THE TURNING TIDES OF STOCK-BOND CORRELATIONS
As the classic 60/40 portfolio is heading for its worst annual performance in several decades, it’s important to consider the role that stock-bond correlations have played in this downturn. The global inflation-shock has been the key driver of poor equity and bond performances this year. As a result of the monetary policy reactions to this inflation, we’ve seen stock-bond correlations change significantly in 2022 and become positive for the first time in more than a decade.
Given this unusual situation where both equities and bonds are losing value, the diversification effect of a multi-asset strategy hasn’t played out as expected. So, what can we expect from stock-bond correlations going forward? To try and predict future correlations, we use a model based on three variables – the current inflation regime, the output regime, and the monetary policy regime. The key variable will be the evolution of inflation in 2023. If inflation continues to come down from its current high levels towards 5%-6%, we can expect correlations to turn negative again. This means that we expect the strong positive correlations that we’ve seen in 2022 to subside next year, and for fixed income and equity markets to move more independently of each other.
From a diversification standpoint for a multi-asset strategy, this should be seen as a positive development.
INCOME OPPORTUNITIES IN A DECELERATING GROWTH ENVIRONMENT
2023 is shaping up to be a year of two halves. In the first half of the year, we expect to see a mild recession in Europe and a growth slowdown in the US. However, this could eventually turn into a stabilisation and market recovery in the second half of the year. In the short-term, we are looking for income opportunities in fixed income markets, as they are providing attractive returns in this decelerating growth environment. With moderating inflation and peaking rate volatility, we want to aim for income opportunities in multi-asset strategies via risk-free instruments and attractive spread products.
We’ve identified four key asset classes that could surprise on the upside in the coming year:
- US TREASURIES: The risk/reward for US Treasuries is attractive in our view. The only caveat is the strength of the US dollar. This asset class could become quite interesting in the coming year. Markets are expecting US policy rates to peak at around 5% in Q2 2023. But even if US 10-year yields rise by another 1% from their current levels, it will only take a little over a year to recoup the incurred losses given the high current running yield on the treasuries. If rates on the other hand stabilize at current levels or decline further, this might provide an interesting income opportunity with attractive returns. If the FED signals that they are willing to stabilize rate hikes before the ECB does, this might cause the dollar to depreciate further. However, given the high economic uncertainty, we don’t expect the dollar to depreciate all that much in 2023.
- SHORT-TERM HIGH YIELD: Despite the fact that we are more cautious on high yield as a whole, and prefer investment-grade credit, we see an attractive opportunity in the short-dated high-yield spectrum (1-3 years). Many companies were able to refinance at attractive interest rates in 2020 and 2021, so the “maturity wall” – the amount of maturing bonds that need to be refinanced – is largely a challenge for 2025 and 2026. Short-dated high-yield bonds currently trade at a yield-to-worst of 6.6%, which provides an attractive carry. Spreads are elevated at 450 basis points, and already cover an above-average default cycle. If spreads were to tighten, this could provide some additional return on top.
- EMERGING MARKET DEBT: Emerging market debt has been facing record outflows this year as investors sought safe havens amid concerns about the strength of the US dollar and the risk of default in countries such as Sri Lanka, Russia, Lebanon, Belarus, and Suriname. However, this presents a final opportunity for fixed income investors, as emerging market debt currently offers an attractive carry of 5% above German government bonds. One reason for this is that many emerging market central banks have stronger fundamentals than their developed market counterparts, as they began tightening monetary policy earlier in the cycle. On average, emerging market central banks have tightened more aggressively than developed market central banks, and many have already largely completed their tightening cycles as inflation expectations start to come down. In addition to this attractive carry, emerging market debt also offers low correlation with European rates, at only 9.7%. This makes it a valuable addition to a well-diversified multi-asset strategy. However, it is important to remain selective in emerging market debt, with some Eastern European and selective Latin American countries looking particularly attractive, while caution is warranted in frontier markets such as Sri Lanka. The biggest risk to the outlook for emerging market debt is, of course, the US dollar and emerging market currencies, but the environment is expected to be supportive for emerging market currencies in 2023.
- EUROPEAN EQUITIES & SMALL CAPS: We see a final opportunity in European equities. However, when looking at equities in the context of a multi-asset strategy, we remain cautious in the near term due to economic uncertainty and fading risk appetite. Current earnings expectations are still too optimistic, and we have not yet seen capitulation in terms of positioning. In the short-term, investors need to keep an eye on resilient margins, dividends, and strong cashflow, i.e., quality and defensive picks. Therefore, in terms of regional allocation, we have a slight preference for US equities in the near term. This is despite high valuations in absolute and relative terms, because US companies have the highest margins and the lowest operational leverage of any region. Additionally, the economic outlook for the US economy is better and the inflation peak should be behind us, which is good for rate-sensitive stocks. Furthermore, the market structure of US equities is more tilted towards defensives and growth names, which should outperform in a slowdown. However, as we believe that over the course of next year, equity markets can bottom out as recession uncertainties fade and the tightening cycle ends, we are warming up to European equities for the second part of 2023 given their low valuations and more cyclical nature. This asset class is obviously rather broad. If we had to focus on any one area of European equities, we particularly like the prospects of small cap stocks.
Small caps have underperformed large caps considerably in 2022. This is because small caps are typically more cyclical and more domestic than large caps. Consequently, they tend to underperform when growth slows and PMIs decline. We can expect some further downside in Q1 2023 as earnings expectations continue to be revised downwards. Given the strong underperformance of small caps, they are already discounting a big part of this growth slowdown in our view. Small caps typically outperform large caps in the recovery phase. Turning points in leading indicators such as the IFO business expectations and the new orders component of the PMI survey signal that small caps typically lead the recovery. As we expect inflation to decelerate in 2023 and recession uncertainties to fade towards the second half of the year, this should provide a positive environment for small caps to outperform, given their leading characteristics. In the short term however, investors should focus on the strength of balance sheets and cash flows, and be careful with companies that have high staff costs or interest rate charges.
