It’s complicated

After riding out two years of a global pandemic with relative ease (and double-digit returns), markets and investors around the world faced a rude awakening in 2022. Inflation shot to a 40-year high, interest rates spiked to a 15-year high, and markets around the world responded with the worst losses many had seen since the 2008 global financial crisis.

Results from a recent survey of 441 fund selectors at leading wealth management, private bank, and insurance platforms in 28 countries call for more of the same in 2023. Except now 62% globally, and 65% in EMEA, believe recession will be absolutely necessary in order to get inflation under control.

Where the risks lie
Looking at the year ahead, inflation (70%) and interest rates (63%) continue to rank at the top of portfolio concerns, and as policy makers plan more hikes in 2023, a central bank error (52%) ranks as the biggest economic risk. One year into Russia’s war on Ukraine, geopolitics also factor prominently in the economic picture. Almost half of fund selectors (49%) see the specter of war as a pressing economic risk. Almost the same number see US/China relations (48%) as a risk as trade and Taiwan policies intersect.

The risks all come at a time in which the wealth management business is facing dramatic changes: Investors want more comprehensive financial planning services from wealth managers, and the firms themselves are working to tailor their offerings to meet the evolving needs of higher net worth clients and deliver a more consistent investment experience. As a result, selectors not only have to address the market challenges ahead, but also deliver new investment choices to an anxious client base.

Success in 2023 will come down to how well they perform in three critical areas:

• Reading the market: After last year’s losses, selectors are relatively optimistic about the prospects for 2023, with 73% going so far as to say they will maintain or increase average return assumptions of 8.8%.
• Shoring up client portfolios: While few believe they will need to make wholesale changes to portfolio strategy, many will adjust bond holdings to better yield potential, equity weightings to capture the upside of market dislocations, and turn up the risk management potential of alternatives.
• Refining the product offering: With 48% of investors saying they want advisors to deliver financial planning services,¹  firms are looking to model portfolios to streamline client accounts, and separately managed accounts and direct indexing to enhance customization and tax efficiency.

It all begins with navigating an uncertain economic and market environment.

Another year of inflation rates and volatility – and now recession?

After a decade of low inflation, low rates, and high growth, the global economic environment changed dramatically in 2022. For the first time in decades, high inflation became a pressing threat – a problem that was only aggravated by geopolitical turmoil as Russia invaded Ukraine and energy prices spiked.

In the wake of all this change, six out of ten globally and 70% in EMEA believe that recession is inevitable. It’s important to note that sentiment on the prospects for recession differs widely by region. Significantly fewer in the UK (57%) and Asia (56%) see recession as inevitable. Fewer still in North America (53%) believe recession is a foregone conclusion for 2023, but that number could be lower because one-third (32%) believe the economy was already in a recession at the end of last year.

Regardless of when recession concerns are realized, recovery is already on the minds of fund selectors. Professional sentiment suggests investors should buckle up for the long haul: Many (53%) believe that markets may be underestimating how long recession could last, a sentiment that runs strongest in Asia (67%).

Even as 60% anticipate recession, it appears to be too early for selectors to accurately project how it all turns out. Out of our 441 respondents only 45% believe a safe landing is possible. However, when they are forced to choose between a safe landing and a crash, 66% favored safe, which indicates sentiment favors a less painful outcome.

Inflation will remain stubbornly elevated
Inflation continues to be a primary concern. Central banks have been on the case for most of the past year, implementing a series of rate hikes aimed at quelling inflationary threats. In the US, the Fed has implemented seven rate hikes taking the fed funds rate from 0.25% in January of 2022 to 4.5% in December, the highest rate since 2007’s 5.25%. Similarly, the Bank of England undertook aggressive action that included eight rate hikes in the same period.

While rising rates can stymie markets, fund selectors see a significant upside for clients. Three-quarters believe rising rates will usher in a resurgence in traditional fixed income. Despite the efforts, 72% believe central banks cannot curb inflation on their own. Maybe they can’t, but bankers are still seen as an essential piece in the puzzle: More than half say the biggest economic threat in the year ahead will be a central bank error.

