Why Diversification May Be Key in 2023

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Leslie Alba, director, portfolio solutions, CIBC Asset Management.

Similar to the majority of last year, market sentiment and performance over the last quarter continued to be dominated by the trend in inflation and expectations around the path of interest rates. Although inflation continues to decline from peak levels we saw mid last year, other economic data points such as employment and consumer confidence indicators remain reasonably strong. We did, however, start to see some cracks appear in the financial system exposing some lagged effects of higher interest rates on the overall economy.

We’re beginning to see some stress on economic resilience. In March, two US regional banks failed. Silicon Valley Bank, or SVB, which was an important lender to venture capital-backed startups, saw an outflow of deposits as their deposit base had businesses that needed cash in a very tough environment. This eventually required SVB to realize the mark to market losses on long dated fixed income securities that they held as assets on their balance sheet.

When the Fed increased interest rates last year, the prices of these assets fell rapidly and the way that bonds work is the longer the tenor of the bond, the greater the decline in value. This wouldn’t have been a problem if SVB had been able to mature these bonds since they were generally credit-risk free, but the spiral of deposit redemptions forced them to sell and therefore, recognize these losses to cover the depositor’s demands. This triggered more concerns and thus more withdrawals until the bank was no longer viable. It was a pretty classic example of a bank run.

Following that, regulators shut down Signature Bank, another U.S. regional bank that had evolved to become a lender in cryptocurrency lending. Fearing a similar situation to SVB, their customers were moving their deposits to larger banks, and soon there were fears of a banking contagion across the entire U.S. financial system. Then across the pond, Switzerland’s Credit Suisse Bank, although arguably the problems it faced were slightly more idiosyncratic, was rescued in an acquisition by UBS. Before the end of the quarter, there were market concerns of a global banking crisis.

Since then, things have stabilized somewhat. Novel interventions such as the Federal Reserve’s Bank Term funding program were arranged quickly and for now at least effectively. While equity markets have seemed to shrug off the concerns, we continue to monitor the situation closely given that the story on rates doesn’t seem to be finished yet. In general, when we look at markets, the market’s concerns of contagion in the financial systems seem to have subsided and equity investors appear encouraged by government intervention and the slowing pace of central bank rate hikes. This is demonstrated by strong equity performance over the quarter, especially in the more tech heavy sectors. The question for us, as investors, is whether markets had already priced in a very negative outcome and is now rebounding as they see light at the end of the tunnel, or if investors are currently being too optimistic. For now, it seems like the equity markets are treating most news as good news and are pricing in a soft economic landing.

Meanwhile, bond yield curves continue to be inverted, which tends to signal a recession. There’s a bit of a dichotomy there in terms of what’s happened in the markets over the last quarter and how markets are reacting to it, both the equity side and the bond side.

We don’t yet feel like we’re out of the woods, so we remain cautious in our market outlooks and therefore, slightly defensive in our tactical positioning. Consistent with the pause in Bank of Canada policy rate hikes, we believe the debt burden on household balance sheets here in Canada creates a natural ceiling for how high rates could go. Also, we view increasing potential for financial instability. And while this isn’t our base case, it’s not a zero probability event.

Our economy remains closely impacted by the U.S. economy, and while Fed policy rate hikes might have slowed to take into account that credit tightening might help curb inflation, we believe it’s critical to continue monitoring the economy in case further cracks appear. We’re relatively cautious on equities. Although valuations have contracted over the last year, we believe many price multiples remain high relative to some of the risk. Our view is that there’s potential for a further correction in equity markets, especially if earnings trend lower or in a gloomier hard-landing scenario.

While we’ve seen some valuation multiple contractions since the beginning of 2022, 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. Where we’re able to, we’re tactically slightly underweight in equity and overweight cash and bonds, which also helps us take advantage of more attractive yields on the short end of the bond curves relative to the long end.

That said, our long-term strategic positioning remains unchanged. This is important because over the long term, strategic asset allocation that is rooted in financially productive assets has been a time tested money maker and it’s really hard to time markets. Because of this, our advice is always to keep most of your or clients’ focus on long-term investment objectives. While we take a view on markets in the economy and add incremental value through tactical positioning, as a team, we acknowledge that economic cycles end by definition, and similarly, they begin again. Markets don’t always get these inflection points right. That’s part of why timing things based on indicators is very difficult. Our strategic positioning reflects our base probability estimates for long-term outcomes, which haven’t changed. 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.

The current rate environment and broader market conditions certainly support holding a diversified portfolio of stocks and bonds in 2023. Bond and cash yields now offer a powerful source of return potential and higher yields are generating better income than the past, which will at least partially shield the portfolios from equity draw downs. We’ve also more recently started to see counter-cyclicality in bond performance, which was missing last year. Last year, we saw equities in [and?] bonds suffer due to high starting valuations, both by way of low bond yields and high equity price multiples. That positive correlation we saw in equities and bonds made it a very challenging environment for multi-asset investors. However, we have seen evidence of this turning in 2023.

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.