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2023 saw investors grapple with a volatile, yet surprisingly resilient, market environment. How should investors think about opportunities and challenges in 2024?
One of the new macroeconomic regime’s most prominent hallmarks is its tendency towards shorter and more frequent cycles. Inflation is also likely to be structurally higher and more volatile over the next decade than it has been in the past. This creates an uncertain environment for investors, but an interesting set of opportunities. I’ll highlight three key points that are top of mind for us as we review our portfolios and discuss with clients their portfolio positioning in 2024 and beyond.
This time last year, I suggested investors could expect significant volatility in 2023. The reality was even more volatile than I expected, but markets held up well. Why? It comes down to people.
When we talk about the resilience of economies, what we really mean is the resilience of people — and the companies they start, run and work for — that help drive the economy. There is a lot to be uncertain about, but when I think about the future of investing, I get excited about the ingenuity and resilience of people. We have an ability to innovate, whether through developing and using technological advancements like AI or tackling problems such as climate change.
Our thematic team targets this potential for innovation through taking a thematic approach, investing in the structural trends that are changing the world. There are a significant number of exciting companies working at the forefront of innovations within fields such as health care, electric vehicles, financial inclusion or working to help drive the energy transition. By taking a thematic approach, our team can potentially capture two opportunities: the tailwind of the theme itself as well as the alpha generated by a company that is at the pinnacle of innovation.
In a world of more frequent and less predictable economic cycles, we think an allocation to thematic investments has other benefits beyond exposure to innovation. If thematic investments generate their returns by exploiting structural change, then including them in a portfolio can potentially help mitigate exposure to the shorter business cycles. Thematic allocations could also help increase diversification given how much cyclical return is typically found in a portfolio. Research from our Multi-Asset Team found that this oft-cited benefit of thematic investing is supported by historical data, with themes on average about half as sensitive to the cycle as sectors.
The low-rate, low-yield environment of recent years has given way to a completely new landscape for income-seeking investors, with core fixed income currently looking increasingly attractive for long-term investors, in our view.
High-yielding cash has also been attractive to investors, especially given uncertainty over the economic outlook, but if interest rates have peaked, we think it could be time to consider a move into bonds. Our Multi-Asset Team has observed that locking in yields has historically provided higher total return versus cash after central banks have stopped hiking rates — and holding cash while waiting for more certainty could ultimately translate into a lower total return relative to bonds.
However, while bonds are currently an attractive source of income and return enhancement, the inflation volatility we expect may alter some of the diversifier behaviour we used to rely on. While fixed income continues to have a critical role in asset allocation, we believe alternatives also continue to have an important role to play within solutions and portfolios. Global macro hedge funds, as one example, could potentially provide diversification and downside protection, which will be critical for this new investment regime.
Finally, concentrated equity markets have been a challenge for many investors this year. As the weight of megacap stocks in US and global benchmarks increases, the risk arising from active managers being underweight companies like these increases as well. These underweights may be seen as the cost of maintaining high active share relative to a benchmark, but the magnitude of this underweight has become so large that it can overwhelm the impact of owned names.
Our clients are keenly focused on this as they increasingly look to manage factor risk in their asset class building blocks. It’s a dilemma that has been growing over time. To combat this, our Fundamental Factor Team makes use of a completion sleeve in many of their solutions, which seeks to account for the impact of market concentration by passively owning a small allocation to the megacap stocks. this, in effect, “right-sizes” the proportionality of underweights and overweights, allowing stock picking in the rest of the portfolio to then shine through. The team has also carried out research on the benefits of taking an “extended” approach in more concentrated markets, where a manager is able to be underweight or short some names in order to be overweight or long others they really want to own. Extension strategies may give managers flexibility to underweight positions based on conviction rather than market cap, and to potentially take greater advantage of price dispersion in mid- and small-cap stocks without introducing a market-cap tilt to the overall portfolio. Our research on the market efficiency framework provides a structure for considering where to deploy fee budget or which markets may offer the least efficient areas of opportunity.
Looking at this year, we see a heightened risk of a cyclical turning point for markets and economies. We are excited about the opportunities that market dislocations may present for active strategies, while keeping a keen eye on risk management and downside protection. In a world of shorter and more volatile macroeconomic cycles, balancing return generation with risk management necessitates, in our view, allocations to diversifying and defensive strategies, such as commodities, macro strategies and other defensive hedge fund or equity styles, alongside return-generating asset classes such as equities and credit.
The bottom line is that volatility is here to stay, bringing with it a dynamic set of opportunities and challenges.