Overall, 53% believe inflation will remain stubbornly elevated in the next 12 months. The scenario which began playing out at the end of 2022 illustrates what stubborn could look like. In December, after six consecutive months of declines, markets were buoyed to learn that inflation in the US had moderated to 6.5% in December. Inflation trending steadily lower from its high-water mark of 9.1% is certainly reason to breathe a sigh of relief, but it’s important to note that headline CPI at 6.5% is still well above the Fed’s target rate of 2%.

Recession and growth concerns are not limited to inflation-related factors. Changing trade practices are also weighing on their minds, as 62% of fund selectors worry that the move from global trade to more domestic production and friend-shoring will hinder growth.

Geopolitical risks are on the rise
Fund selectors also see significant geopolitical risks in 2023. War (49%) and US/China relations (48%) both rank among their top economic risks – though it should be noted the threat is felt greatest where the issue hits closest to home.

Those with a front seat to the Russian war with Ukraine, including EMEA (57%) and UK (52%), feel the threat of war most acutely, while those in Asia (63%) and EMEA (61%) are most concerned with US/China relations. Fewer in the UK (37%) and North America (38%) are as concerned about the threat posed by US relations with China.

Consumer spending (32%) and global trade (27%) round out the five greatest economic threats. It should be noted that the impact of war in Europe’s breadbasket, related energy shortages, and natural disasters in the agriculturally rich US West leaves almost one-quarter (23%) to worry about the threat posed by a potential food or natural resource crisis.

Currency will also factor in their minds, as 84% believe the US dollar will maintain its global dominance while more than half (55%) believe the GBP will remain at historic lows. Similar to inflation, US dollar dominance is seen in varying degrees. After a year in which the dollar led, 63% of selectors globally still see it weakening in 2023. Those in Asia (74%) and EMEA (70%) are most likely to project the dollar weakening, while only 48% in the UK agree, a number lower than even the six in ten in North America.

Sector outlook favors those with shorter-term cash flows
Inflation may hurt sectors that have longer-term cash flows, but financials may look attractive to fund selectors because their cash flows tend to be short-term. That, and they also benefit from higher interest rates.

Despite seeing energy prices come back down to earth recently, many believe the sector is still likely to outperform the broad market, suggesting they may anticipate additional disruption to fossil fuel supplies as the Russian war enters its second year.

Big tech is one area where they anticipate at least a turnaround. After seeing big tech take a battering in 2022, more than half of selectors (52%) are bullish on the sector. With losses adding up, it may be that many see the sector as coming back in line with market returns (33%) or exceeding the market average (38%). But few believe big tech will continue to underperform in 2023.

Recession concerns may impact the view on performance of many selectors: They reserve their harshest outlook for the interest-rate-sensitive real estate sector, where 56% of those surveyed believe the sector will underperform the markets. The outlook is at the convergence of two significant trends in post-pandemic markets: A rising rate environment doesn’t bode well for the performance of residential properties, and the view for commercial real estate may be further compounded by the uptick in companies adopting permanent remote work policies.

Inflation is a common denominator across market views, but it is also a trigger for a range of concerns in 2023. Inflation itself may present the top risk, but the knock-on effects of rate hikes (63%) implemented by central banks to curb inflation, and volatility (49%) driven by anxious investors, round out the top portfolio risks for fund selectors.

The outlook in Asia is slightly different. Fund selectors there still see these as the top three portfolio risks, but they are most concerned with volatility (65%), then interest rates (56%), and then inflation (51%).

Not only will fund selectors need to consider these prime risks in client portfolios, but they acknowledge a number of secondary concerns including valuations (28%), liquidity (26%), and currency fluctuations (22%) that will influence investment and business decisions in 2023.

Among these secondary concerns, valuations are top-of-mind. After watching the bull market run up over the past ten years, 65% of fund selectors worry that the markets do not reflect the fundamentals. They will be watching closely to see if current volatility will change the circumstances, as 77% believe markets will finally realize that fundamentals matter.

Volatility likely to continue
Volatility was one of the key outcomes of economic and market shifts in 2022, and fund selectors see more of the same in 2023. Even after last year’s uptick, more than half (51%) project that stock market volatility will increase over the next 12 months.

Bonds were also historically volatile in 2022, and while only 37% expect bond volatility to increase in 2023, almost the same number (35%) expect the same level of volatility in the year ahead.

