Investors should lower their expectations for equities, with the asset class likely to experience ongoing turbulence for the foreseeable future, according to Georgina Taylor, head of multi-asset at Invesco.
Stocks may have dominated the post-financial crisis bull market but allocating to different asset classes will be needed in this new environment of higher inflation and interest rates if investors are to achieve decent returns over the long run.
The past decade was characterised by low interest rates and an abundance of free cash, which created the prime environment for equities to thrive. During this period, there was little need to allocate outside of stocks as few places offered better returns, but investors have become too set in their ways, Taylor said.
She said the principles that governed the past decade are no longer valid and investors who refuse to adjust to the new environment will be left disappointed.
“The change in behaviour required, in our view, will take time given the seismic shift in investment regime in 2022,” Taylor added. “Some participants will remain anchored in the past for quite some time, while others will adjust more rapidly.”
In her view, most investors will cling onto the ingrained idea that equities are the best route forward before coming to a “reluctant acceptance” of the new regime when no rebound arrives by the end of the year.
Taylor said: “The first part of the year could see ongoing disappointment that financial markets are not reverting to type and reflecting performance and correlations that market participants understand and can process.”
When equities underperform – as they did last year – these periods are often followed by a rebound, but investors should not bank on this happening in 2023.
Many may be optimistic about the prospect of lowering inflation and unwinding fiscal policies, but the effects of these are unlikely to benefit stocks much this year.
Inflation may well have passed its peak and central banks are under less pressure to tighten policy, but impact of this on equities will lag and the restrictive monetary environment of last year will continue to influence markets well into 2023.
Likewise, many companies are likely to disappoint on their earnings forecasts in the upcoming recession, so equities have not hit the bottom yet, according to Taylor.
She said: “If growth does disappoint in a meaningful way, then equities could see another leg lower before the bottom.”
Analysts at BlackRock shared the same message, warning investors that markets are too optimistic about falling rates and haven’t priced in the fact that inflation is unlikely to return to the Fed’s 2% target any time soon.
In the long term, ageing populations, geopolitical tension and the transition to clean energy could keep inflation higher than what investors have become accustomed to over the past decade.
BlackRock said: “The old playbook of simply ‘buying the dip’ doesn’t apply in this regime of sharper trade-offs and greater macro volatility.
“The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.”
This is not to say that the long-term outlook for stocks is dire – in fact, BlackRock has a strategic overweight to equities – but the firm has moved underweight on developed markets in the short term.
Analysts at BlackRock said: “Investors with a longer-term investment horizon can position for the rebound now but could see more pain to come in the near term.”
This was echoed by Taylor, who reiterated that it’s too early to call a rebound with so many challenges still in front of them.
Stocks will recover eventually, but ditching the idea that equities are the only option and allocating cash towards alternative assets will boost returns and protect against the worst of the downside.
Taylor said: “Higher yields available across cash, bonds, and credit are leaving equities lagging some way behind and are leading investors to believe that there are reasonable alternatives.
“This doesn’t mean equities will stay on the side lines forever, but it does mean the hurdle rate for investing just got higher.”
She added that investors with a “flexible toolkit” of diversified assets in their portfolio will not only be better positioned to ride the volatility of 2023, but also stay ahead in this new era where equities do not dominate continually.
While the outlook for equities continues to spiral, the opportunities arising in investment grade credit have improved, according to BlackRock analysts.
Equities are highly exposed to recessionary risks, but assets in credit markets are well shielded from most of these dangers.
BlackRock has taken an overweight position on investment grade credit over the short term to see out volatility this year, but the firm has also allocated more to these assets in its long-term strategic view too.
“The case for investment grade credit has brightened. We think it can hold up in a recession, with companies having fortified their balance sheets by refinancing debt at lower yields,” the firm said.
It added that long-term government debt would typically have been the asset of choice in the old playbook, but not this time around.
This was also the case for Invesco, which increased exposure to credit as the upcoming recession poses a threat to the health of equity markets.
Taylor said: “We maintain a cautious and selective stance on equities near term and prefer credit instead as our risk asset of choice. Yields on credit are now very attractive and whilst we believe the earnings downgrade cycle is still to come, balance sheets remain strong meaning that defaults should remain relatively contained.”
Investors who still want to buy into equities this year may want to consider emerging market assets above those in developed markets, according to BlackRock analysts.
Many developed markets are approaching recessions this year, but the fact that this risk hasn’t been fully prices into stocks means they are likely to suffer another wave of downgrades.
BlackRock said: “Developed market recessions should be the key focus tactically, yet markets don’t appear to price in that outcome. We think that makes them vulnerable to more negative surprises – and volatility – in 2023.”
Emerging markets, on the other hand, have proven resilient to the Federal Reserve’s rate hikes this year and their domestic policies are beginning to unwind before the developed world thanks to early intervention from their central banks.
“We think investors betting on Fed rate cuts later in the year are likely to be disappointed – even as a recession is foretold and we start to see more economic damage from their policy overtightening,” BlackRock said.