Multi-assets: opportunities await as global rates take new turns
In the past decade, investors have enjoyed loose monetary policies and near-zero interest rates globally, which have driven equity multiple expansion, tighter credit spreads, and overall positive returns across asset classes. The current environment, in our view, consists of a macro regime beleaguered with elevated inflation and higher interest rates.
Given the importance of peak terminal rates, all eyes are on when global central banks will end their monetary policy tightening cycle. Against a backdrop of slowing global growth, elevated inflation, and recessionary concerns, we think investors should remain thoughtful in taking exposures and generating income returns amid heightened volatility, implement effective diversification, and seek specific outcomes, potentially through a multi-asset approach.
Macro is back on centre stage
Investors of the past decade have enjoyed relatively easy liquidity conditions from loose monetary and fiscal policies globally and near-zero interest rates. During this time, macro dynamics played a lesser role in shaping investor portfolios; however, we expect the next decade will be different, with less-defined trends and more focus on managing portfolio return drivers through time. Today, investors are seeing elevated inflation globally, with markets experiencing varying interest-rate hike profiles.
The current conditions have returned macroeconomics to the centre stage when considering portfolio positioning and construction. Macro conditions are influencing market volatility amid the tightening policies of central banks. The U.S. Federal Reserve (Fed), for instance, has arguably been ahead of other developed-market (DM) central banks with its introduction of relatively steep interest-rate hikes since March 2022. Meanwhile, slowing industrial activity suggests that growth in most DM and emerging-market (EM) economies could slip further in the next one or two quarters. In Asia, Mainland China remains challenged by slowing growth, although recently announced policy shifts around COVID-19 controls, supporting consumer consumption and property developer liquidity have been encouraging.
As inflation persists, the overriding question facing investors over the coming months is when the global tightening cycle will end. We believe there will come a point when inflation eases sufficiently that policymakers will be able to prioritize supporting slowing economic growth. The European Central Bank, for example, has signaled that it’s looking beyond current inflation data to a more holistic view of growth. Inflation remains the dominant factor considered by the Bank of Canada in its decision-making process, including the effects of past rate hikes and current real activity. Weaker demand on goods would likely help to quell cost-push inflation before the end of the second quarter of 2023, thereby allowing the Fed to pause on tightening early this year and potentially ease in the second half of the year.
A potential upside risk to global inflation that we’re monitoring is increased demand for goods and services, basic materials, and metals arising from Mainland China’s reopening rebound.
The extent to which a stagflationary environment lingers is key to the Fed’s rate-hike profile, terminal rates, and global growth prospects. These macro considerations could cause yet more challenging market conditions into 2023.
Navigating market uncertainty can be difficult. We highlight key macro anchors that investors can look for in the coming months.
What to watch in the coming months?
While the next few months may be challenging, there are several market events that could offer opportunities:
1 A rollover of U.S. dollar strength
We expect movements in foreign exchange (FX) to be an important driver of returns in 2023. The U.S. dollar (USD) has been on a decade-long uptrend since 2008 and has gained further by 16% to 25% in 2022.¹ The key question for many investors: Will dollar strength persist or should we expect a reversal in the near future? In our view, respite from the strong USD may arrive once we’ve witnessed a peak in inflation expectations, in U.S. Treasury yields, and when the Fed signals a pause to tighten further. Sustained USD depreciation may potentially trigger allocation to non-U.S. equities. March’s FOMC meeting would be a key event to watch.
USD strength gathered pace in the past 18 months
Source: U.S. Federal Reserve, Macrobond, Manulife Investment Management, as of December 9, 2022. USD refers to the U.S. dollar. DXY refers to the U.S. Dollar Index. It is not possible to invest directly in an index.
The risks to our views, however, would be if the Fed’s dovish pivot comes later than expected, in which case USD strength could persist well into 2023. Other factors that could extend the dollar’s strength include sustained U.S. economic outperformance, limited narrowing in the U.S. yield advantage, flight to safety, and/or EM central banks replenishing their FX reserve buffers.
2 Is now the time to return to EM?
EM faced several headwinds in 2022: supply chain disruptions, weaker demand for goods and services, USD strength, geopolitical uncertainty, and slowing Chinese growth—all these factors have contributed to a 27% decline in EM equities in the first nine months of 2022.² EM remains interesting for spread and potential FX opportunities, but risks of a global recession mean EM allocations are continuing to be trimmed and will potentially be further assessed in 2023. While select EM markets are featured in positions within our tactical portfolios of late, we remain cautious with a slight bias to U.S. equities and debt in the near term, as our views toward the dollar and recessionary concerns are having more of an impact on the asset class.
