By Mikhail Borisov* and Artem Kalinin**
If you ask family office investment professionals to describe 2023 markets in one word, many will probably choose “confusing”. It hasn’t been outright bad as 2022, but hardly enjoyable.
Quality bonds slid another 6%, while equities gained 8-10%, thanks to virtually a handful of “big tech” US stocks (hopefully you avoided non-US stocks, small caps, or passé themes like renewable energy!). Anyway, stock indices are up while bonds are down: The US economy must be doing great, right? Well, surprise: it is on the brink of “the most anticipated recession ever”! Indeed, despite the year-to-date divergence, the usual triggers for stock market corrections this year have been higher bond yields.
The dreadful stock-bond correlation has vast implications for portfolios. Unlike the previous 30 years, the fixed income part of the portfolio does not currently fulfil its role as a portfolio diversifier and stabilizer of the riskier equity allocation. Moreover, the most widespread alternative diversifier, Real estate, also sees low transaction liquidity and, in many regions, lower prices. No wonder: real estate is ultimately a play on interest rates and credit availability, both of which have acted as headwinds recently. The emergence of work-from-home has boosted residential at the expense of commercial RE since 2020, but this effect may be fading. Will the confusion be over in 2024?
Bonds for 2024 Best Asset Class
With Christmas looming, it is time for bold predictions. We cannot imagine a world where bonds finish 2024 with returns below 7%+. Our reasoning goes as follows:
- Major central banks are about to stop hiking interest rates (Japan is an exception). It means that prices of sovereign bonds such as US Treasuries will stop falling. US election year may give the Fed additional incentives to turn “dovish”.
- Bonds are once again yielding more than inflation. It means investors receive decent compensation for inflation risk.
- Companies issue new bonds with high coupons. It means investors receive a high stable current income, regardless of interim price movements.
- High probability of a US recession in 2024. It means we will buy corporate bonds at extremely attractive levels. There are 2 components to this: the US Treasury yield and the credit spread.
Firstly, should the US economic data start to weaken, investors will once again see the Treasuries as a safe haven asset. Thus far, the US GDP growth exceeded projections. No recession, case closed? Skeptics cite several factors such US Fed’s “higher for longer” policy, high oil prices, and no room for stimulus from already enormous fiscal deficits.
Secondly, credit spreads widen in recessions, typically by 3 percentage points in our space, as investors demand more compensation for credit risk. Just imagine that sometime in 2024, our LEON Income Fund RAIF will be buying high-yield corporate bonds with a 12% yield!
Equities for 2024 Nothing-Burger
We perceive equities as neither cheap nor critically overvalued. Price-to-earnings multiples contracted to historic averages, but earnings themselves are at risk. Consumer spending faces headwinds: The $2+ trillion of excess savings due to COVID-related stimulus have been finally exhausted; student loans are back after a 3-year sabbatical. Strikes (United Auto Workers and others) illustrate the shift of bargaining power to employees and will impact jobs and margins. Another “earnings margin killer” is the strong US dollar and resilient fuel costs. Last but not least, the recent trend for de-globalization of supply chains will also suppress productivity.
This trendless range-bound outlook is infrequent and can be exploited profitably. Equity returns can be enhanced via option products and strategies. In our portfolios we have been increasingly “selling volatility” (writing options) either on the upside or on the downside, collecting nice premiums.
Arbitrage Hedge Funds for 2024 Best Diversifier
If we are wrong about Bonds-2024: what asset class can be a true risk diversifier? We firmly believe uncorrelated hedge funds should be a core part of the Alternatives allocation of any well-constructed portfolio now. Studies show that adding uncorrelated high-return high-risk components to a portfolio improves returns are improved with the same amount of risk taken. This is particularly true when there is no clear trend in equity markets.
As in credit, risk premia are currently lower in many hedge funds strategies. In LEON Global Hedge Fund RAIF, we are cutting some Liquid Private Credit and increasing systematic and arbitrage strategies with target returns of 9-12%, but at the cost of somewhat higher portfolio volatility.
For more information, please visit the website: www.leoninvestments.com.cy
*Portfolio Manager in charge of liquid strategies at Leon MFO Investments
**Portfolio Manager in charge of fixed-income strategies Leon MFO Investments
Disclaimer: This article and the funds mentioned are only intended for professional and/or well-informed investors within the meaning of the Cyprus Alternative Investment Funds Law of 2018 124(I)/2018.