Asset Allocation Outlook for 2023: Greater Diversification and Divergence

Episode Summary

Executive Summary: Christian Mueller-Glissman argues that 2023 is likely to remain volatile as markets shift from inflation/rates shocks to growth volatility. He sees little protection in traditional 60/40 portfolios, more opportunity in higher-quality fixed income and alternatives, and renewed appeal in regional diversification as the dollar peaks and global cycles diverge.

Main Topics: 2022 asset performance and inflation shock: 2022 was dominated by rising real yields, which compressed valuations across assets and hit long-duration exposures hardest. Tech, growth, crypto, and FANG lagged, while commodities and the dollar were standout performers. Why stock volatility may persist: The year’s equity drawdowns were prolonged rather than abrupt because the main shock came from rates and inflation, not a classic fast-moving earnings crisis. Next year may see more conventional growth volatility, which could still keep equities unsettled. Valuations, recession risk, and equity downside: Equity valuations have reset, but Christian says they do not yet compensate for weaker growth, margin pressure, and potential corporate damage. He believes another equity drawdown remains plausible. The challenged role of 60/40 portfolios: Both stocks and bonds were expensive entering the year, and rising yields hurt both sides simultaneously. Christian expects 60/40 to remain volatile because bonds may no longer reliably cushion equity risk, at least in the near term. Alternatives and real assets as diversification tools: Investor interest has increased in real assets, infrastructure, hedge funds, and trend-following strategies like CTAs. These are seen as better suited to inflation uncertainty and trending macro regimes. Fixed income becomes more attractive: With yields higher, investment-grade credit offers meaningful income and a better risk/reward profile than equities. Bonds may be more useful now as return generators than as portfolio hedges. Dollar peaking and global diversification: A likely peak in the dollar could make non-U.S. assets more attractive. Christian highlights valuation discounts in Europe, Japan, EM, and potential reopening-driven opportunities in China.

Key Arguments: 2022 was a difficult year because rising real yields reversed the broad valuation boost that had existed when real rates were deeply negative. Long-duration assets such as growth stocks, tech, and crypto were especially vulnerable to higher real yields. Commodities were the brightest spot because inflation, reopening demand, and the Russia-Ukraine shock supported prices. This year’s stock volatility was prolonged and driven by bond-market stress rather than the classic fast equity crash pattern. Next year’s volatility may shift from inflation/rates toward growth, which could trigger equity drawdowns if growth slows more than expected. Valuations have improved, but they do not yet reflect the likely combination of below-trend growth and still-strong corporate headwinds. The 60/40 portfolio remains vulnerable because both equities and bonds may fail to offset each other in a new shock regime. Alternatives, especially real assets and trend-following CTAs, are increasingly valuable because they can better handle inflation volatility and trending markets. Fixed income now offers compelling carry, particularly investment-grade credit with materially less volatility than equities. An inverted yield curve is signaling late-cycle stress and recession risk, though it also reflects Fed tightening and some normalization of inflation expectations. A peaking dollar could broaden opportunities outside the U.S., especially given attractive relative valuations in Europe, Japan, and EM. Broad cyclical assets appear too optimistic after the recent relief rally; Christian prefers caution over prepaying for a recovery too early.

Data Points: VIX peak: Never really above 40 - Christian notes equity volatility was elevated but not as extreme as prior cycles where the VIX exceeded 45. Equity valuation level: Below the average since the 1990s - He says valuations have derated materially as yields rose, though he questions whether the 1990s average is the right benchmark. Yield curve inversion coverage: Around 80% of the yield curve inverted - He uses this to underscore broad late-cycle stress and recession pricing. 2s/10s recession signal: 90% probability of recession in the next 12 months - This comes from their recession probability model based on the 2-year/10-year spread. Investment-grade credit yield: 6% to 7% - Christian cites U.S. investment-grade credit as an increasingly attractive fixed-income opportunity. Equity return expectations: 8% to 12% - He references this as a plausible equity return range, with less upside for U.S. equities than global equities. Volatility comparison: Investment-grade credit has roughly one-third to one-fourth the volatility of equities - Used to argue that fixed income is a better place to be paid while waiting. Recording date: Monday, December 5 - The episode notes the market commentary and forecasts are based on this date.

Pivotal Quotes: "we feel that going into next year, there's a good chance that 6040 portfolios remain volatile" — Christian Mueller-Glissman: His central view on the outlook for traditional balanced portfolios. "it's been like more slow tail risk" — Christian Mueller-Glissman: He explains why 2022 felt unusual versus prior sharp equity sell-offs. "fixed income currently is a very good place to get paid to wait" — Christian Mueller-Glissman: His case for moving toward higher-quality bonds and credit after yields rose.

Implications: Investors may need to rely less on the classic 60/40 mix and more on quality fixed income, real assets, and active diversification. With growth risk rising and the dollar potentially peaking, relative value and regional opportunities may matter more in 2023.