More recently, EM equities staged a remarkable rally in November (+14.8%), recovering almost all the losses they suffered over the previous two months.³ This rebound could be attributed to a combination of lower U.S. bond yields (10-year Treasury yields declined 44 basis points to 3.6%), a weaker USD, as well as Mainland China’s reopening after easing COVID-19 restrictions.
Investors may be questioning to what extent U.S. equities can continue to lead global equity markets or does Mainland China's reopening catalyze interest in the broader EM complex and non-U.S. equities. It’s worth noting that past market drawdowns have left EM valuations at significant discounts to fundamentals and a structurally weaker USD could provide a modest tailwind to the region. While it may be too early to determine if the recent rebound in EM is sustainable, the asset class’s growth and dividend profiles are still attractive over our five-year forecast period.
Equities, fixed income, and alternatives—expected total return (%)⁴
Source: Multi-asset solutions team, Manulife Investment Management, as of October 2022. Forecasts are based on annualized returns over a five-year horizon. REITs refer to real estate investment trusts. The charts shown may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and are only as current as of the date indicated. There is no assurance that such events will occur, and if they were to occur, the result may be significantly different from that shown here.
3 Value vs. growth stocks: which style will outperform?
Value investments, from utilities to consumer staples and healthcare, outperformed last year as dented investor sentiment and heightened volatility—coupled with tighter financial conditions—took a toll on growth stocks.⁵ But can value stocks continue to outperform, particularly with the inflationary landscape shifting, with the end to monetary policy tightening somewhere on the horizon? Fears of a recession have halved valuations of growth stocks in the last two years.⁵ Will 2023 be the year where duration-sensitive growth stocks stage a comeback? Priced at these distressed levels, the market seems to have assumed muted-to-zero revenue and earnings potential for these companies (including tech), but there could be more pain to come. Ultimately, time will tell if investors believe valuations truly reflect the asset class’s fundamentals.
The two H’s: how high can rates rise and how long can they stay high?
In a nutshell, it all comes down to the two H's for the Fed: how high will interest rates rise and how long will they stay high? Although Fed officials raised the projected terminal federal funds rate to between 5.00% and 5.25% by the end of 2023 at its December meeting,⁶ we’re carefully considering how quickly interest rates can peak, and for how long they may hold—these two H’s will heavily impact our asset class positioning across and within markets.
In the meantime, we believe investors should stay nimble and access appropriate diversification across asset classes, geographies, and/or factor styles. A more agile investment approach might benefit from the flexibility to shift between asset classes when markets rotate and interest-rate changes.
Our dynamic asset allocation views7
On equities, we’ve opted to take a barbell approach with select countries and sectors. We’re relatively more positive toward USD-denominated assets, Southeast Asian equities within Asia ex-Japan, and select sectors within U.S. equities (including energy and utilities). Despite headwinds to growth, the prospect that policy tightening could end may prompt a rally in U.S. equities. U.S. stock valuations are also fairly priced relative to historical levels and could provide an attractive tactical entry point.
We think value-orientated styles would work well in a slowing economy. This includes sectors with defensive properties such as consumer staples and utilities, and would be less constructive for duration-sensitive assets (e.g., technology), which are often hurt by aggressive rate-hiking cycles. High-quality equities, particularly stocks that offer the prospect of capital appreciation in addition to dividends, can potentially offer relative protection if earnings come under pressure.
We also think income-oriented securities—both high-quality investment-grade fixed-income and dividend equities—that offer defensive attributes can help weather an environment of slowing growth and high inflation. Furthermore, we remain constructive on real assets since they can offer a degree of inflation protection amid the current macro backdrop. These include assets such as metals or mining, energy, infrastructure, global real estate investment trusts (REITs), and real estate assets.
In Asia, there are economies that have been thriving relative to others. India’s stock markets, for example, reached an all-time high in 2022. With early signs of inflation broadly easing, growth in the Asia-Pacific region has held up relatively well and may allow for a shallower and shorter tightening cycle. There are also opportunities in Japanese equities, supported by a potential reversal of the yen’s breathtaking depreciation and continued monetary and fiscal support.
We see tactical opportunities in Chinese debt and in Mainland China and Hong Kong equities, given the recent easing of COVID-19 restrictions and measures to prop up its property sector. Although recent market moves have been quite extended, we believe that sentiment will continue to drive these markets higher in the short run. Chinese debt has been trending to deeply distressed levels; however, the latest supportive measures allow Chinese property developers a 6- to 12-month window to recalibrate their financial positions and have encouraged a recovery across Chinese credits as market sentiment shifted from being very bearish to somewhat less bearish currently. On a longer-term perspective, we need to see an improvement in economic activity, a sustained recovery in property sales, and a revival of consumer confidence before we can be confidently overweight allocations to Mainland China and Hong Kong.
