Asset Allocation Outlook for 2023: Greater Diversification and Divergence

Episode Summary

Executive Summary: Christian Mueller-Glissman argues that the 2022 inflation/rates shock has upended the classic 60/40 playbook, leaving equities, bonds, and other risk assets vulnerable to further volatility into 2023. He sees better fixed-income yields and more diversification opportunities in alternatives, real assets, and international markets, but remains cautious on cyclical optimism and believes markets are too early in pricing a recovery.

Main Topics: 2022 asset performance and the inflation/rates shock (Priority: 5/5): Most assets struggled because starting valuations were expensive and real yields rose sharply. Long-duration assets like growth stocks, tech, FANG names, and crypto were hit hardest, while commodities and the dollar were relative winners. Why stock volatility looked different this cycle (Priority: 5/5): Equity volatility was prolonged rather than fast and sharp because the main shock came from bonds and inflation trends, not from a classic rapid earnings or growth collapse. Mueller-Glissman expects growth volatility to become the next major source of equity risk. Why 60/40 portfolios may remain under pressure (Priority: 5/5): Traditional stock-bond diversification broke down because both asset classes were expensive and hurt by inflation/rate repricing. He thinks the 60/40 mix may stay volatile going into 2023 and not quickly return to the low-correlated regime of the last 20 years. Diversification via alternatives and real assets (Priority: 4/5): Investors are increasingly looking to real assets, hedge funds, and trend-following strategies such as CTAs. These offer inflation-sensitive cash flows or momentum-based diversification that worked well in a year when markets trended more persistently. Fixed income’s role is shifting from protection to carry (Priority: 4/5): Bond yields have risen enough to improve expected returns, especially in investment-grade credit, even if bonds may not yet reliably offset equity drawdowns. The focus is shifting from bonds as a hedge to bonds as a source of return while investors wait. Yield curve inversion and recession signaling (Priority: 4/5): A deeply inverted Treasury curve reflects Fed tightening and market expectations for mean reversion/recession risk. He views it mainly as a late-cycle warning, reinforced by labor market tightness and elevated profit margins. Dollar peak and regional diversification (Priority: 4/5): He expects the dollar to peak in 2023, which could help international diversification. Europe, Japan, EM, and China may offer relative value or reopening opportunities as inflation and growth diverge across regions.

Key Arguments: Higher real yields were the central force behind 2022’s broad asset revaluation, reversing the valuation boost that came from negative real yields in 2021. Inflation is persistent and autocorrelated, so market shocks have tended to come in waves rather than one single correction. Equity volatility is likely to shift from rates/inflation-driven stress to growth-driven stress in 2023. Valuations have reset, but not enough to fully compensate for weaker growth and margin pressure, so another equity drawdown remains plausible. The classic 60/40 portfolio is still challenged because both sides can fail simultaneously when inflation and rates are the dominant macro drivers. Bonds now look better as a return source, especially investment-grade credit yielding 6-7%, but may not yet offer strong crisis diversification. Alternatives such as CTAs and real assets are gaining appeal because they better match an inflation-volatile regime and can diversify multi-asset portfolios. International and regional diversification should improve if the dollar peaks and if inflation/growth paths diverge more across the US, Europe, Japan, EM, and China. Cyclical assets broadly appear too optimistic, with equity risk premiums, credit spreads, and cyclical pricing already reflecting too much confidence in a near-term recovery.

Data Points: VIX level: Has never really gone above 40 - Used to describe 2022 equity volatility as elevated but less extreme than prior fast-crash bear markets Equity valuation benchmark: Below the average valuation since the 1990s - Describes the degree of equity derating after the selloff 2s10 Treasury curve recession signal: 90% probability of recession in the next 12 months - From their recession probability model based on the deeply inverted yield curve Yield curve inversion breadth: About 80% of the yield curve inverted - Shows inversion is broad, not limited to the 2s10 spread Investment-grade credit yield: 6% to 7% - Illustrates the improved income opportunity in fixed income Expected global equity return: 8% to 12% - Reference point for forward-looking equity upside from here Expected US equity upside: Less upside than global equities - He implies US equities are less attractive than non-US markets

Pivotal Quotes: "we feel that going into next year, there's a good chance that 60-40 portfolios remain volatile" — Christian Mueller-Glissman: On the outlook for traditional stock-bond portfolios in 2023 "the source of the risk has been rates" — Christian Mueller-Glissman: Explaining why equity volatility has been prolonged and driven by bond-market repricing "fixed income currently is a very good place to get paid to wait" — Christian Mueller-Glissman: On why higher bond yields make fixed income more attractive again

Implications: Investors should expect a still-fragile multi-asset regime in 2023, favor more quality and income, diversify beyond US assets, and consider real assets or trend strategies. The market may be too early in pricing a cyclical rebound.