Last year was disappointing for investors. Equity and fixed income investments across the globe fell sharply after strong returns leading up to and following the pandemic.
What made 2022 especially challenging was that both equity and fixed income markets fell in tandem, making it very difficult to diversify portfolios. However, falling markets have brought one silver lining: valuations, which stood at multiyear highs as we entered 2022, have fallen back sharply.
For fixed income, there is a strong link between yields and expected total returns. Higher government bond yields and increases in credit spreads for both investment grade and high yield bonds have moved longer-term expected returns higher. As for equity markets outside the US, many valuation measures are now as low as they have been for the past decade or more.
No single asset type will always provide an anchor for portfolios
This combination of rising bond yields and falling equity valuations means expected returns have increased sharply for multi-asset portfolios. That said, market risk has increased and, given the removal of monetary policy support in most major economies, we believe this is likely to be a structural change.
So, how should investors construct portfolios in 2023?
1. Diversify the diversifiers
The spread of returns and ongoing volatility across major markets show the importance of investing globally and having the flexibility to take advantage of a wide opportunity set actively. Returns over recent months show no single asset type – such as government bonds, alternatives or precious metals – will always provide an anchor for portfolios. Looking to ‘diversify the diversifiers’ is sensible.
2. Appeal of government bonds to reassert
After the recent rise in yields, government bonds may reassume their traditional role of safe haven during a very negative economic or geopolitical outcome. If market sentiment turns negative, particularly if there is a flight to quality because of a sudden economic or geopolitical shock, the ‘return of capital’ appeal of US treasuries, German bunds or Japanese government bonds is likely to reassert itself.
More broadly, tapping the global government bond market, while systematically hedging overseas currency exposure, offers diversification and a wider investment opportunity set. In addition, inflation-linked bonds are one of the few assets offering cashflows which increase in line with inflation.
3. Safe haven currencies
Allocations to safe-haven currencies – such as the US dollar, Swiss franc and Japanese yen – may add to portfolio diversification at times of stress. Exposure may be obtained through tailoring the currency hedging programme within global fixed income mandates, for instance.
4. Volatility is a friend
For skilful active managers, volatility is a friend. It creates opportunities as prices move away from intrinsic values. In particular, more conservative strategies which provide genuinely uncorrelated exposure to traditional liquid markets, or even seek out opportunities to offer return streams diversified from these, showed their worth last year.
To get to the long term, investors need to survive the short term
Utilising a mix of high-quality fixed income, select ‘risk off’ currencies, inflation-linked assets, proven actively managed defensive and uncorrelated assets is more likely to help shield investors from what may be an increasingly volatile journey to come.
5. Emphasis on downside risk mitigation with equities
For long-term investors, investing in equities has been one of the best ways to generate attractive returns, and prospective returns for global equities look more attractive than they have in some years. However, to get to the long term, investors need to survive the short term.
Higher volatility in equity markets is likely to mean a bumpier journey. To help smooth the ride, investors should consider techniques that allow them to retain exposure to shares, while looking to mitigate severe downside outcomes.
We see the use of downside mitigation and volatility management techniques gaining interest as market turbulence persists.
Yoram Lustig is head of multi-asset solutions EMEA at T. Rowe Price
