Asset allocation: Expect the unexpected

Investors would do well to expect the unexpected, diversify and lean on active management, stepping out of cash and into risk assets to take advantage of the anticipated changes ahead

Investors looking back at 2023 face a slew of contradictions. Inflation eased, the labor market cooled, a war broke out and banks failed, yet the Fed pushed rates higher; despite lower confidence and higher borrowing costs, the U.S. consumer kept consuming; growth equities outperformed value, though stretched valuations and rising rates should have encouraged the opposite; and the international recovery has been fragmented despite China finally emerging from the pandemic.

As a result, when investors look forward to 2024, asset allocation must reflect a hard-learned mantra: “expect the unexpected.”

The health of the U.S. economy remains top of mind, and investors are likely confounded by its remarkable resilience. While tighter lending standards, weaker job gains and lower savings should result in some “belt tightening,” a recession may once again be avoided.

Some of this economic optimism can be attributed to growing confidence that the U.S. has already pushed through peak rates, with the Fed likely finished hiking. A lower Federal Funds Rate should translate into lower borrowing costs more broadly, providing a reprieve to indebted Americans. Meanwhile, the international economic laggards of 2023, like China and Europe, should accelerate through 2024 as other economies gradually lose steam, resulting in less divergence across global growth. Still, politics at home and abroad have the potential to temporarily sour this outlook.

In other words, investing remains a challenge, and asset allocation must reflect the inherent uncertainty of a world very clearly in flux.

Assuming that rates fall in 2024, bond investors should embrace intermediate-duration instruments while having confidence that attractive coupons will act as a “cushion” in portfolios if the rate view unexpectedly changes. They should also shore up quality to account for tighter-than-expected spreads and protect against unpredicted economic risk.

From an equity perspective, stretched valuations and overly optimistic earnings projections, coupled with a slowing economy, mean U.S. stock investors should look toward profitability in large cap names. This favors an allocation to quality regardless of sector and underscores the importance of security selection. Outside the U.S., favorable valuations and an improved growth outlook, including positive interest rates, should translate to further multiple expansion, benefiting most regions around the world and emerging markets in particular. Moreover, a declining dollar should provide an extra tailwind to local currency performance.

This backdrop is also supportive of alternative assets. Infrastructure investments can dampen portfolio volatility, particularly with a renewed interest in expansive industrial policy; real estate can protect against structurally higher inflation; and private equity and hedge funds can thrive if the beta trade weakens. Against this backdrop, however, investors should recognize that a repricing in some private markets is possible, underscoring the need for a long-term view.

Looking at the current portfolio positioning of individual investors, this outlook has only partially been implemented (Exhibit 1). Within fixed income, appetite for higher-quality, extended-duration bonds has increased since the start of the year. Within equities, growth investing is back in vogue, likely a reflection of investors chasing momentum given this year’s surprise rally; this has somewhat unwound the shift toward value that had occurred earlier in 2023 and has driven up duration in stock allocations. Meanwhile, interest in non-U.S. stocks has increased since the beginning of the year, albeit mostly through passive vehicles, with investor allocations trending higher than the historical average despite a hazy geopolitical horizon. Finally, investors are still broadly overweight cash, weighing on returns in 2023 and positioning portfolios poorly relative to the opportunity set in 2024.

All told, the investing landscape is challenged, and predicting the winners and losers in periods of uncertainty is nearly impossible. Instead, investors would do well to expect the unexpected, diversify and lean on active management, stepping out of cash and into risk assets to take advantage of the anticipated changes ahead.