With the sudden shift in market conditions and the U.S. Federal Reserve’s monetary policy, investors are facing an environment we haven’t seen since the 1970s and ’80s. With this change, it’s critical to reexamine some fundamental principles of diversification to help build resilient portfolios. Here are three important areas to consider when reviewing your investment strategies for 2023.

Inflation and high interest rates are now realities

Here are tips to help you build a well-diversified portfolio in these market conditions

After an extended market rally that routinely delivered double-digit equity returns, 2022 marked a turning point. Going forward, we believe investors should be prepared for a period of more muted equity returns on a nominal basis. With higher inflation, this means inflation-adjusted returns will be even lower.

In such an environment, investors typically need equity portfolios that can capture more than just market returns — which is why diversifying with factor exposure may be important. Factors to consider include:

Value: Low inflation and low interest rates benefitted growth-oriented companies whose earnings were projected farther into the future. But higher interest rates cause the value of those future earnings to decline. Value stocks, which tend to have higher current cash flow and earnings, may perform better when interest rates are high. We saw this effect in 2022, when the Russell 1000 Value Index returned -7.54%, compared to the -29.14% for the Russell 1000 Growth Index.

Low Volatility: The surge in market volatility during 2022 highlighted the importance of diversifying among stocks that are less tied to the market’s broader movements. An allocation to low volatility stocks historically has helped cushion equity portfolios on the downside, while still capturing some of the market’s upside.

Quality: High interest rates and increased costs for goods and labor will put pressure on companies that lack financial strength. The quality factor can help differentiate among stocks within the same sector by identifying companies with stronger balance sheets, higher current cash flows, and conservative capital expenditure strategies.

FOCUSING ON COMPENSATED RISK IN FIXED-INCOME ALLOCATIONS

Advisors should help their clients assess whether they are more comfortable with interest rate risk or credit risk in their fixed-income portfolios. FlexShares believes that investors should be compensated for the risks they’re taking, and in the current environment we don’t see investment-grade corporate bonds offering investors much in the way of compensation over U.S. Treasuries.

Instead, investors may want to diversify fixed-income holdings with exposure to high-yield bonds. The yield advantage of high-yield bonds offers potential compensation for the additional credit risk that investors are taking.

What’s more, the increase in interest rates during 2022 has created a potential opportunity for investors should yields begin falling in 2023.

ADDING EXPOSURE TO REAL ASSETS

Real assets — which include natural resources, infrastructure and real estate — have historically offered investors diversification benefits through their inflation-hedging potential and low correlation with fixed-income and other equity classes. In the current market environment, we believe that natural resource and infrastructure stocks, in particular, may warrant a closer look.

We anticipate supply and demand imbalances may provide investors with opportunities in the energy sector, which often are classified under natural resources. However, avoiding concentration in any one sector is critical to managing risk in a natural resources strategy. That’s why we encourage investors, in consultation with their advisors, to consider diversified natural resources strategies that include exposure to additional categories beyond energy, such as agriculture, timber, metals and mining and water.

Infrastructure investing strategies also tend to be concentrated in utilities, which carry a higher degree of interest rate risk than other stocks. Utilities stocks may prove to be a challenging sector if interest rates remain elevated in 2023. To help reduce interest rate risk, investors may want to examine diversified infrastructure strategies that include exposure to categories such as such as pipelines, communications equipment and government outsourcing.