The turn of the year is often used as a time for investors to take stock of performance over the past 12 months and assess their strategy for the following year.

It’s also a time for commentators to produce their outlook for the coming year, attempting to predict what might be to come for returns across asset classes and the economy in general.

2023 is a year that will be associated with a challenging macroeconomic and geopolitical landscape. Yet, we’ve equity markets at, or near, record levels, while bond markets rallied at the end of the year to produce positive returns across the risk spectrum for multi-asset investors.

While our team expects the macroeconomic and geopolitical environment to remain challenging, we continue to identify bright spots that should encourage investors.

Fixed Income: potential for attractive returns

In the face of more than five-fold returns for US equities since the global financial crisis and the worst year in decades for bonds in 2022, it’s perhaps not surprising that fixed income assets have fallen out of favour with investors.

However, fixed income could well offer attractive returns going forwards, particularly when looking at their overall yield-to-maturity (the expected total annual return of a bond if it’s held to maturity). While not a guarantee, starting yield-to-maturity has historically been an accurate predictor of five-year returns, and yields at these levels have provided solid returns for investors (see Figure 1 below) in the past.

Within fixed income, government bonds are an area that, in our MPS portfolios, we’re overweight as we believe they offer an attractive return profile from here. Yields have risen to levels where they offer not just meaningful income, but also the potential for large capital growth if interest rates are unexpectedly cut more aggressively. As indicated in Figure 2 below, which models the 12-month total return for US Treasuries in different yield movement scenarios, government bonds stack up well from a risk vs. return perspective and can offer real protection to portfolios in traditional risk-off events.

Infrastructure: an opportunity

Looking at alternative asset classes, we feel listed infrastructure is an attractive opportunity. From a valuation perspective, it’s an asset class that’s significantly undervalued relative to global equities when compared to its historical average. Taking a long-term view, this should be a tailwind to produce strong returns.

Looking shorter term at 2024, the relationship with real bond yields (inflation-adjusted yield) could prove as a catalyst to realise this outperformance. Going forward, we believe real yields are more likely to fall than they are to rise, which would (all else equal) benefit infrastructure returns.

As Figure 3 below illustrates, there’s been a positive correlation between infrastructure outperforming global equities and real yields (as measured by the 10 year US TIPS [Treasury Inflation Protected Securities] yield) falling. This is an asset class our portfolios are overweight.

European Smaller Companies: the potential

Our team tends to tilt our portfolios with a suitable overweight exposure to small capitalisation (cap) stocks due to the fact that small cap stocks outperform large cap stocks over the long-term. By managing this exposure carefully, we can boost our equity returns without, crucially, adding material increments of risk.

While we’re not significantly overweight European small cap equities currently, we’ve identified them as an attractive opportunity, which are currently trading at an extreme low valuation relative to their large cap counterparts. This follows a bruising period for small caps in Europe relative to large cap.

Figure 4 below shows that over the past two years they have underperformed large cap by almost 20%, by far the most since at least the global financial crisis.

Wary of the macro backdrop, our analysis shows that smaller companies tend to underperform in the run-up to recessions, before outperforming shortly after the recession has been entered as markets start to price in the future economic recovery. Hence, in the near-term there will likely be volatility, but it is an opportunity we are monitoring and we expect to be increasing our European small cap exposure in portfolios over the coming twelve months.

Investing for the long term

Regardless of the time of year, it can be easy to be swayed by the risks facing financial markets, particularly at a time when cash is offering meaningful returns. However, while predicting the source of investment returns at some point in the future is notoriously difficult, being invested in a diversified portfolio has been shown to provide greater returns than cash more often than not, with those benefits magnified by time invested.

abrdn Portfolio Solutions Limited (aPSL) offers a range of portfolio strategies for adviser firms, with a choice of management styles and risk levels to meet clients’ investment needs. To find out more, go here.

The value of investments can go down as well as up and your clients could get back less than they paid in

The views expressed in this blog should not be regarded as financial advice.