What will drive multi-asset returns in 2023?

By Giulio Renzi-Ricci, head of asset allocation, Vanguard, Europe

• High inflation per se doesn’t cause stocks and bonds to be positively correlated.
• Inflation expectations relative to central bank targets and expected monetary policy response is a key driver in the return correlation between equities and bonds.
• Should economies enter recession this year, global bonds would be expected to perform well.

After a tough 2022 for multi-asset portfolios, our longer-term outlook for investors has improved, but what can clients realistically expect from their investments in the near-term?

How will markets respond if inflation remains persistently above target? And how will equity and bond markets react if economies enter recession?

In this article, we answer these questions and offer our thoughts on the dynamics of traditional multi-asset portfolios in the current economic environment.

What drives the inverse relationship between stock and bond returns

Naturally, the breakdown in the negative return correlation between equities and bonds in the first nine months of 2022 was concerning for multi-asset investors as both asset classes experienced significant falls¹.

In the final quarter of 2022, though, global bond yields fell, reflecting a rise in prices, while global equities remained volatile².

A key variable in the dynamic between stock and bond market returns is monetary policy – or expected policy rates. Central banks target a specific level of inflation and when the rate of inflation goes beyond the bank’s target rate unexpectedly, markets anticipate monetary policy tightening to bring inflation back down (unless the rise in inflation is due to strong economic growth, which in the current environment is not the case).

The expectation of tighter monetary policy can result in a short-term positive equity-bond correlation. That’s because rising rates pull bond prices down and tighter monetary conditions tend to be a headwind for companies’ real earnings, meaning equity prices also fall.

Ultimately, the positive correlation witnessed in 2022 was the result of a sharp change in interest rate expectations, due to a series of supply side shocks, including Covid-19-induced supply chain disruption, the war in Ukraine and resulting energy crisis. Central banks have been explicit in their intentions to bring inflation down through monetary policy tightening – and markets have largely priced this into valuations. We think inflation will come down to around 3% in the US, 3.4% in the euro area and 4.4% in the UK by the end of 2023.

Looking for historical parallels

Some may point to history when stock/bond returns were mostly positive from the late 1960s to the late 1990s and the rate of inflation was, on average, higher than it has been since 2000. However, the key difference between then and now is that central banks didn’t consistently target lower inflation through monetary policy – an approach they have employed since the late 90s. Historically, central bank policy was less rules-based relative to today with little commitment to keep inflation low and steady.

High inflation per se, in our view, doesn’t cause stocks and bonds to be positively correlated – the expected reaction from central banks is the key driver behind the reversal in the relationship. So, if for example, inflation is higher but that is consistent with a higher inflation target for central banks (e.g., 4% rather than 2% targeted today), markets would not expect a response from central banks and the negative return correlation between stocks and bonds should persist.

What matters most for multi-asset investors is where inflation is expected to be compared to the central banks’ inflation target.

Outlook for 2023

Looking at the next 18 months or so, inflation appears to have peaked across major economies but uncertainty may persist throughout 2023, meaning stock/bond returns might be positively correlated at times (should interest rate policy pivot or exceed current expectations). However, given the intention of policymakers to bring inflation down, we expect the negative return correlation to reassert itself in the near term.

The sharp rise in rates last year heightened fears of recession in the US, Europe and the UK, although momentum in the data has been stronger than expected and the recession could be milder, or narrowly avoided in some regions.

So, what would recession mean for 60/40-style portfolios?

With all else being equal, in a recessionary environment we would expect negative economic growth to impact equity markets, with investors seeking higher quality investments. This would likely push bond prices up, leading to a negative return correlation between equities and bonds. In addition, if inflation were to come down fast and central banks showed signs of loosening monetary policy (even just in expectation), this would further lead to higher bond price returns.

Even though volatility may persist in the near term, higher income returns for long-term bond investors and fairer equity valuations have led us to raise our long-term return outlook for 60/40-model portfolios.

That’s why we think long-term investors will be rewarded for maintaining discipline with a strategic approach to equities and bonds.

¹ Vanguard calculations in GBP, based on data from Refinitiv. Data between 3 January 2022 and 31 October 2022. Global equities represented by the MSCI AC World Total Return Index Sterling. Global bonds represented by the Bloomberg Global Aggregate Index Sterling Hedged.

² Source: Vanguard calculations in GBP, based on data from Bloomberg and MSCI. Data between 3 October 2022 and 30 December 2022. Global bonds represented by Bloomberg Global Aggregate Float Adjusted Index Hedged. Global equites, represented by MSCI All Country World Index.