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This is an excerpt from our 2023 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come. This is a chapter in the Investment Strategy Outlook section.
iStrat is the investment strategy and solutions group within Wellington. We are allocators and investors, like our clients. So, where do we think the investment focus should be in the coming year? I’ll highlight three areas that are top of mind:
Over the last few decades, the negative correlation between equities and bonds has provided an excellent balance to many allocations. This last year saw both markets decline, and this positive correlation turned the equity/bond relationship from risk-mitigating to risk-additive.
As our team explained in a recent article, the shift in correlation was driven by the evolving economic environment. Over the past decade, markets came to assume that central banks would respond to any deterioration in macro conditions by cutting interest rates and doing, as former ECB President Mario Draghi once put it, “whatever it takes”. This helped maintain the negative correlation: a struggling economy is negative for equities but positive for duration when the response is lower rates. But now central banks face higher inflation, setting up the potential for a difficult choice: loosen monetary policy if the economic outlook worsens or hike rates to stem inflation. Bonds will struggle in this environment and especially if central banks are perceived to be behind the curve in the inflation fight.
We think inflation will remain a challenge (even if it’s not at current 40-year highs) and central banks and governments will be forced to wrestle with this growth/inflation trade-off. While bonds may still play an important role in portfolios given their potential for income, liquidity and total return enhancement, this high-inflation regime may limit their diversification and downside protection roles. To prepare, allocators may want to consider strategies that can complement the protective role of bonds, including:
In the new economic reality described above, where central banks can no longer focus exclusively on maintaining stable growth, our macro strategist team has argued that we will see a return to a traditional economic cycle with distinct and possibly more frequent moves from one phase to the next. We also expect more cyclical divergence between countries as policymakers make different decisions about the growth/inflation trade-off and as globalization is unwound. Cyclical volatility will likely translate to increased volatility in macro-driven assets, including rates and currencies. This may create challenges but also opportunities to consider:
We believe that we are in the midst of regime change — that is, the economic shifts we’re witnessing are likely structural rather than cyclical (hear more on the subject from Macro Strategist John Butler). With this in mind, we think 2023 will be a year for allocators to ensure they are positioned for the change.
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