As a result of elevated volatility, selectors will be watching a number of key indicators: Dispersion, or the difference in returns among securities, was elevated in 2022, and while four in ten (42%) believe it will remain the same, almost the same number (41%) are looking for dispersion of returns to be even higher in 2023. This is one clear reason that 72% of fund selectors globally call for active management to outperform passive investments this year.

Active management stands out in an uncertain market
As they contemplate the reality of a recession, fund selectors are looking to active investments as a critical tool for managing client portfolios. In fact, 80% of these professional investors say active management is necessary to find alpha during a recession.

After a year in which 56% say active investments outperformed the passive investments on their platform, 71% of selectors believe markets will favor active management in 2023. Six out of ten go so far as to say they will increase the number of active funds on their platform this year. Recent product innovations give selectors choices. For example, half of those surveyed believe active ETFs will revolutionize how they build portfolios.

Job one: Shoring up client portfolios

As the individuals responsible for $30 trillion in assets, the primary job of fund selectors in 2023 is to ensure client portfolios are positioned for a more volatile and uncertain market and shored up against recession. Given a wide range of risks, they will need to start with adjusting allocation strategy and then move on to how they allocate within specific asset classes.

Given all that is on their plate in 2023, fund selectors are remarkably optimistic about what they can deliver for clients. Overall, those surveyed share an average long-term return assumption of 8.8%. Few will reduce their expectations this year, while 44% will maintain their assumptions. Three in ten go so far as to say they will increase their assumptions.

Regionally, those in Asia set highest expectations at an average of 10.2%. Fund-of-funds platforms (10.1%), registered investment advisors (9.7%), and wealth managers (9.1%) all share high assumptions for investment returns, while the lowest can be found with investment divisions of insurance (7.3%).

The moderate risk portfolio benchmark
The best place to gauge how selectors will adapt their portfolio strategy to address the economic threats and market risks is the go-to moderate risk portfolio, which represents a large number of clients at each firm.

Overall selectors report that they will make only small adjustments in their allocations for these clients. But these small shifts are significant in scope. Most telling among the data are North American fund selectors, who appear to be positioning client portfolios to capture the yield advantage presented by higher interest rates. Their plans show that they will increase allocations to fixed income, while dialing back those in alternative assets where they turned for yield replacement. This strategy is clearly backed up by how they are adjusting bond allocations.

Bonds are back
Fund selectors may see inflation as a portfolio key risk, but they also see a potential opportunity in the interest rate hikes that come with it. After seeing numerous rate hikes in 2022, 54% believe interest rates will continue to rise. This is good news to fund selectors, as three-quarters believe that rising interest rates will usher in a resurgence in bonds. In the short term, more than 55% say they are bullish on bond market prospects for 2023.

This is a significant turning point for income-oriented investors. After experiencing historically low rates since the global financial crisis, many had turned to higher-risk alternative investments to enhance their yield potential. After 15 years on the hunt, 62% believe investors are taking on too much risk in pursuit.

Bond allocation calls show that selectors are prepared to up investments in bonds of all types. Most prominently, 51% globally will increase investments in government bonds. Another 46% say they will also increase allocations to investment grade corporates and 33% will up their high yield bond holdings. It appears these moves represent the beginning of lasting sea change in bonds as 55% project long duration to outperform short.

The sweet spot for lengthening durations
When to lengthen duration is a critical consideration. While a small number (16%) say they are already lengthening duration, others are waiting for rates to climb higher. For now, the sweet spot that will lead most selectors to move is somewhere between 4.25% and 5.0%. In the US, where the fed funds rate hit in the middle of that range (4.5%) in December, 20% say they will be waiting for 5% before they lengthen duration.

In Asia, where interest rates range from -0.1% in Japan to 3.65% in China to 4.25% in Hong Kong, almost one-quarter of selectors (23%) say they have already seen enough to lengthen duration. In the UK, where rates now stand at 3.5%, it will take another 100 basis points before half of fund selectors will have lengthened duration.

Valuations matter again
Despite the challenges, fund selectors appear to be relatively optimistic for equities in 2023. Almost six in ten (59%) are bullish on stocks – a full 10% more than institutional investors who were surveyed about a month earlier. But views vary widely by region. Two-thirds of those in EMEA say they are bullish while the same number in Asia are bearish on stocks.

