The world is a very different place today, at the start of 2023, than it was a year ago. The changes visible in financial markets and the economy appear even more jarring when looking back three years—the last time we revised our long-term capital markets assumptions and strategic asset allocations (SAA) for client portfolios. We have therefore updated our assumptions for the economy and asset class returns, as well as the resultant SAA portfolio allocations. This letter details the changes and provides an update on our tactical (shorter-term) views to start the year.
Reanchoring client portfolios
The SAA is the foundational, or anchor, portfolio for our clients. It utilizes a fiveyear investment horizon but is updated whenever our economic and market conditions substantially deviate from our prior assumptions, typically every three to five years. The goal of the SAA is to improve the return profile over a simple, market-capitalization-weighted stock/bond mix of similar risk, known as a baseline portfolio. Our work shows this involves the inclusion of high-yield fixed income, real assets, and alternative assets (liquid alternatives, hedge funds, and/or private markets for qualified investors). Our tactical market views, adopted by our Investment Committee, which look out over a nine- to 12-month horizon, are then layered on top of the SAA “benchmark.”
Three critical market dynamics have changed since the prepandemic period:
- Rates and inflation. The incredibly high inflation experienced in 2022 is expected to recede this year, but we are unlikely to return to the easy-money, zero-interest-rate policies that characterized the era post the global financial crisis. Instead, inflation and interest rates are likely to settle at a higher long-run rate, particularly for cash substitutes and the short-duration Treasuries, both of which tend to be more influenced by monetary policy. We detail the reasons for this outcome in our 2023 Capital Market Forecast.
- Market cap drift. The U.S large-cap equity market has outperformed the rest of the world by 25% over the past three years,1 making the U.S. a larger piece of the equity pie in the baseline portfolio. As a result, to maintain a home bias for a U.S.-based investor requires an increased strategic allocation to domestic equities.
- Valuations. One positive of the market’s drawdown in 2022 is better valuations for both equities and fixed income. The rates reset has taken the edge off fixed income valuations and enhanced medium-term total return prospects. Similarly, the 20% pullback in the equity market and slightly higher inflation forecast improve the returns prospects for equities compared to our prior forecast.
When we incorporate these elements into our models for forecasting risk and return across asset classes, we project slightly higher risk-adjusted returns for equities, both versus fixed income and our 2020 forecasts. High-yield fixed income also looks more attractive, particularly within municipal bonds, an asset class that is inefficient by construct and experiences major defaults on an infrequent basis. As a result, our 2023 SAAs have a higher allocation to equities overall, as well as high-yield fixed income. In contrast, we are removing the strategic allocation to U.S. inflation-linked bonds (Treasury inflation-protected securities, or TIPS). This asset class is one that we expect to shine at select points in the economic cycle (when our inflation expectations are above those of the market, for example), but which we can include going forward when compelling as a tactical rather than a strategic allocation.
Looking underneath the hood of the equity asset class, relative risk and return profiles have shifted in favor of U.S. large-cap equities. When coupled with the upward drift of U.S. large cap’s share of the global equity pie—and our desire to retain a home-country bias in portfolios—our 2023 SAAs carry a higher weight to U.S. large cap, and a lower weight to U.S. small cap and international developed equities, while emerging markets remains the same. Turning first to small cap, multiple years of underperformance suggests some degree of mean reversion is in order, but a deterioration in profitability, earnings growth, and quality of the small-cap universe may leave the asset class structurally impaired relative to large cap. International developed equities face a lackluster economic backdrop compared to the U.S.—particularly in light of the Russia–Ukraine war where we see no clear end in sight—which translates into more meager projected returns even when factoring in relatively more attractive valuations. When it comes to emerging markets equities, the projected economic growth of the region and returns for the asset class remain favorable relative to developed markets. However, an escalation of tensions between the U.S. and China and weakening of the globalization edifice offsets the more attractive return profile via the higher risk associated with the asset class. Our emerging markets equity allocation is unchanged from the prior SAA.
1 Compares the S&P 500 to the MSCI ACWI ex-US index. Source: Bloomberg.