Cross-asset correlations are well positioned to “normalize” this year, suggesting that both stocks and bonds can play their traditional roles in portfolio construction.
As investors look into the back half of this year, it is clear that the backdrop for investing has changed from the beginning of 2023. It is unclear, however, whether this change has been for the better or the worse – as some old sources of uncertainty have faded, new ones have cropped up to take their place.
The position within the U.S. economic cycle remains top of mind with investors still pondering the much-discussed and predicted recession. The U.S. economy’s remarkable resilience has confounded the skeptics and even now a recession does not feel inevitable. Still, challenges exist.
Higher interest rates have had an impact across the economy, with higher mortgage rates exerting significant downward pressure on homebuilding activity and higher borrowing rates dampening both business and consumer spending. A divided government in the U.S. following mid-term elections last year suggests that future fiscal stimulus will be limited. Meanwhile, the re-acceleration in global economic momentum, which got off to a bumpy start last year, now feels a bit more stable, and narrowing interest rate differentials mean that the U.S. dollar may no longer be a headwind for international investors.
In other words, investing is still quite complicated.
The natural next question, then, is: How should investors be positioned?
After more than a year of aggressive U.S. monetary policy tightening, the market is now talking about a pause or a pivot rather than more hikes. For this reason, fixed income investors may consider making a larger allocation to duration while shoring up quality to account for tighter-than-expected spreads.
From an equity perspective, investors should look primarily toward profitability, especially since valuations have ballooned on the hope for interest rate cuts that may not fully materialize. This favors an allocation primarily to quality regardless of sector tilt. Outside the U.S., cyclically oriented markets like Europe and Japan could benefit from the global recovery. Moreover, a falling dollar alongside a re-opened China should present attractive opportunities in both developed and emerging markets for U.S.-based investors.
This changing backdrop should also push investors to further diversify portfolios. Cross-asset correlations are well positioned to “normalize” this year, suggesting that both stocks and bonds can play their traditional roles in portfolio construction. In addition, investors should consider a heartier allocation to alternatives, which are typically uncorrelated to public markets and in some cases have healthy income streams. Meanwhile, while rising interest rates proved a significant headwind for ESG investing in 2022, the turning tide on central bank policy coupled with the long-term reality of decarbonization suggest that this investing style is not dead.
Looking at portfolio positioning, this outlook has largely been implemented, as can be seen in Exhibit 1. Fixed income allocations to intermediate duration core and core-plus bonds are elevated as portfolios start to position for the end of the rate hiking cycle; moreover, appetites for dedicated high yield have continued to move lower as investors embrace flexibility. In equities, allocations to both sides of the style box are being trimmed as investors focus more down the middle in blended portfolios of both growth and value stocks. Meanwhile, allocations to international equities across both developed and emerging markets are among the highest seen in over a year.
All told, the investing landscape is challenged, and predicting the winners and losers in periods of heightened uncertainty is nearly impossible. Instead, the best way to approach asset allocation is to both broadly diversify and to work with active managers.