2022 has been a difficult year for UK and international investors. News of Russia’s invasion of Ukraine, China’s domestic policy and Britain’s brief experiment with trasonomics rocked markets.
The dominant narrative that drove markets throughout the year was central bank efforts to curb runaway inflation. A stagflationary environment of slowing growth and high inflation hit both stocks and bonds throughout the year. However, bonds were the hardest hit as a result of the sharp rise in interest rates.
As it stands, UK government bonds — gold coins — have had one of their worst years yet. And this even after recovering from the lows following Kwasi Kwarteng’s ‘mini’ budget.
However, 2023 is expected to be a much better year for bonds. Inflation in the United Kingdom, as well as the United States and Europe, is expected to drop significantly next year. Major central banks, including the Bank of England and most importantly the US Federal Reserve, will slow the ferocious pace of rate hikes and at some point stop rate hikes altogether.
This should make bonds perform much better than they did last year. Moreover, high-quality bonds should offer some protection to investors’ portfolios should the stock market come under pressure again next year.
The traditional 60/40 portfolio (three-fifths of the portfolio is invested in equities and the rest in bonds) has been very successful in recent decades. This is because stocks and bonds have acted as diversifiers for each other throughout the economic cycle.
This relationship fell apart in 2022. But a peak in inflation and soon-to-be higher interest rates means that bonds will once again need to provide diversification to riskier assets.
However, the outlook for stocks is less optimistic. The economic situation in the UK is very precarious. The UK and Europe are already in recession, and the US is expected to follow suit soon. UK consumers are already feeling the pinch of higher energy prices and this will only get worse if government intervention is announced. The housing market, a key driver of UK sentiment, could also come under pressure this year as mortgage rates surge.
UK equities have the advantage of being very cheap. However, the many economic problems facing the UK make us hesitant to recommend them, but their cheap valuations may make them better than other regions. We believe a cautious investment approach is prudent at this point, even as interest rate direction becomes clearer.
For now, investors should consider placing a lower weight in equities and a higher weight in government bonds in their portfolios.
That said, we have a positive view of China. Strict Covid rules are easing there, and growth should accelerate by the second half of 2023. Furthermore, in the medium term, we believe the decoupling of the US and China will take hold. However, the extreme views that emerged as a result of Russia’s invasion of Ukraine are likely to be assessed more practically given China’s important role in the global financial and economic system.
Goodbye, 60/40?
But the bond resurgence may be short-lived. Although inflation will ease from recent highs next year, we believe average levels of inflation and interest rates are likely to be higher in the future than they have been in the past decade.
Depositors may appreciate 4-5% interest on cash accounts after years of virtually no interest being paid. The reality, however, is that real returns on fixed-income assets such as cash and bonds will decline once inflation rises and interest rates have fallen for the past 40 years.
The 60/40 portfolio has been an investment staple for decades. We still think it holds its place, but in the higher inflation world we’re entering, investors are looking to make alternative assets such as real estate, infrastructure, private equity and credit a more significant part of their holdings. means that you should consider .
Infrastructure projects, for example, often have guaranteed inflation-linked revenue streams.
Many institutional investors have already taken steps to strengthen their portfolios by allocating funds to alternative assets, looking to benefit from the ability to deliver uncorrelated and sometimes superior returns. An analysis of some of the world’s largest pension funds found that he held one-third of his assets in illiquid alternatives.
Also, given the expected weak long-term real returns, many countries choose to limit their government bond allocations to the minimum level acceptable to regulators.
Access to private markets is more difficult for individual investors. However, there are many alternative mutual funds listed on public exchanges for depositing capital, such as real estate and infrastructure, as well as niche areas such as shipping and music royalties.
Given the breadth of choice and benefits that alternative assets can offer, some investors are asking whether a 50/30/20 combination of equities/bonds/alternatives is better than a traditional 60/40 portfolio. It is probably appropriate to Especially those with long investment horizons.
In terms of both return and protection, government bonds are expected to play a key role in portfolios in 2023. But in a world of rising average inflation going forward, investors will be rewarded for thinking outside the box.
Salman Ahmed is Global Head of Macro and Strategic Asset Allocation at Fidelity International.
