Natasha Brook-Walters (pictured), co-head of investment strategy at Wellington Management
2023 saw investors grapple with a volatile, yet surprisingly resilient, market environment. After the recession that did not happen, how should investors think about opportunities and challenges in 2024?
One of the new macroeconomic regime's most prominent hallmarks is its tendency towards shorter and more frequent cycles.
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Inflation is also likely to be structurally higher and more volatile over the next decade than it has been in the past.
This creates an uncertain environment for investors, but an interesting set of opportunities.
The link between resilience and innovation - and how portfolios can benefit
Last year, everyone was talking about how resilient markets were.
When we talk about resilience, what we are really talking about is the resilience of people and companies, and our ability to innovate.
Even if we do see a slowdown this year in growth and earnings, or simply more volatility around the business cycle, one way to help protect portfolios could be to specifically capture that potential for innovation and resilience.
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Thematic investors aim to target innovation through taking a thematic approach, investing in the structural trends that are changing the world.
Because thematic investments generate their returns by exploiting structural change, including them in a portfolio can potentially help mitigate exposure to shorter business cycles.
Thematic allocations could also help increase diversification given how much cyclical return is typically found in a portfolio.
Research from our multi-asset team found that this oft-cited benefit of thematic investing is supported by historical data, with themes on average about half as sensitive to the cycle as sectors.
There are a significant number of exciting companies working at the forefront of innovations within fields such as healthcare, electric vehicles, financial inclusion, or working to help drive the energy transition.
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By taking a thematic approach, investors can potentially capture two opportunities: the tailwind of the theme itself as well as the alpha generated by a company that is at the pinnacle of innovation.
Opportunities in today's higher yielding world
The low-rate, low-yield environment of recent years has given way to a completely new landscape for income-seeking investors, with core fixed income currently looking increasingly attractive for long-term investors, in our view.
High-yielding cash has also been attractive to investors, especially given uncertainty over the economic outlook, but if interest rates have peaked — and we expect central banks to pivot to rate cuts this year — it could be time to consider a move into bonds.
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Our multi-asset team has observed that locking in yields has historically provided higher total return versus cash after central banks have stopped hiking rates - and holding cash while waiting for more certainty could ultimately translate into a lower total return relative to bonds.
However, while bonds are currently an attractive source of income and return enhancement, the inflation volatility we expect may alter some of the diversifier behaviour we used to rely on.
While fixed income continues to have a critical role in asset allocation for multi-asset portfolios, alternatives also continue to have an important role to play within solutions and portfolios.
Global macro hedge funds, as one example, could potentially provide diversification and downside protection, which will be critical for this new investment regime.
In the meantime, while we favour investment grade fixed income, we are looking for opportunities to add high yield bonds on the back of any market weakness between now and the summer.
Take advantage of regional diversification
We continue to see opportunities to take advantage of regional diversification, with economic and monetary policy cycles remaining less synchronised than in recent years.
For example, we continue to be overweight on Japanese equities, where we continue to see a confluence of higher nominal growth and evidence of corporate governance shifts boosting profitability.
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Japan did underperform some other markets in the fourth quarter, but it still has a long runway for improved profitability, even if monetary policy tightens slightly.
Looking at this year, we see several possible scenarios for markets, each with vastly different investment implications.
A very positive macro backdrop has been priced in, but there may be some bumps in the road.
For example, will the lagged effect of higher rates hurt the economy and reignite recession fears?
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Or could the economy reaccelerate and drive inflation higher, preventing the rate cuts the market expects?
Either way, we are not sure the path is going to be quite as smooth as markets anticipate, which leaves us excited about the opportunities that market dislocations may present for active strategies, while keeping a keen eye on risk management and downside protection.
In a world of shorter and more volatile macroeconomic cycles, balancing return generation with risk management necessitates, in our view, allocations to diversifying and defensive strategies, such as commodities, macro strategies and other defensive hedge fund or equity styles, alongside return-generating asset classes such as equities and credit.
The bottom line is that volatility is here to stay, bringing with it a dynamic set of opportunities and challenges.
Natasha Brook-Walters is co-head of investment strategy at Wellington
