2022 Was One Of Only Five Instances Since 1948 Where Both US Stocks And US Bonds Were Down Simultaneously In A Calendar Year
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Don’t stand on the sidelines in 2023
For investors, 2022 is a year to forget. Surging inflation and central bank interest-rate hikes have conspired to undermine stocks, bonds, real estate, cryptocurrencies, and many commodities. Little wonder that investors are peering into 2023 with trepidation, concerned that more of the same could be in store.
While we see risk of further downside in some market segments during the first half of 2023, most notably in global equity markets, we also envision a year of select opportunities. Crucially, in our view, investors who remain committed to disciplined diversification and prudent risk allocations should be rewarded, as the typically negative correlations between asset classes seen historically will likely return in 2023.
Storm before the calm
Given the resolute commitment of central banks—above all the Fed—to force inflation down, our base case is that inflation has peaked and will further recede in 2023. But the cost of achieving lower inflation will be high. Every US tightening cycle since 1979—the year then-Fed Chair Paul Volcker took the reins of monetary policy—precipitated an episode of considerable financial stress. Whether cause or effect, the Latin American sovereign defaults in the 1980s, the 1987 stock market crash, the savings and loan crisis of the early 1990s, the Mexican debt crisis of 1995, the Asian financial crisis and Russia/Long-Term Capital Management defaults of 1997–98, the collapse of the “dotcom” bubble in the early 2000s, and the global financial crisis (GFC) of 2008 all followed periods of Fed tightening.
All those tightening episodes produced strong returns for US Treasuries once inflation began to decline. But most of them also produced sharp declines in global equity markets—some brief and others longer-lasting—as monetary policy tightening took its toll on the financial system and corporate profitability.
The key takeaway, in short, is “don’t fight the Fed.” Bonds will likely rally as the Fed achieves its goals, whether the economic landing is soft or hard. Equities are less likely to perform as well as fixed income unless the landing is soft. Otherwise, falling profits will offset falling bond yields and equities are unlikely to advance. That outcome is also a recipe for elevated equity volatility.
The implication is that the risk/reward profile favors fixed income over global equities at the outset of 2023. That assessment need not prevail for all of 2023, but may be decisive in the first half of the year.
Again, at the risk of repetition, the critical insight is that for bonds to perform well, only interest rates must fall. For equities to perform well, everything else—risk premiums and profits—must also line up. Yet, when central banks firmly apply the brakes, the wheels often come off, with unpleasant consequences for equity investors.
It’s back! Less correlation
As wretched as 2022 was for both stocks and bonds, we believe 2023 holds out the promise of renewed potential for benefiting from diversification. 2022 was one of only five instances since 1948 where both US stocks and US bonds were down simultaneously in a calendar year. Suppose, for instance, that our preceding assessment is correct. Tighter monetary policy brings down inflation but produces increased financial risk and a profits recession. In that case, bond market strength will cushion stock weakness.
Alternatively, if the Fed miraculously pulls off a soft landing of lower inflation without a financial stress or an earnings recession, then both stocks and bonds can rally. It is difficult to overstate the conclusion—now is not the time to jettison diversification. Rather, we think investors ought to consider extending back toward less-liquid investments and diversi- fying not only stocks and bonds, but seek to find more ways to diversify for potential longer-term benefits.
