I think about the equity story next year, it's really going to continue to be all about earnings. Valuations rerated substantially over the course of 2022. Earnings expectations have begun to soften, but have remained relatively resilient.
 

And the expected growth rate next year remains positive for the S&P 500 on an operating earnings basis. And every client is saying that earnings are the next shoe to drop, right? And we're going to see this big drawdown in public markets as earnings expectations rerate early next year. 
 

What I would say is that we would agree with the idea that earnings expectations today are too high, but we're not necessarily sure that they need to collapse, even if we were to have a recession next year.
 

And the reality of the situation is that if you look at earnings declines during recessions in the United States, back to 1950, the average decline in profits is about 30%. If you isolate the period from the late 1960s through the early 1980s, which I would argue is an inflation environment more similar to where we are today, the average decline in profits is closer to 15%.
 

And so, why is that the case? A big part of it has to do with the fact that in periods of higher inflation, top line revenue growth can actually remain positive. You know, you think about the post '08 period. If we were in a recession and real GDP fell by 3% and inflation was 2%, well, nominal growth is negative one.
 

If you think about next year, real GDP falls by 3%, inflation's at 5%, nominal growth sales growth, right, positive two. So, revenue should continue to grow next year, even if we see a contraction in the real economy, and that very much leaves margins in the driver's seat when it comes to the outlook for profitability.
 

Margins are going to be impacted by a number of things. They're going to be impacted by interest rates. They're going to be impacted by inflation. They're going to be impacted by labor markets.
 

And we recognize that margins today are too high and will need to rerate next year, but we're not necessarily sure that they're going to fall in line with their long-run average. We think that rather they will revert to the broader trend.
 

And so, if we have a recession next year, again, we would expect earnings to decline, not by as much as what's been seen on average historically since 1950. And furthermore, if by some magical draw of the cards, we do land on that narrow path to a soft landing, we would expect earnings growth to be about flat.
 

So, that's the view in the United States. The view in the rest of the world is a bit more idiosyncratic. Obviously, Europe is in a tough spot today, likely already in recession. We think that the earnings story there over the next 12 months is going to be pretty downbeat. So, that's not necessarily a beta that's looking all that attractive.
 

But EM is beginning to look more interesting. And particularly if the United States can avoid a recession, we think that that could mean that EM keeps its head above water as well, and any stimulus that we see in China as they attempt to focus a little bit more on supporting economic growth, could well end up leaking out into the broader EM complex.
 

And so, when we think about where the opportunity lies in 2023, on the public equity side, I think that it continues to exist in US equities. I think that non-US equities may have a little bit of time in the sun here, given that we've seen the dollar begin to weaken, and given that generally, things seem to be moving in a bit more positive direction, but I'm not sure we're out of the woods quite yet.
 

I do believe that when the US catches a cold, the rest of the world gets sick. And Jared, similar to the point you made about having quality in a portfolio, right, we do like the higher quality nature of those US equity assets relative to the opportunities that are available in other parts of the world.
 

And so, quality very much the story when it comes to the public side of the equation. Looking ahead to 2023, Jared, maybe I'll bring you back in, and we can talk a little bit about private markets and alternatives. How are you thinking about the more liquid and open-ended alternatives over the course of the next 12 months?
 

Jared Gross: You know, that's an interesting topic. And before I go there, it occurs to me as we have opened up with the public markets, bonds and stocks, it's worth at least just stepping back and referencing what happened in 2022, because it was so unusual, and if not completely unprecedented, certainly nothing that had occurred in recent memory, which was the sharply positive move in correlations between public market assets and what that did to portfolios.
 

And without wanting to rehash history here, I think looking ahead, there is almost a symbiotic relationship between the positive outlook for equities and fixed income in two ways. First, in that we very well might see the upside benefits of positive correlation in the event that we get a genuine pivot from the Fed, which is risk assets for both stocks and bonds could do quite well.
 

Obviously, we don't know when and if that will happen, but the reversal of the 2022 trade is certainly a possibility. And also the fact that yields in the fixed-income markets have returned back to something close to normal levels, means that bonds now can, at least in theory, resume their role as a diversifier, and that gives us comfort to take risk in the portfolio.
 

And I mention this not just to rehash the public markets, but it's a good entry point for the conversation around alternatives, because one of the things we have to be very mindful of in the event that the inflationary world persists perhaps a bit longer than we think, is that correlations, while they probably will not stay as positive as they have been in the past year, may not revert immediately back to where they have been historically.
 

And so, one of the genuine challenges that asset allocators are going to have to think through is, where do they find diversification in their portfolios if bonds are not as effective as they have been historically, particularly? You know, that's a real challenge. And so, alternatives can step into that role.
 

And I think you and I would both agree that a year ago, when we looked at the alternative markets, we were focused primarily on their role as a source of returns and income that was very hard to find in the public markets given where valuations were at the end of 2021.
 

