So far, 2023 is a great year for investments. Global equities are up double-digits, but they are not alone: absolutely all major asset classes are in the green. The reason is simple: consensus is building on the combination of moderating inflation with resilient activity, the so called ‘soft landing’, and this positive scenario gains traction at a time when most international investors were very risk adverse.
Confidence replaced pessimism, as illustrated by the fact most Wall Street oracles, including the bearish ones, have upgraded their views and year-end targets.
We of course enjoy the situation, and our own diversified portfolios are thriving, in absolute and relative to our competitors, as we started the year by materially increasing our allocation to developed market stocks, now up 18 per cent year-to-date.
But let’s be clear: we do not expect the second-half of the year to be as parabolic as the first one. Pessimism turned into confidence, but we see no reason for confidence to become euphoria. For now, the soft-landing narrative is strong: Western central banks are close to a pause, corporate earnings deliver, and while activity indicators are deteriorating, employment and consumption remain solid enough to postpone recession fears.
That’s exactly the message from this July’s Fed meeting: US economy is resilient while the end of hikes is in sight. However, we do not think that unpredictability - our theme for 2023 - has vanished. It is a good time to have a cold look at the main risks ahead and what to do about them, portfolio wise.
Let’s start with the positive risk: a complete bearish capitulation lifting markets higher. We are not alone to view the current happy episode as temporary: I hate to say it, but it is totally consensual. Differences are in portfolios.
Watch out for any 'euphoria'
Many market participants, who do not enjoy the comfort of a great first-half, have maintained their defensive positioning even if they suffer. They can’t take much more pressure and could throw in the towel in case of further positive fundamental or market development.
We see a reasonably low probability for that, so we do not advise to proactively position for it. But there are two consequences. First, in the absence of a fundamental shock, market corrections would probably not last long.
Second, if euphoria takes place, then it will be a reason to go outright defensive. Consider buying dips, and for sure, ‘sell euphoria’. In case it materializes.
This is the transition to the real fundamental risk. It’s not that much about recession, which will probably happen in one form or another but is widely anticipated. Bonds would do well, risk-aversion would spike but ultimately markets would enjoy restored friendship with central banks.
The massive fundamental risk is to see inflation re-accelerating. We do not expect it -with our unpredictability theme, our priority is not trying to forecast, but having the best portfolios for all scenarios. The issue is that nobody expects it.
Let’s be humble: inflation has continuously surprised for years, if not decade, from its ultra-low levels of the 2000s to its recent meteoric rise (remember the ‘transitory’ rhetoric?). To that extent, the recent tensions on commodities in a complex geopolitical landscape show that nothing is impossible.
Keep that cash around
The market impact would be very negative as the dominating narrative would be challenged. This is one of the (numerous) reasons why we overweight cash, keep a material exposure to gold, and favor Asia in our equity allocations.
My key message today is that unpredictability has not disappeared, but the good news is that diversification is a very effective response. First, after the correlation shock of last year, asset classes have reconstituted their ability to counterbalance each other, making multi-asset portfolios more robust.
Second, below the surface of market-cap weighted indices, which are as concentrated as ever, regions, sectors, styles behave differently: it’s not just about mitigating risk, it’s also about genuine investment opportunities that haven’t unlocked their full potential in a market dominated by macro factors.
Finally, diversification brings peace of mind, which is key to navigate unpredictability. It’s a difficult time to speculate, but a great one to invest, for the medium-term, in a well-diversified portfolio.
