Over the past several decades, the negative connection between equities and fixed income has provided an excellent balance for many investors. Last year both markets fell, and this positive confirmation turned the stock/bond relationship from risk-reducing to risk-enhancing.
The change in developments was driven by the evolution of the economic environment. Over the past decade, markets have come to assume that central banks would respond to any deterioration in macroeconomic conditions by cutting interest rates and doing, as former ECB Mario Draghi once said, “whatever it takes”.
“This helped maintain the negative connection: a troubled economy is negative for equities, but positive for duration when the answer is lower rates,” says Natasha Brook-Walters, co-head of investment strategy at manager Wellington. .
But now central banks are faced with rising inflation, posing a tough choice: ease monetary policy if the economic outlook worsens, or raise rates to curb inflation. Bonds will struggle in this environment, especially if central banks are perceived to be behind in the fight against inflation.
Is it time to take advantage of the volatility and dispersion for when you arrive on the scene? According to Book-Walters, increased volatility and economic divergence across countries would be expected to contribute to further asset price differentiation. “We think this is a potentially attractive environment for active managers and especially global macro strategies,” she explains. She also confirms the need to centralize liquidity in the portfolios.
New regime in the markets
One of the questions they plan is whether we are in the midst of a regime change, meaning that the economic changes we are witnessing are probably structural and not cyclical. With this in mind, 2023 could be a year for managers to ensure they are positioned for change.
Following market declines in 2022, medium to long-term capital market assumptions (CMAs) look more attractive, driven by lower valuations. “This may be a good entry point for long-term investors, as well as a good time to assess one’s strategic asset forecast in light of this opportunity,” says the Wellington Management expert. She is also worth noting that our CMAs incorporate weather-related risks (physical and transition), which are expected to contribute to higher inflation,” she adds.
In this regard, to help build inflation resilience in a portfolio, we believe managers should consider the source of inflationary pressure, which can guide decisions on mitigation strategies. “For example, the lack of investment in the production of various raw materials has limited supplies and has pushed up prices, which makes us more structurally positive in terms of raw materials,” the expert qualifies.
Furthermore, one possibility in the face of a spike in volatility is exhausting in the secular trends that spur innovation and disruption in the global economy, creating what we believe to be attractive investment opportunities. For example, financial inclusion. The global push to ensure that people have access to useful and affordable financial products and services – has broad political support around the world and has received a boost from the digitization of finance.
“These trends can lead to attractive investment opportunities to watch such as consumer lending, microfinance, insurance, access to capital markets, and savings/investment,” Brook-Walters says. In a more volatile regime, the risk levels of growth and value allocations may be less stable, which could make defensive allocations even more important to balance risk throughout the cycle.
“In addition, as our fundamentals team has noted, expect more volatility/less sustainability on margins, more attention to balance sheets, more stock-picking opportunities across the market capitalization spectrum, and more opportunities to re- media”, says the co-director of investment strategy. “We expect this to benefit bottom-up fundamental analysis and support active management,” she concludes.