Now, valuations in the public markets have reset, and we have much higher expectations for where those assets will deliver returns going forward, but what we really have to be careful about is the diversification.
 

And so, that role for alternatives is really critical. So, that's a very long preamble to what you asked me to talk about, which is the liquid end of the alternatives market. So, maybe I'll just dip into a couple of these areas, and you may want to come back to these points later on as well.
 

But first, will just briefly touch on hedge funds. This is a very tough asset class to analyze because it's so idiosyncratic at the manager level, but there are a few things we can speak to. First, higher volatility tends to be positive, not for all hedge funds, but for certain categories of hedge funds.
 

So, global macro, equity long, short, you know, they tend to benefit from not just higher volatility, but greater dispersion among asset classes and securities within those asset classes. And that's where they can really step up and generate attractive returns. And we think, generally speaking, this should be a fairly benign environment for hedge fund strategies.
 

Obviously, their liquidity, while it tends to be pretty good in the scope of what alternatives offer, it is somewhat conditional in the sense that, you know, managers can always put up gates and so forth if they run into trouble. So, as with any alternative asset class, the liquidity budgeting is something that you have to be very thoughtful about. 
 

But we do see investors starting to be a little more nuanced in their approach to the liquidity aspects of alternatives, and recognizing first that not all alternatives are equally illiquid, which was frequently a sort of implicit view that many investors held in years past, and also not limiting themselves to a binary choice between so-called illiquid and so-called liquid, but recognizing that it's much more of a continuum.
 

And so, when you think about that continuum, and you start moving a little further out in illiquidity, and you start getting into the space inhabited by what we would refer to as core real assets, open-end vehicles that typically offer some degree of initial lock, but then have the ability to redeem down the line, things like core real estate, core infrastructure, core transportation, this is where there are some very interesting diversification characteristics, particularly in an environment like the one we're in, where a lot of the volatility elsewhere in the markets, particularly in the public markets, is being driven by inflation and the reaction to inflation by the central banks.
 

So, if you can find assets that are positively correlated to inflation, they have a positive beta to that risk characteristic, or that have the ability to pass through inflation from their source of revenue on one end to the investor on the other, those can be extremely attractive in this environment, even if they have to give up a little bit of liquidity to get them.
 

And so, within real estate, obviously a lot of this relates to leasing and the rollover of leases across time and the ability to adjust prices and so forth. Right now, real estate as a market certainly has its share of challenges, but it's also incredibly diverse. And I think as investors, you have to approach real estate as a massively diverse asset class, not only by property type, but also by geography.
 

And so, a large, well-diversified fund, not only does it limit its risk concentrations from the top down, but it has the ability at the bottom up to identify really attractive individual property opportunities and put money to work and sort of recycle capital across time, whereas highly or very narrowly tailored investment strategies that only operate in sort of one segment of the market, can find themselves in a very hot market environment when capital's flowing into their space, but that can reverse, and you can find yourself on the wrong end.
 

So, within office, we tend to see a lot of support for very high-quality buildings in good locations. Obviously, the further away you get from sort of the core class A central business district properties, particularly newer properties, the harder that market gets, but the market is repricing, and we expect to see opportunities there.
 

Retail, we've sort of come full circle, interestingly. We're in sort of a post-COVID pre-recession space, trying to sort of figure out what the impact is going to be on retail properties. But certainly, the rebound post-COVID has been very material.
 

Industrial's been almost the reverse story. It's been a massive flow of capital into industrial properties, not only because of sort of supply chain issues and the growth of eCommerce and warehousing and so forth, but longer term, this may have legs as a deglobalization story, as trade flows are sort of rewired from foreign trade into more domestic zones, and that may have some impact on where that capital flows.
 

And then residential, the individual housing market may be a little bit weak right now as mortgage rates have risen, but obviously, multifamily has done quite well with higher levels of rent and elevated demand for rental properties in the market. So, we think real estate remains a little bit of a mixed bag from a sector perspective, but a lot of opportunities, and we expect to see that continue.
 

And then just very quickly, I'll touch on infrastructure, and its sort of cousin, transportation. Infrastructure is going to require a massive amount of global investment over the next 10, 20, 30 years or more, roads, power, water, telecom, you name it.
 

And so, investors who are well positioned to take that money from investors and channel it into productive investments and find assets that they can hold long-term, that's going to really be where the value lies.
 

And again, a lot of that comes with a measure of inflation resilience that could be extremely valuable. And then transportation, we're seeing really in the near term two broad trends. One is, the rewiring of the energy supply system away from piped gas to ship-borne LNG, which has enormous implications for the transportation sector.
 

And we're also seeing the growth, over a slightly longer horizon, of the offshore wind market, and that requires an enormous capital investment in ships to service those offshore turbines, and we expect that to continue to grow. So, within this space, the opportunities remain very real.
 

I think it would be easy to say hedge funds in this moment in time, but I'm always a little reluctant because the level of sort of manager volatility and dispersion is just so high in that space.
 

