Inflation is already trending lower. Central banks are expected to continue to tighten, but not to the extent seen in 2022. As a result, bonds will come under less pressure. Oil and natural gas prices are less likely to gyrate, the group said in its outlook.

However, there is still great uncertainty. “The US Federal Reserve may overtighten monetary policy and create a recession in the United States. A recession in the world’s largest economy would reverberate globally. China’s disorderly abandonment of its zero-Covid policy may unleash another wave of Covid-19 infections, including new variants, globally,” the group continued.

The group believes that the eurozone and UK inflation rates probably peaked in October at 10.6 per cent and 11.1 per cent, respectively. “We expect US inflation to decline to 3.7 per cent, as measured by headline CPI, by the end of 2023,” the group said.

In 2022, central banks raised rates at one of the fastest paces on record to combat inflation, the group added. “Such a large and rapid increase in policy rates contributed to the turmoil in financial markets. We do not expect a repeat in 2023,” it said.

“Clients’ portfolios experienced more volatility in 2022 than usual because equities and bonds declined at the same time in most markets. It is very rare to have equities and bonds drop over the same period in the US,” the group continued.

60/40 stock/bond model portfolios
Reports issued last year by several financial institutions challenged the 60/40 stock/bond model for portfolios. Some recommended adding real assets such as commodities, infrastructure and real estate. Others recommended diversifying portfolios by allocating more assets to Asia ex-Japan. Still others recommended adding trading strategies, including hedge funds and momentum- and volatility-based strategies, the group said.

The proliferation of such recommendations prompted some of our clients to ask whether they should re-evaluate their strategic asset allocation accordingly.

The group's response is twofold. First, appropriate, customised diversification for both institutional and private wealth clients has been a key pillar of the group’s investment philosophy since its inception more than 20 years ago. Such diversification around a core holding of equities and bonds already includes asset classes and investment strategies that enhance risk/return to preserve and then maximise risk-adjusted wealth, especially at times of heightened uncertainty, the group said.

Second, nearly a hundred years of data demonstrates that a mixture of stocks and bonds is an effective starting point for a portfolio, consistent with another pillar of ISG’s investment philosophy that history is a useful guide. The 60/40 portfolio has generated positive returns on a rolling 12-month basis 80 per cent of the time since 1926, the group continued.

Recession
Turmoil in financial markets coupled with heightened geopolitical risks has raised the risks, though not the certainty, of a recession. Historically, rapid and extensive tightening by the Federal Reserve has led to recession in the US.

The group assigns a range of 45 to 55 per cent to the probability of a US recession in 2023. 

Today, many leading indicators are pointing in opposite directions, and the group believes it is important to convey this uncertainty to its clients unequivocally. “In this uncertain environment, we believe portfolios should not be positioned for the certainty of recession nor for the certainty of modest economic growth,” the group said.

“Instead, we recommend portfolios be positioned at their customised strategic asset allocation, where they are designed to ride out volatility and provide staying power in the event of geopolitical disruptions,” the group continued.

“If a recession is averted, financial market returns in 2023 will be less volatile than in 2022; we expect a moderate-risk diversified portfolio of stocks and bonds to provide a total return of 9.0 per cent for taxable clients and 9.8 per cent for tax-exempt clients,” the it said.

The group believes that if a recession occurs early in the year, corporate earnings and equities will decline – possibly beyond the maximum drawdown of 2022 – but bonds will hedge the portfolio by increasing in value, because the starting point of interest rates is much higher than it was at the beginning of 2022.

“However, by the end of 2023, as the recession recedes and the fog of uncertainty lifts, the equity market will most likely rally. We would expect high single-digit returns for a moderate-risk diversified portfolio,” it continued. 

“If the recession lasts beyond year end, the equity market will most likely end the year near the lows we saw in 2022, providing a total return of negative 4.4 per cent from year end 2022 and resulting in a low- to mid-single-digit negative return for a moderate risk portfolio,” the group concluded.