PM Corner: Multi-asset strategies for a normalizing environment

Portfolio manager Philip Camporeale explains the opportunity for multi-asset investors as stocks and bonds get back to normal.

What was the biggest challenge for investors in 2022?

2022 was a year investors will never forget. Among the year’s many extreme market challenges: It was the worst year ever for fixed income.1 It was the first year since 1974 that a 60/40 stock-bond portfolio declined as both asset classes posted negative returns. Investors had nowhere to hide.

It was also the year of the fastest Federal Reserve (Fed) interest rate tightening in history to rein in inflation,2 which spiked interest rate volatility by 100%.3

Bond and stock prices will once again move in opposite directions…for multi-asset investors, that’s good news. - Philip Camporeale

Looking to the second half, how is 2023 shaping up to be a more normal environment for multi-asset investors?

As of the May Fed Open Market Committee meeting4, there is sufficient evidence of disinflation, measured by both wages and prices, to slow the Fed’s pace of tightening. Combine that with regional banks tightening their lending standards, and the Fed is now likely to pause, as risks shift from too much inflation to too little growth.

The potential for slower growth shifts the conversation, to whether the economy is headed for a “hard” (overly rapid) or a “soft” landing. While these have different implications for stocks vs. bonds, the appeal of multi-asset portfolios is that you do not have to be right about which scenario will occur. It is more a bet on the relationship between stocks and bonds.

And we forecast that relationship will normalize: Bond and stock prices will once again move in opposite directions, returning to their typical negative correlation, after last year’s unusual positive correlation. For multi-asset investors, that’s good news.

Do you think the economy will have a hard or a soft landing?

Our base case remains a soft landing. This has been policy makers’ intention all along. Ultimately, in the soft landing scenario, the Fed eases policy in early 2024 as inflation gradually moves toward its 2% target. The economy may slow to less than 2% annual GDP growth, or even dip into a “technical recession” (two consecutive quarters of negative growth).

What types of investments might fare better in a soft landing?

We don’t think a soft landing scenario requires a significant underweight to risk assets, such as equities. While some companies seeking to borrow will face challenges while rates are above 5%, investors will find plenty of high-quality companies that are less affected by tighter financial or credit conditions because they have more than enough free cash flow.

Slower growth and tighter conditions could also be ideal for high-quality corporate credit. Credit is a good middle ground between an overly defensive allocation to cash and a premature overweight to equities while the earnings picture remains uncertain. Active credit investors can potentially “outyield” an index.

What happens if the economy experiences a hard landing?

While this scenario is not our base case, two paths could take us there. One would be if the Fed’s tightening campaign is overly aggressive. That does not look imminent.  

The second path would be via a chaotic outflow of deposits from regional banks that shakes U.S. consumer confidence, leading to reduced consumer spending, slower economic growth and weaker employment.

Thankfully, important steps to bolster economic stability are now in place, including an additional backstop for banks undergoing a liquidity crunch that allows them to borrow from the Fed. It’s called the Bank Term Lending Facility, and it was set up recently to address the declining value of banks’ bonds as interest rates went higher.

A hard landing would be very difficult for risk assets, but should it happen, we believe bonds will at least provide positive returns, because normal negative correlation historically has reasserted itself in times of stress. Last year bonds were the problem for portfolios—in a hard landing, they would be the solution.

Cash may not lose you money, but it will not make money in times of stress. - Philip Camporeale

Why not just hide in cash yielding 5%?

For the first time since the 2008 global financial crisis, the risk-free rate makes cash a reasonable investment alternative for the most defensive portion of a portfolio.

But many investors who piled into cash last year likely now have the wrong risk profile and face a steep opportunity cost: They may not have sufficient risk if a soft landing plays out and the stock market performs well. Or, more importantly, in a hard landing scenario, they may be under-exposed to interest rate-sensitive (longer-duration) fixed income that can provide positive returns when other assets do not.

Cash may not lose you money, but it will not make money in times of stress. For example, a 60% allocation to global developed market stocks and a 40% allocation to bonds rose roughly 7% in the first four months of 2023. A cash investor would need well over a year to achieve this result at current rates.

This brings up another concern: reinvestment risk. The three-month Treasury bill yield is above 5% right now on an annualized basis. But, these T-bills need to be reinvested every three months. With Fed easing now more a question of when, not if, T-bills will need to be reinvested in an environment where yields are likely lower than today’s 5%. 

To close, could you elaborate on multi-asset portfolios’ appeal for the remainder of the year?

In recent years, bond returns were challenged by very low interest rates and stocks by stretched valuations, particularly in the U.S. equity market. Many investors considered the 60/40 portfolio dead. But now, following the historic anomalies of 2022, our outlook for the 60/40 portfolio is the best it has been since 2010. We have a very high level of confidence that diversification will provide durability in a variety of macro environments. It’s time to get back to normal.

The benchmark Bloomberg US Aggregate Index dropped 13% in 2022.
2 Policy rates were increased 450 basis points in nine months.
3 MOVE Index measuring interest rate volatility per Bloomberg.
4 And following 75 basis points of rate hikes year-to-date.
International investing has a greater degree of risk and increased volatility due to political and economic instability of some overseas markets. Changes in currency exchange rates and different accounting and taxation policies outside the U.S. can affect returns. There may be additional fees or expenses associated with investing in a Fund of Funds strategy.