So, I really think as a long-term investor, infrastructure right now just remains in such a sweet spot between policy and capital flows, and ultimately kind of long-term macroeconomic needs, that I think that's really the place to be
 

David Lebovitz: Excellent. I would very much agree with you on that. I think the hedge fund thing can be difficult to call. We have a chart in our guide to alternatives that looks at manager dispersion by strategy, and it is certainly wider than what we see in traditional long-only equity strategies. And so, I'm sympathetic to the view on infra and tend to agree.
 

So, I'm going to bring us home with a quick conversation around the outlook for financial alternatives, so things like private equity, venture capital, and private credit. A lot of people over the past few years have gotten very familiar with a TV show where they like to say that winter is coming.
 

And what I would say about the financial alternatives in 2023, is that the write-downs are coming. The write-downs have begun in places like venture capital. I think that they will very much begin to accelerate and show up more in the buyout space over the course of the coming months.
 

That's going to be somewhat painful if you're an existing investor in these strategies and your capital has already been deployed, but Jared, as you and I were discussing the other day, if you're an investor with new capital that you're looking to put to work, 2023 and 2024 may end up being some interesting vintages, particularly for things like venture capital and private equity.
 

But I would go back to it to something that you were alluding to and that we highlighted in our long-term capital market assumptions, which is that while we expect at some point, the Fed will ease in response to a deterioration in macro conditions, it's not a foregone conclusion from where we sit that they're headed back to the zero bound.
 

And so, we're thinking a higher cost of capital is very much going to be pervasive over the course of the coming business cycle, and that's going to create greater differentiation between winners and losers.
 

And so, the day of, well, I'm going to buy a software company because it's a software company and I know I'm going to make money, that feels like it has very much run its course. And I do think that you're going to see a more evenly distributed set of opportunities within the financial alts, particularly within places like venture capital and private equity as well.
 

Private credit is an interesting one. I would break that into two pieces, direct lending, and then special situations. From a direct lending perspective, we think that yields have held up a bit better than has been the case in the public markets.
 

In general, these tend to be higher quality loans, with more flexibility, but we do have a slowdown in economic activity next year, if you're running a direct lending fund, your job is going to go from finding people to lend to, to managing the existing portfolio.
 

And so, that's an area that looks like it could get a bit choppy as we look ahead to 2023. The flip side of that is that if the Fed overdoes it, and we do have a default cycle, and at some point then the more speculative parts of the fixed income universe begin to look attractive and there's an opportunity in distress and special situations as well.
 

And so, would kind of bifurcate the private credit space as we think about 2023, and certainly be more constructive on things like special sits, not running away from direct lending, but being a bit more conservative in terms of our due diligence and the underwriting standards when evaluating those investments and those investment managers.
 

And so, from a financial alts perspective, again, you know, answering the question of, what will do well next year versus what will do well over the life cycle of a fund, are somewhat two different things.
 

Where I'm going to shake out on this is that if I had one year to generate a return, I think you're still going to want to lean into private credit, but if I can lengthen my time horizon to a couple of years, I would argue that the opportunity which will be created on the back of those write-downs in things like private equity, is going to generate healthy returns over longer periods of time.
 

And so, with all that said, that brings us to the conclusion of our 2023 asset allocation draft. Just a quick review of what we chose, in fixed income, Jared reminded us to focus on quality and maybe think a little bit about adding back some duration into portfolios. When it comes to public equities, we like the US.
 

We like the higher quality nature, and earnings are very much going to determine what happens from an overall rate of return perspective. In the liquid alts, thinking about hedge funds and infrastructure seem interesting, particularly infra from a long-term perspective.
 

And then in the financial alts, maybe a near-term opportunity in private credit, but certainly a long-run opportunity which we think will be created in things like private equity, particularly the traditional buyout part of that asset class.
 

And so, that's the way we're thinking about the world as we look ahead to the coming calendar year. Let's wrap up with a final pick. And Jared, I'm the host, you're the guest. So, you get to go first. Give me one asset class for 2023,
 

Jared Gross: I'm going to be really boring and say core bonds is going to be the best place to be in 2023.
 

David Lebovitz: It feels uninteresting at the surface, but I think it could end up being a pretty interesting trade when all is said and done. And you know what, actually, I'm not going to be terribly interesting myself. I'm going to stick with the public side of the equation, and I'm going to say plain old vanilla US equities look interesting to me next year, particularly if we see long-term rates begin to decline and the earnings story actually plays out a bit better than what consensus is beginning to expect.
 

And so, with all that said, Jared, as always, a pleasure having you join us on the Center for Investment Excellence, and I look forward to having you back sometime again soon.
 

Jared Gross: Thank you, David. After those two picks, I can just say the public markets are clearly back, back to basics, as they say.
 

David Lebovitz: Exactly. Well, thanks again, and we'll have you back soon. Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Recorded on December 5th, 2022.