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Portfolio implications behind the regime shift
Investor may need to strike balance between strategic patience, tactical flexibility
Leon Goldfeld 23 Nov 2022

The past year signalled a significant shift in the internal dynamics of asset allocations. Diversification within public markets disappeared in 2022 as stocks and bonds declined in lockstep, the relative outperformance of private assets led to allocation imbalances, and the forceful policy response to rising inflation upended traditional yield curve and currency dynamics.

If these trends persist, strategies will need to adjust; even if they are temporary, these trends may offer a compelling opportunity. Having said that, investors may need to strike a balance between strategic patience and tactical flexibility. According to the strategic asset allocation models derived from capital market forecasts – returns, volatilities and correlations – there are five key takeaways worth a closer look.

First, the typical 60/40 allocation delivers one bit of very good news: At the current market juncture, a traditional portfolio is far more likely to present long-term opportunities, given the significant repricing of markets that has taken place in 2022. Forward-looking returns on stocks and bonds are expected to be materially higher over the coming 10 to 15 years. Our forecast annual return for a US dollar 60/40 stock-bond portfolio over the next 10 to 15 years leaps from 4.3% last year to 7.2%.

However, the picture is not all rosy. Stock-bond correlation should remain volatile and less negative than before.

Second, the role of diversified alternatives has been even more fully demonstrated over the past year. While alternatives are no longer as critical to reaching forward return targets as they were at the end of 2021, they are now even more important from a diversification standpoint. The rise in stock-bond correlation makes a 60/40 portfolio much riskier, even if its returns are more compelling. As a result, alternative allocations across private equity, global core real estate, infrastructure, diversified hedge funds and direct lending are essential as a means of managing volatility as well as providing a reliable source of high returns.

Third, credit sectors appear to be particularly compelling, given the attractive entry point and relatively low volatility. Much of the investment-grade market continues to be BBB rated, leverage has fallen from the pandemic’s historic highs, and we do not foresee meaningful further moves. In high-yield, we believe that the growth of the leveraged loan and private credit markets, each now worth over US$1 trillion, has seen the development of a higher quality index, which should better protect investors in case of default.

Fourth, the size of equity exposure and the corresponding need for an uncorrelated hedge asset constitute a critical pivot point in the asset allocation process. Just as a negative stock-bond correlation allows for a large equity allocation to be maintained safely alongside risk-diversifying fixed income, the shift to a more positively correlated environment reduces an investor’s capacity to safely hold equity risk. In such a scenario, equity investors may wish to employ active strategies that manage exposures dynamically.

Fifth, the strength of the US dollar and the level of current valuations in global equity and credit markets make non-US investments more compelling to a US investor (and, conversely, make US investments less compelling to a non-US investor). Countries and firms that are positioned well relative to dollar strength are likely to be the biggest beneficiaries.

The emergence of a new macroeconomic regime presents an opportunity for investors to stress-test their allocation process and implement changes that will support risk-adjusted returns over multiple horizons. The long term, after all, is simply a series of shorter periods in which thoughtful strategic adjustments can make a real difference.

Leon Goldfeld is the head of multi-asset solutions for Asia-Pacific at J.P. Morgan Asset Management.

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