After a long bull market run in which low rates helped lift stock prices virtually all around, almost two-thirds of fund selectors (65%) are convinced that current valuations do not reflect company fundamentals. Now, as they anticipate elevated volatility and increased dispersion, they will likely turn to active managers, as 86% believe the market will recognize that valuations matter again.

In looking at the opportunities, 61% believe large-caps will outperform small-caps, and 64% project developed markets to outperform emerging markets.

Overall, selectors are prepared to increase allocations first to US equities (45%) over emerging markets (37%), Europe (34%) and APAC (30%), indicating that they find opportunity in the volatility that plagued major markets across the globe in 2022.

That may be the global average, but selectors in Asia are the biggest outliers. Large numbers here are prepared to trim from European (54%) and US (23%) equities, while significantly more will add to APAC (54%). One reason for the optimism may be the loosening of the tight restrictions that came with China’s zero-Covid policy. After posting a relatively low growth rate of 3% in 2022, relaxed restrictions have led even the Chinese government to up 2023 GDP estimates from 4.7% to 5.2%.² 

Alternative: New reasons to believe
Fund selectors’ alternative allocation calls show that while rising rates may lead them to trim certain investments, the inherent risks presented by an uncertain market are giving them new reasons to believe. Almost six in ten say they are recommending increased allocations in alternative investments, thanks to higher levels of risk. Risk views run so strong that 63% say they believe alternative investments belong in retiree portfolios to help mitigate their exposures.

When it comes down to it, 64% believe portfolios composed of 60% equities, 20% bonds, and 20% alternatives will outperform the traditional 60/40 portfolio in 2023.

Mitigating risk with alternatives
A strong indication of their conviction is that worldwide, fund selectors are twice as likely to increase allocations to absolute return strategies (32%) rather than trim (13%), with the remainder maintaining current allocations. The sentiment is even stronger in North America where 37% will increase compared to only 8% who will trim. Options-based strategies, such as hedged equity, show similar sentiment both globally (25% add / 9% trim) and in North America (33% add / 6% trim).

Of all alternatives, selectors are most likely to add to infrastructure investments both globally (48 add / 6% trim) and in North America (46% add / 4% trim). Six in ten investors in Asia agree and will increase their allocations as well.

Maximizing yield with alternatives
Plans here may be twofold. On one hand, certain infrastructure can mitigate risk by providing a steady long-term return stream. On the other, infrastructure has been gaining a toehold in portfolios as selectors looked to enhance yield while rates were low. That’s also a likely motivation now, as 58% say their firm is recommending alternative investments as a yield replacement.

Despite better news on bonds, selectors appear to still be worried about their ability to generate yield. In fact, they are more likely to say they will add to private debt investments globally (31% add / 17% trim) and in North America (39% add / 15% trim).

The popularity of private assets is not limited to debt. Globally, selectors are more likely to add to private equity / venture capital investments both globally (43% add / 13% trim) and in North America (46% add / 9% trim). The same number (46%) in the UK plan to increase allocations to these assets.

The long-range product plan

Fund selectors may face tough portfolio choices in 2023, if they are going to address the wide-ranging risks clients face with their investments this year. But in the long run, selectors also need to be thoughtful about the types of products that will offer clients for both today and many years down the road.

Product calls show that they are actively managing their offering to ensure they can meet these key objectives. In some cases, they will need to adapt their offering to meet new regulatory requirements.

Such is the case with sustainable investments. While 61% overall say they will add to their sustainable offering, the highest level of respondents who said they’ll add (71%) hail from EMEA, where MIFID iii requires all financial advisors to ask their clients about interest in sustainable investments. Meanwhile in North America, only 37% say they’ll add to their offering.

In other instances, selectors show they are backing up their convictions by increasing their offering in areas such as active investments. Projecting more volatile markets with greater dispersion in which they think valuations will matter more, it’s not surprising that 72% believe active investments will outperform passive. It should also be no surprise that, given their view, six in ten (59%) say they will increase the number of active funds on their platforms.

Why private assets retain their luster
Interest in private assets has been growing steadily as interest rates hovered in the low to negative range across the globe during the past decade. Even now, as the yield picture begins to change, 50% say they will add to their private investments offering. One key factor in this decision may be that they see a new reason to invest, as 44% believe private assets will provide a safe haven for investors.

