The return of decorrelation

Comment by Cedric Baron, Head of Multi Asset Strategies at Generali Investments Partners

Next year is likely to be a turning point that will require a new investment playbook. For multi-asset investors, one crucial element may be back in favour: decorrelation between asset classes, the basis for the sacrosanct rule of diversification.

Extreme jumps in inflation have turned equity and bond correlations in positive territory, while a return to more ‘normal’ levels of inflation should refocus investors on economic growth to determine price equilibrium. If growth is weak and inflation sufficiently low, then growth will again be the main concern for investors and equity and bond decorrelation will return to the fore. Indeed, as we expect high interest rates and tight financial conditions to eventually hurt consumers when refinancing needs arise, we think growth should decelerate in 2024, shifting correlations between assets.

In addition, we believe that much higher yields will be positive for multi-asset strategies, which have benefited from high carry this year and which we expect to continue into 2024. We also expect these strategies to benefit from price rises in the fixed income segment.

The equity market's reaction will depend on the resilience of economic growth. If inflation slows while economic activity is low but positive, we will return to a Goldilocks scenario, which is positive for equities. But if the slowdown is deeper than the soft landing currently priced in, equities could fall despite lower interest rates. This illustrates how uncertain 2024 could be, as it will depend on hard-to-predict price and activity data.

We therefore believe that multi-asset strategies can play an important role for investors in this environment. Uncertainties are high and the economic scenario can change drastically depending on macro variables (from prices to activity). A passive allocation is therefore unlikely to meet the need to adapt to very different scenarios. Reactive and flexible allocation will be key. Multi-asset strategies can also add significant value through their ability to use sophisticated financial instruments to better adapt to market changes across a very broad range of asset classes. The use of optionality will help provide flexibility, while sources of carry have the potential to be multiplied through different asset classes such as fixed income volatility, commodities and equity dividends.