Last year was disappointing for many investors. Those who depend on cross-asset diversification to obtain some degree of stability in their portfolios were especially disappointed. Investors typically rely on fixed income assets to reduce volatility in times of trouble, given the more or less constant negative correlation between bonds and equities observed over the past 25 years. That relationship, however, broke down in 2022.

What made last year unique? The 2022 bear market was due to excessive economic growth accompanied by surging inflation, whereas previous crises usually resulted from economic contraction caused by an exogeneous shock, such as the tech bubble bust or the housing crisis, accompanied by deflation. This is according to the recent TDAM Low Volatility Investing: Year in Review and Look Ahead article, which unpacks the factors that made last year difficult and offers reflections on the 2023 investment landscape.

While 2022 was a difficult year for many, it was much less so for low volatility investors. Those who stayed the course and kept in mind the long-term strategic benefits of low volatility investing were able to obtain above-average downside protection for their assets.

While there are strategic long-term benefits to holding low volatility equities, equity markets will likely face an abundance of risks for the foreseeable future. Although supply chain constraints are easing amid the full economic reopening, disruptions will likely continue this year due to the ongoing war in Ukraine.

Now that the rate of inflation appears to be slowing, the market has used this as a reason to take on more risk, move more into equities, and hence cause a rally. But risks to recovery remain, as the question of how long-term inflation targets will be achieved without creating some slack in the labor market is yet to be answered.

As economies recover from the pandemic, they will have to think about paying back the debt incurred from the generous stimulus packages their governments offered during the height of the pandemic. This debt will likely be repaid through a mix of anemic growth and above-target inflation for many years to come.

If inflation remains above target, the policy rates of central banks are unlikely to be reduced, regardless of their impact on economic growth. This means that the deconcentration process equity markets saw last year has probably just begun. If this is the case, low volatility investors might experience tailwinds for the next decade to come.

For more detail, read the full article.

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