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CIO Macro and Market Observations from Multi-Asset Solutions

January 5, 2023  |  5 Minute Read

Maria Vassalou, PhD

Co-Chief Investment Officer, Multi-Asset Solutions

Maria Vassalou, PhD


The world we live in is becoming more complex. It is undergoing what we believe to be a historic transition that is likely to alter economic alliances, change how monetary policy is conducted and, in the long run, potentially alter the economic structure of many countries. We believe market participants will have to start allocating capital based on what the world may look like tomorrow, not what it was in the past. But as investors who lived through 2022 will appreciate, the journey is unlikely to be smooth or straightforward. In 2023, we believe underlying economic and market conditions may get more challenging before they ease.


For instance, we expect the US economy to enter recession in 2023 as the Federal Reserve pushes borrowing costs to 5% or higher. What’s more, we do not expect the Fed to cut rates in the year ahead, as the US downturn is likely to be relatively shallow. Investment conditions will remain challenging, though a gradual cooling of price pressures should help to gradually reduce the positive correlations between equities and bonds seen last year, helping to reestablish the long-term efficacy of multi-asset portfolios. Building durable and diversified portfolios in these conditions will require careful risk management, a mix of traditional and alternative assets across public and private markets, and a keen focus on generating alpha.


Macro Outlook


Economic data was relatively resilient by the end of 2022, but we still believe investors should embrace a cautious approach in the year to come. First, the US labor market remains tight, with the unemployment rate below 4% and the labor force participation rate having stagnated around 60%. This keeps the pressure on the Fed to maintain its restrictive stance and increases the likelihood of a recession. While some initial signs of cooling inflation are welcome, the economy is not yet out of the woods. Inflation is still outpacing nominal wages, resulting in negative real wage growth. Corporate earnings are expected to deteriorate in the upcoming quarters, and many companies are removing job openings while others are initiating layoffs. As a result, households are likely to experience further declines in real disposable income with real wage increases continuing to be negative and job mobility getting restricted. On the other hand, household savings have declined sharply from a peak of 33.8% at the onset of the pandemic to a mere 2.8% of disposable income, the lowest since the Global Financial Crisis. On the activity side, the Markit US Composite PMI has been falling since the first half of 2021, entering contractionary territory in July. That signals weaker growth ahead.


Complicating matters further, equity and fixed income markets are pricing in distinctly different scenarios. The equity market remains relatively optimistic of a soft landing that will produce 5.5% earnings growth in 2023. On the other hand, the US 2y10y and 3m10y spreads have broken below levels seen in prior recessions; in December, the 2y10y spread once reached the most inverted levels since the early 1980s when then-Fed Chairman Paul Volcker set in place the most aggressive interest rate hikes in the Fed’s history.


Exhibit 1: The US Treasury Yield Curve is Deeply Inverted

Source: FRED, Goldman Sachs Asset Management. As of January 04. 2023.


Given the Fed’s determination to bring down inflation and how widespread inflation has become, a recession would seem hard to avoid. How deep and how prolonged a recession may turn out to be will depend on many factors. Our base case scenario is that a recession will be relatively shallow, barring any unexpected negative external shock or major escalation on the geopolitical front. The duration of a recession will be determined by both the extent of possible fiscal support as well as the trajectory of inflation expectations, which in turn will determine the monetary policy stance.

On the fiscal side, governments have already engaged in significant stimulus programs to provide support to blunt the economic impact of COVID-19 and the energy shock, leaving less room for additional accommodation than previous cycles and making a recession harder to escape.


On the monetary side, any policy accommodation going forward will firmly depend on how quickly inflation returns to the Fed’s comfort level of 2-3%, and how well inflation expectations are anchored. If inflation comes down relatively quickly and inflation expectations are stable around 2%, then the recession will likely be short-lived. Otherwise, the Fed may need to keep raising rates and even keep them elevated longer than the market is pricing in order to anchor inflation expectations, potentially deepening and delaying economic recovery.


Rising borrowing costs are likely to push up default rates as well. But because companies are entering an economic downturn with better balance sheets than during previous episodes and less need to tap the markets in the next 3-5 years, the increase in default rates is likely to be smaller than in previous downturns. Similarly, while savings have come down significantly, households are still not carrying significant leverage into this economic slowdown. This suggests less need for the Fed to cut rates once the economy enters recession, as the probability of a credit crisis appears small at the moment. Currently, Fed Funds Futures are pricing in 40~50 bps of rate cuts in the latter half of 2023. We think that the market is overestimating the strike price of the “Fed put”. In the December Statement of Economic Projections, the median expectation of Federal Open Market (FOMC) participants is for the PCE to reach 3.1% and core PCE to reach 3.5% by the end of 2023. These levels are still above the Fed’s long-term inflation target and are unlikely to justify easier policy, especially if market conditions do not portend a credit crunch or abnormal lack of liquidity.


The uncertain geopolitical environment also tilts the balance of risks to the downside. Any escalation of the war in Ukraine would be negative for economic growth and likely amplify global inflation. Similarly, worsening tensions between the US and China are likely to slow China’s growth potential, limiting the potentially positive impact of the end of China’s Zero-COVID policy and the resulting economic reopening.


Global price pressures are also coinciding with what we have characterized as a significant restructuring of the global economic order, amounting to a partial rolling back of the globalization gains of the last decades. This may make the effectiveness, timing, and implications of monetary and fiscal policies harder to gauge. Less globalization, more frequent external shocks and the reversal of a multi-decade trend of monetary accommodation all adds up to increased market volatility and a plethora of dislocations that would also provide significant investment opportunities. These developments materially change the investment playbook and the way we should approach portfolio construction and management.


Key themes will include:


  • The Importance of Risk Management: Uncertainty about geopolitics and policy initiatives and outcomes will make markets more volatile, putting a premium on investors’ ability to anticipate disruptions and manage investment risk. We expect volatility to affect different asset classes and geographies in different ways. Excessive portfolio leverage in these conditions will, in our view, add significant risk. The good news is that higher interest rates and increased volatility suggest there’s less need for leverage to boost return potential. However, investors must also pay attention to the distribution of the expected returns of their investments. Left tail events may become more frequent and pronounced and will need to be accounted for in the portfolio construction process.
  • Keep an Eye Correlations: The relationships between asset returns are likely to vary more often than they have in the past. As a result, we think investors should consider doing two things. First, keeping overall portfolio risk within a pre-determined range should be part of ongoing portfolio management. In other words, volatility targeting at a portfolio level becomes even more relevant and important now than ever before. Second, detailed research and active management will be paramount for a successful dynamic management of portfolio positions. Passive investing is a thing of the past.
  • Timing Matters: Downturns, volatility, changing asset relationships and liquidity conditions, geopolitical developments: they all amplify risk. But they also create investment opportunities. But these opportunities need to be harvested at the opportune time. In our view, that is typically soon after volatility stabilizes and shows signs of starting to subside. In these conditions, we believe investors are likely to find opportunities across public and private markets, asset classes and geographies. Being nimble and agile will be necessary to navigate the investment landscape.
  • Think Beyond Factors and Styles: In the current environment, compartmentalizing investments into traditional categories—growth or value, this country/sector or that one, public or private—may be the wrong way to approach the investment opportunity set ahead of us. We’re living in market conditions that have not existed for a long time. Generating alpha in these conditions would require investors to consider the entire investment universe holistically and identify investment opportunities and risks wherever they may be found.


The world is changing. In 2023, we believe the investment approach should change, too. But opportunities will always exist for the patient and nimble investor.

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Date of First Use: January 5, 2023. 302558-OTU-1723026.