On fixed income, we believe U.S. investment-grade credit is becoming increasingly attractive in terms of yield and capital appreciation, and it can be used by investors to add duration to their portfolios.
We think exposures to alternatives, real assets, and natural resources, which can provide an inflation-hedge and diversification properties in portfolios, could make sense. For example, prices of oil and agricultural commodities will likely stay well supported over the medium to long term due to geopolitics and supply bottlenecks. Publicly listed infrastructure is also becoming an attractive income alternative.
Our strategic asset allocation views7
Recent market corrections have narrowed the disparity between the income profiles of EM and DM debt. In other words, EM debt’s relative return profile is slightly lower for the time being; however, we remain structurally overweight in EM debt. The USD can continue to serve as a safe-haven asset amid monetary policy uncertainty, but we believe there’s scope for the currency to weaken once policy tightening comes to an end. Within fixed income, EM bonds can offer higher carry and a selection of both USD-denominated or local currency debt can make sense.
What’s more, we observed that income-oriented portfolios can benefit from exposures to alternatives/real assets and natural yields (the cash generated from invested income sources). We think REITs can generate stable and higher-yielding income over the long term, while offering traditionally less volatility than equities and an element of inflation protection.
Capture opportunities with agility, diversification, and outcomes in mind
The past has shown us that the investing environment is constantly changing and increasingly complex. Rates rise and fall, and economic cycles fluctuate. Each sector of the economy or asset class can perform differently from another at any given time in a market cycle. This is why having an agile investment approach is so important during times of uncertainty—the flexibility to shift across and within asset classes during market fluctuations.
Asset allocation during stages of the economic cycle
Source: Manulife Investment Management. For illustrative purposes only
Investment freedom allows investment managers to find opportunities that can fit an intended outcome, enable them to position within the capital structure, offer natural-yielding income or better risk/return profiles, or those that are less sensitive to changes in interest rates. Indeed, the sources of income can be spread across a wide spectrum of assets, depending on one’s desired levels of risk and yield preferences.
Income investing can provide a wide spectrum of yield and risk profiles
Source: Bloomberg and Manulife Investment Management, as of November 2022. For illustrative purposes only. The chart depicts general long-term directional and ranking relationships among asset classes on the dimensions of yield and risks. The relative positioning among these asset classes will vary over time.
Diversification has often been used to enhance portfolio resilience—especially in times like these. In recent years, however, diversification has moved beyond traditional investments and can include factor, premia, relative value, alternatives, and/or real assets.
A look at returns in the past decade indicates that no single asset market outperforms perpetually. The top-performing asset class can be different at various points in time; however, unpredictability can afford opportunities though investors should be thoughtful of when and where to allocate in their investment approach. For example, an allocation to the energy sector over the last five years would average to less than 2% total return; however, the same exposure to energy has returned over 46% in 2022. Therefore, diversification—or perhaps better to frame as the opportunity set—requires a deeper understanding of both the individual asset class and cross-asset behaviors over time.
Asset class returns vary, understanding where to allocate is key
Source: Morningstar, as of December 30, 2022. EM Equity, Asia Pac ex Japan, and European Equity are measured by MSCI indexes; US Equity is measured by the S&P 500 Index; Global REIT is measured by the FTSE EPRA Nareit Global REITs Index; High Yield Bond and Preferreds are measured by ICE BofA indexes; US Agg Bond, EM USD Bond, EM Local Bond, and Money Market are measured by BBgBarc Index. Energy, Infrastructure, and Mining are measured by the MSCI World Energy Net TR, S&P Global Infrastructure Index TR, and S&P/TSX Global Mining TR. It is not possible to invest directly in an index. Past performance is not indicative of future results.
In conclusion, the current macro regime is considerably different from the previous decade due to greater inflation and higher interest rates. Furthermore, it’s unclear when central banks will stop monetary tightening—this will ultimately affect asset class returns. Uncertainty, however, can bring about opportunities, allowing a thoughtful approach of when and where to allocate risk budgets. Each asset class has its distinct risk/return profile and behavior during different economic cycles. A multi-asset approach that focuses on a specific outcome with diversified sources of returns and opportunity set may hold the key to helping investors generate and protect income streams during these less-than-certain times.
1 Bloomberg, as of December 2, 2022. 2 Morningstar, as of September 30, 2022. The performance of emerging-market equities is measured by MSCI indexes. 3 MSCI, MSCI Emerging Markets Index (USD) fact sheets, November 30,