2023 Outlook for Alternative Assets
January 19, 2023
2022 was a challenging year for stocks and bonds. The S&P 500 entered bear market territory and stayed there throughout the year, and the correlation of stock and bond returns turned significantly positive. With a backdrop of high inflation and rising interest rates, bonds’ lost their efficacy as a hedge for stocks in investment portfolios. Both asset classes posted negative returns for the year.
As we enter 2023, inflation remains elevated and the Federal Reserve’s campaign to tamp it down suggests ‘higher for longer’ rates. As such, volatility in the stock and bond markets appears likely to continue, giving alternative investments—which provide uncorrelated returns and diversification away from the broader public markets—a key role in client portfolios again in 2023. In this commentary, we share our outlook on specific alternative asset classes, the risks associated with certain illiquid assets, and our playbook for asset allocation in this space.
Illiquid Assets Outlook
WE Family Office Playbook
In consideration of the potential tailwinds and risks described above, we are approaching alternative asset allocation with the following factors in mind.
1. Yield-oriented strategies providing income can mitigate expected equity and fixed-income volatility.
As mentioned above, forward capital market assumptions creates a relatively unattractive risk/return outlook for equities. We therefore believe that locking in attractive yields reduces capital at risk and should add stability during volatile markets.
High-yield bonds, although producing attractive yields, could be impacted in a recessionary environment due to credit risk and market beta.
- Diversifying yield strategies can help mitigate against uncertainty, allow diversification away from corporate credit risk, and reduce portfolio volatility.
- We recommend being flexible in fixed income and credit beyond ordinary investment grade and high-yield corporate bonds, looking also to loans, securitized credit, emerging markets debt, mortgages, corporate hybrid securities, semi-liquid credit markets, etc.
2. Real asset overweight can provide stabilized yield, serve as an inflation hedge, and capture structural tailwinds.
Here there can be a few areas of focus:
Commodities: De-globalization appears likely to drive raw material hoarding, and the energy transition to renewables will also require significant raw materials to generate. 2022 made it clear that the transition will take time and cannot be executed without keeping fossil fuels as an integral part of the transition.
Infrastructure: Midstream projects and development are needed to transport fossil fuels, and clean energy infrastructure is in a nascent stage. Investments in these areas can provide long-term stable yields.
Real Estate: Real estate tends to outperform post interest rate increases while allowing for diversification amongst macro factors. There may also be sources of inflation-linked rental adjustments. Looking ahead, it will be important to weigh potential exposures in the table below.
Other Real Assets: Additional diversification to real asset portfolio and unique return streams, from maritime, aircraft, and mineral royalties for example.
3. Overweight global macro and long/short credit. With volatility expected to continue for the foreseeable future, hedge funds can cushion against drawdowns, take advantage of passive fund flows and capture unique return streams while adding to portfolio diversification.
Global Macro: Macro tends to outperform during periods of elevated equity, credit spread, currency, interest rate, and commodity volatility. With expected volatility and sideways trending markets, macro should continue to outperform.
Long/Short (LS) Credit: LS credit offers a low volatility approach to holding bonds and loans, offering a hedge to eroding credit quality, arbitraging passive fund flows, and credit selection.
4. Investing in innovation. Demographics and an aging population produce the need for innovation across many sectors, including manufacturing, healthcare and tech.
- Aging demographic with low immigration will require greater levels of efficiency and productivity.
- Covid-19 also spurred a wave of onshoring and rethinking of global supply chains, shifting focus from “just in time” to “just in case”.
- Both will require technological innovations in manufacturing.
- Aging demographic and advances in machine learning continue to produce new opportunities in biotech.
5. Selective focus on assets/strategies with tailwinds. As always, manager selection is key, as is the need to target strategies seeking to capitalize on longer-term trends.
- Manager selection. Over the previous few years, many managers enjoyed markets in which returns were fairly easy to come by. As we enter a higher rate, lower growth, less liquid environment with higher asset price dispersion, investors will discover how good managers actually are.
- Focus on strategies that have tailwinds seeking to capitalize on longer-term themes and trends. Healthcare, for instance, makes up nearly 20% of GDP in 2018(1) with an aging population. Meeting the rising demand will require innovation, onshoring and adjustments to supply chains. The energy transition and onshoring of manufacturing and supply chains will also require new investment.
6. Opportunistic credit can provide a countercyclical balance to the portfolio. With a hawkish Fed and sticky inflation, a prolonged higher rate environment should produce a longer window of opportunities both domestically and abroad.
- While credit dislocation funds performed fairly well in the early days of Covid, the opportunity set was a narrow window due to monetary policy and significant investor dry powder.
- Tightening of credit in capital markets and traditional lenders create opportunities for stricter terms, higher coupons, OID and fees.
- Diversify from traditional US corporate credit, casting a broad net across US and Europe, corporate credit, asset-based credit, structured credit and others.
(1) Source: https://www.cms.gov/research-statistics-data-and-systems/statistics-trends-and- reportsnationalhealthexpenddata/nhe-fact-sheet
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