Last year was an extremely challenging year for capital markets and will surely be remembered as one of the worst periods of wealth destruction since the Great Financial Crisis of 2008, with stocks and bonds cumulatively losing a record $36 trillion. Markets shifted to several competing narratives – inflation concerns, tightening of monetary policy, and geopolitical conflicts – but the overarching theme was the repricing of assets related to tighter liquidity conditions. Asset class yields gained significant ground compared to policy rates and corrected over the course of the year. As a result, the classic 60/40 portfolio delivered dismal total returns for investors, posting -16.54% for the calendar year.
In this commentary, we discuss the current macro backdrop and provide our asset class perspectives to offer further insight into why we believe we have entered a new age for portfolio diversification.
- Although valuations across broad markets have normalized, we still believe a cautious outlook is warranted as we enter 2023. In our view, inflation uncertainty is still underappreciated. Asset yields still trade as if global central banks will successfully tamp down inflation close to the sacred “2%” target by year end, which seems increasingly unlikely.
- For the fourth quarter and 2022 YTD returns across asset classes and major indices, both cross-asset volatility and dispersion levels were unusually high, causing heightened uncertainty for investors. In general, financial markets trended downward, but equity markets saw some reprieve during the last quarter of the year.
- Alternative asset classes and strategies outpaced both stocks and bonds by a wide margin. While multi-strategy portfolios (represented by Morningstar’s multi-strategy peer category) helped preserve capital, commodity and macro trend-following managers performed well on an absolute basis.
- In 2022, market dynamics reflected a transition from an era of easy money to a regime of tighter financial conditions orchestrated by global central banks combatting inflation. Geopolitical shocks added fuel to the fire, exacerbating supply shocks, which ultimately increased the risk of lingering inflation. As a result, investor sentiment has soured dramatically, and their focus is now pivoting toward concerns around economic growth as we enter 2023.
- With the yield curve shifting rapidly and recessionary conditions likely on the horizon, we believe pockets of opportunity could open up in the near future. Similarly, we foresee credit becoming cheaper, presenting opportunities to buy into segments of the bond market with higher yields at lower prices than usual.
- It appears that equity valuations overall have finally corrected from their past stratospheric levels and are now sitting right around the 25-year historical median. The corporate profit cycle has also peaked, and margins are coming down. Of course, this earnings downcycle is accompanied by elevated borrowing rates and slowing consumption.
- Alternative allocations provided a necessary ballast against stock- and bond-driven drawdowns in client portfolios. Most other alternative strategies we incorporated including merger arbitrage, convertible arbitrage, and relative value, delivered on capital preservation and outperformed both equity and bond markets.
- Portfolio views and positioning are always tentative. Investors should pay close attention to incoming data and modify their thesis and rationale accordingly, especially in times when there are secular and circular dynamics to be monitored. There is no shortage of risks to be aware of as we make allocation decisions in 2023.