As a result of this continued popularity, fund selectors are able to report that their firms offer a wide range of investment choices. On the equities side, funds of funds (52%), infrastructure (48%), and venture capital (36%) are cited most frequently. For private debt, direct lending (43%) and co-investing (33%) top the list of offerings.

Many are also looking to private assets to enhance their offering of sustainable investments, as 44% say they will increase their ESG (environmental, social and governance) offerings and 30% will turn to private markets for impact investing.

Models make for a more consistent investment experience
Another key consideration for firms is how to best implement effective portfolio management that can deliver a consistent experience for thousands of clients. In recent years, many have implemented model portfolio programs to help unify their investment offering.

Among the 441 selectors included in the 2023 Natixis Outlook survey, 79% report that their firm offers some sort of model program. Most frequently these firms report they offer models because they can deliver a more streamlined approach to investing, and a more consistent investment experience as noted. But they are finding a wide range of other benefits.

One of the key benefits they find models afford their clients is that using models can give advisors more time to address client needs (76%). This can be critical, as investors told us in 2021 the two services they want most from their advisor are financial planning (48%) and retirement income planning (40%). ³  Both exercises require that advisors are able to work with clients on complex issues while still meeting their investment needs. In addition, firms note that giving their client base a more consistent experience helps manage their own risk exposure (76%).

Selectors also find that models help make it easier to implement unified managed accounts (UMAs) for clients. UMAs are becoming important tools for managing the often-complicated assets of high net worth investors. The accounts provide clients a comprehensive wealth management solution by combining a range of investments (stocks, bonds, mutual funds, etc.) in a single, professionally managed account. In the end, regular reporting provides clients with a more holistic view of their wealth.

Use of third-party providers growing
As selectors look to grow their model offerings, they are turning to third-party managers to enhance their offering. In fact, our past surveys show that selectors’ self-reported use of third-party managers has more than doubled in three years, rising from 11% in 2021 to 24% in 2023.

With wider use come clear expectations for third-party managers. Given the current market conditions and the desire to deliver consistency, it’s no surprise to see that a manager’s ability in active risk management (47%) is the first thing selectors are concerned with – even before fees (40%). Beyond that, they are looking for third-party managers who can develop models that are customized to meet firm needs (38%). They also want to be assured that managers can implement tactical asset allocations, again a key consideration in uncertain and unsettled markets. And as firms look to deliver on ESG demand, one-third said they are looking for managers who can deliver model solutions.

Adding new strategies
ESG model capabilities will come into the spotlight in 2023, as almost half (49%) of fund selectors say their firms plan to add these types of portfolios to their offering. Most significantly, MIFID iii, along with other factors, is leading 61% of those in Europe to add more ESG models to their offering, as are 57% in the UK and 55% in Asia.

In North America, the top candidate for addition to model platforms is high net worth models that combine the model structure with enhanced tax management and other customized features. The option is on the planning grid for 38% of selectors worldwide.

Many firms (38% global and 43% in North America) are also setting their sights on income-oriented models, an especially timely choice as a rapidly growing retiree population converges with a more robust set of income investments. With more firms recommending alternative investments, 42% of selectors in North America and 33% globally will look to streamline the process by adding alternative sleeves to their model offerings.

It’s complicated, but manageable
Fund selectors have genuine concerns about what 2023 will bring to their clients. They anticipate elevated levels of inflation, rising rates, and increased market volatility. Only this year, they anticipate it will all end in recession. The scenario will clearly put many clients on edge, and selectors will have to insulate portfolios for a market scenario that has become unfamiliar to many after a decade of solid gains.

Allocation calls show they will actively manage clients’ portfolios to better position them for this new reality. They see rising rates as a resurgence for bonds and are reallocating clients to both government and investment grade corporate bonds – along with almost every other flavor of traditional fixed income.

On the equity side, they are bullish and believe that higher volatility, broader dispersion of returns and a renewed focus on fundamentals favor active managers. Alts will continue to factor into the equation, but they will rely on alts to help mitigate while continuing to look at these investments to help boost yields.

In the long run, they will continue to implement products that will first enhance the investment experience for clients and also deliver a higher level of customization.

They recognize that it may be a complicated world in 2023. But they give every indication that they believe it’s all manageable.