Tom Larm, CFA®, CFP®
2023 to bring a turning point
What you need to know
- 2022 was a challenging — and historic — year for investment portfolios, with higher inflation and tightening central bank policies weighing on stock and bond prices.
- As difficult as the past year was, it served as a reminder to stay focused on your financial goals, and it created opportunities for disciplined investors heading into 2023.
- Higher interest rates have made bonds more attractive. We also believe international stocks can enhance diversification, and we favor emerging markets.
Diversifying across a variety of asset classes can help manage risk and provide opportunity to position your investment portfolio for the year ahead.
Where have we been?
Financial markets experienced turbulent times in 2022, weighing on investment portfolios. High inflation caused many central banks to raise interest rates faster than they have in decades. The Federal Reserve, for example, raised rates at a pace not seen since the 1970s and ’80s.
As central banks quickly shifted policy into restrictive territory, both short- and long-term interest rates rose rapidly, sending stocks and bonds into a bear market at around the same time. As a result, bonds experienced their largest sell-off on record, failing to provide their typical diversification benefits in 2022.
Stocks and bonds regained some losses in the final quarter of the year though stock market volatility reappeared as multiple central banks tightened further and investors shifted the focus toward slowing growth. Nonetheless, U.S. investment-grade bonds were down an unprecedented 13% for the year, and U.S. large-cap stocks were down about 18%.
International stocks weren’t immune from the downturn. Additional headwinds — such as a strengthening dollar, geopolitical tensions and COVID-19-related concerns in China — weighed on international returns through most of the year.
The tide began shifting toward year-end as China eased monetary policy and COVID-19-related restrictions and the dollar lost ground, helping propel international stock returns. As 2022 closed, international developed large-cap stocks ended up outperforming U.S. stocks. International large-cap stocks were down 14.5% in 2022.
Extreme market environments such as in 2022, when elevated inflation sent interest rates significantly higher, can cause stock and bond investments to move in the same direction over short-term periods. As difficult as the past 12 months were, we believe 2023 will bring a turning point for portfolios.
What do we recommend going forward?
Inflation — and central banks’ ongoing response to bring it down — will likely continue to drive markets in the coming months. While the jury may still be out on how much more the Fed may need to do, we believe we’re closer to the end of the tightening cycle than the beginning.
Volatility is likely to persist in the near term, and a mild recession may take shape, but we expect inflation to trend downward over the coming months, easing some pressure on investment portfolios. We also believe diversifying your investments can help level your portfolio’s path.
Interest rates are meaningfully higher now than they were at the start of 2022. Higher yields improve the return potential for bonds and place them in a better position to once again provide their typical diversification benefits for a well-diversified portfolio. Therefore, we recommend a neutral allocation to bonds by staying aligned with your long-term investment strategy.
Although investors have moved toward shorter-duration certificates of deposit (CDs) or one- or two-year bonds, this may be a good time to consider adding longer-term, quality bonds. These bonds not only secure higher income for longer but may appreciate if a weakening economy drives yields lower.
Within equities, international investments can help diversify a portfolio by introducing a different set of sectors, currencies and economies. With valuations now lower than they were before, particularly when compared to those of U.S. markets, we believe a lot of the uncertainty has already been priced into international stocks.
Furthermore, if inflation continues to trend lower and the Fed pauses interest rate hikes as we expect, a weakening dollar could be a tailwind for international stock returns in 2023. We favor emerging-market stocks in particular. We expect emerging-market stocks to benefit from more accommodative monetary policy and relaxed zero-COVID policies in China, supporting returns.
Even though the calendar has changed, your financial goals should continue to drive your investment strategy. Diversifying your investments across a variety of asset classes can help align your portfolio with your comfort with risk and financial goals, while allowing you to be positioned for the year ahead.
Strategic asset allocation guidance
Our long-term, strategic asset allocation guidance represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class will depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.
Source: Edward Jones.
Within our strategic guidance, we recommend these asset classes, from highest to lowest weight:
Equity diversification: U.S. large-cap stocks, international large-cap stocks, U.S. mid-cap stocks, U.S. small-cap stocks, emerging-market stocks, international small- and mid-cap stocks.
Fixed-income diversification: U.S. investment-grade bonds, U.S. high-yield bonds, international bonds, international high-yield bonds, cash.
Opportunistic asset allocation guidance
Our opportunistic asset allocation guidance represents our timely investment advice based on current market conditions and our outlook over the next one to three years. We believe incorporating this guidance into a well-diversified portfolio may enhance your potential for greater returns without taking on unintentional risk.
Source: Edward Jones.
Our opportunistic asset allocation guidance is as follows:
Equities — neutral overall; underweight — U.S. small-cap stocks; neutral — U.S. large-cap stocks, international large-cap stocks, U.S. mid-cap stocks, international small- and mid-cap stocks; overweight — emerging markets.
Fixed income — neutral overall; neutral — U.S. investment-grade bonds, U.S. high-yield bonds, international bonds, international high-yield bonds, cash.
Tom Larm, CFA®, CFP®
Tom Larm is a Portfolio Strategist on the Investment Strategy team. He is responsible for developing advice and guidance related to portfolio construction, asset allocation and investment performance to help clients achieve their long-term financial goals.
Tom graduated magna cum laude from Missouri State University with a bachelor’s degree in finance. He earned his MBA from St. Louis University, is a CFA charterholder and holds the CFP professional designation. He is a member of the CFA Society of St. Louis.