Why diversification may be key in 2023

After a brutal 2022 for investors in balanced portfolios, this year is shaping up to be much better for those invested in a mix of equities and fixed income.

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“The current rate environment and broader market conditions certainly support holding a diversified portfolio of stocks and bonds in 2023,” said Leslie Alba, director of portfolio solutions with CIBC Asset Management.

Although equity valuations have contracted, Alba said price multiples remain high relative to risk levels. There’s also potential for a further correction if earnings trend lower in a hard-landing scenario.

“We find little evidence of extreme undervaluation and therefore don’t believe now is the time to be increasing equities above a strategic weight, especially given continued economic uncertainty and potential for heightened market volatility,” she said.

In the short term, she recommends being slightly underweight in equities and overweight cash and bonds to take advantage of attractive yields on the short end of the bond curve. This can partially shield portfolios from equity drawdowns, she said.

That said, her long-term approach remains unchanged.

While economic cycles end and then begin again, Alba said, markets don’t always get these inflection points right. Her advice is to keep clients’ focus on long-term investment objectives.

“If anything, we think the diversification potential of a mix of asset classes in a broader portfolio has improved in the current economic environment, given that, mathematically, bond yields can once again provide downside protection in a weaker economy,” she said.

Equities and bonds suffered last year in part due to high starting valuations, she said, and the positive correlation in equities and bonds made it “a very challenging environment for multi-asset investors.” However, that appears to be changing this year, she said. 

“Staying diversified ensures some participation in the highest performing asset class at any given point in time and can also mitigate extreme negative scenarios by exposing portfolios to different risk factors that will respond in diversifying ways, should volatility continue,” Alba said.

Despite a slight decline in inflation from peak levels observed in 2022, employment and consumer confidence indicators remain relatively robust. However, Alba said cracks in the financial system suggest the impact of higher interest rates on the broader economy is starting to take hold. 

The failure of three U.S. regional banks and UBS’s acquisition of Credit Suisse at a marked-down price have led to concerns about the global banking sector.

Equity markets have largely shrugged off those concerns, Alba said, and equity investors appear encouraged by the slowing pace of central bank rate hikes.

Alba said the question now for investors is whether markets have been too optimistic.

“We don’t yet feel like we’re out of the woods,” she said. 

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