It is no secret that 2022 was the worst year ever for a multi-asset portfolio. Long-term bonds which were supposed to be safer than stocks lost even more than stocks. However, the good news is that this presents a great opportunity to invest in a multi-asset portfolio. Let me explain.
Cross-Asset Correlation On The Way Down
2022 was such a bad year for multi-asset portfolios because of the rapid increase in cross-asset correlation. This means that almost all assets went down at the same time, rendering asset diversification useless. Correlation hit a multi-year peak but the good news is that it is now coming down as shown below.
Bond correlation with stocks hit a multi-year high but the worst is over
Gold correlation with stocks also hit multi-year highs before coming down
Based on past behavior, once the correlation hit a peak, it tends to reverse below the long-run average correlation. Hence, cross-asset diversification benefits are coming back in a big way.
What If Another Inflation Wave Hits
After a disastrous 2022, it is understandable to be fearful of another inflation wave. If the Great Inflation of the 1970s repeat, we can certainly expect more waves of inflation. However, the extent of portfolio damage suffered in 2022 is unlikely to repeat because we have already gone through the first wave of inflation. This is not unlike the COVID pandemic which also came in waves. The effect from the first wave was the most disastrous but the subsequent waves were less destructive. There are fundamental reasons to expect milder effects from the next inflation wave if it comes.
1) Stocks Valuation Reset
After the prices of many stocks came down in 2022, their valuations have come down from their lofty heights. I am not going to debate whether valuations have come down enough but certainly, they are much lower than before, especially for certain sectors of the economy that were in dangerous bubble territory before. I am not a fundamental analyst so I'll just leave it as that.
2) Bonds Interest Rate Sensitivity Reset
2022 hit bonds a lot harder than stocks. This is due to the extremely low-interest rate environment before inflation. Bonds are sensitive to changes in interest rates but the sensitivity is different at different interest rate levels. This is known as the convexity effect as shown below.
Duration risk is lower at higher bond yields
When bond yields are low just like at the start of 2022, a small increase in interest rate would lead to a big drop in bond prices. However, as bond yield increases, bond prices would become less sensitive to further increases in interest rates. This also explains why bonds did not suffer as much during the Great Inflation of the 1970s. Back then, bond yields were much higher than in 2022 and were less sensitive to interest rate hikes.
Having said that, if we look at things from a nominal perspective in today's context, bond yields are now much higher than at the start of 2022. With the yield curve already inverted and a majority of the economists projecting a mild recession this year, another wave of unexpected inflation is likely to force Fed's hand to further hike interest rates. This will run the risk of pushing the economy into a deeper recession. In that scenario, bonds will benefit as it has now restored much of their safe haven properties.
3) Major Headwind Against Gold Is Gone
Gold was a disappointment in 2022 because it failed to hedge against inflation but to be fair, at least it didn't lose much.
Gold lost a lot less than stocks and bonds
The main headwind for gold in 2022 was the strong USD. That was in turn driven by the Fed being the most aggressive central bank in the world to hike interest rates. One of the main drivers for currency movement is interest rate differentials. With the US interest rate rising faster than the rest of the world, USD strengthened significantly. However, the days of rapid rate hikes in the US are over and the rest of the world is now catching up. Therefore, USD has lost that tailwind and has weakened quite a fair bit since.
The interest rate differential has narrowed since August 2022
Going forward, USD strength should be less of a problem for gold. Even if another inflation wave comes along and the Fed has to hike interest rates again, the differential with the rest of the world should not be as large as before.
Conclusion
If you currently do not have a multi-asset portfolio, now is an excellent time to start. If you already have a multi-asset portfolio, you can consider adding more funds to it either as a once-off or starting a regular contribution every month.
Disclaimer: This is not financial advice. Do your research or consult a financial advisor.
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