Last year’s dramatic rise in bond yields, the likelihood of continued central bank tightening and the multiple contradictions between the macro and micro view demand a radical re-think of asset allocation.
There are four key factors at work.
1. Contradictions between macro and micro
A survey of chief financial officers in the US from Duke University showed the greatest divergence on record between the optimism of CFOs about their own companies and their predictions for the broader economy.
This macro-micro dichotomy appears in (gloomy) top-down versus (sanguine) bottom-up forecasts for corporate earnings and defaults. We see it in deviations between what central banks say they are going to do and what the market expects. This is natural during regime transitions, and it can be a source of opportunity.
2. Central banks will continue to tighten
Last year saw some of the fastest monetary tightening on record, but the end-point is further away than the market expects. While headline inflation has been slowing, it remains high in the components of the basket where it tends to be stickier. The jobs market remains very tight, and central banks following models tied to labour market strength will probably have to continue to hike, barring a dramatic change in the data.
3. Reality of tighter financial conditions
The speed of this financial tightening – via rates, quantitative tightening and market corrections – increases the risk of financial accidents.
In 2022, some $2tn of cryptocurrency paper wealth evaporated. The European Central Bank had to build a transmission protection instrument to protect weaker euro members as it fights inflation. The Bank of England had to underwrite the gilt market. Initial public offerings and syndicated lending has dried up. Some large real estate vehicles have had to provide deal enhancements to attract new investment. In many areas, marginal liquidity is hard to find.
4. Credit trumps equity
In the macro-micro debate, we concur with the macro forecasters for equities: the potential for downward revisions to earnings outlooks isn’t baked in. On credit, we agree with the micro forecasters: fundamentals are generally strong enough to limit defaults over the next two or three years.
For a long time, the higher-risk sectors of the lower-risk asset classes, such as credit, were regarded as marginal sources of yield. In the economic slowdown of 2023, however, a combination of attractive yields, lower volatility and a position higher than equity in the capital structure suddenly brings them to the core of suggested asset mixes.
Figure 1 sums up one implication of all this. It shows estimated returns and volatility for a range of asset classes according to our latest capital market assumptions (grey), relative to our assumptions a year ago (orange). The flattening of our estimated capital markets line indicates how much more attractive the outlook is for lower-volatility fixed-income assets, relative to riskier assets, than it was a year ago.
Figure 1. Capital market assumptions: 2023 versus 2022
Estimated annualised return and volatility, five-to-seven-year term
Source: Neuberger Berman, Bloomberg, Cambridge Associates, FactSet. Analytics as of 31 October 2022.
The other thing to note is how big and rapid this adjustment has been. When things move this quickly, and when the economic crosscurrents are so complex, it’s important to focus on active management and markets that offer the most opportunity for active managers. Investors need to be mindful of opportunities across a broader range of risk factors and be ready to provide liquidity in a market prone to shocks and dislocations.
There tends to be less dispersion between long-only public market investors’ returns compared with those of private market or hedge fund investors, but over the past decade that difference has become extreme (Figure 2). There will be much greater dispersion between winners and losers in all strategies, in both public and private markets, over the next decade.
Figure 2. Low dispersion in active management over the last decade
Manager performance dispersion, 2012-22
Source: JPMorgan Guide to Alternatives 4Q 2022.
(Manager dispersion is based on annual returns for US fund global equities and US fund global bonds over the 10-year period ending 2Q 2022. Hedge fund returns are based on annual returns over a 10-year period ending 3Q 2022. Global private equity and global venture capital are represented by the 10-year period IRR ending 2Q 2022.)
Niall O’Sullivan is EMEA Chief Investment Officer, Multi Asset Strategies, Neuberger Berman.