Bond, stock volatility, correlation to continue in 2023 – Northern Trust exec says

Market volatility and inflation are the key themes to watch in 2023, said Michael Hunstad, Northern Trust Asset Management's chief investment officer for global equities, who explained that "we're in a strange environment where stock and bonds remain highly correlated."

The Chicago-based Mr. Hunstad sees this high equity and fixed-income correlation and volatility continuing through 2023 and possibly longer, he said in an interview.

Investors should take note of the rise in what he dubbed volatility "shocks," that is, not just movement in the closely watched Cboe Volatility index itself, but a 5-point move or higher in the VIX in one day.

"That's what I believe to be a volatility shock, and the frequency of those is off the charts," Mr. Hunstad said.

He researched equity market volatility starting in the year 2000, and found roughly five of these shocks rocked the stock market leading up to the Great Financial Crisis in 2007.

"Since the crisis, we've experienced another 68 shocks--and 13 of those were just in the past 12 months," he said.

Mr. Hunstad found a similar pattern in bond volatility, represented by the ICE BofA MOVE bond index.

Volatility spikes represent tail risk, Mr. Hunstad said.

"If equities fall, and then bonds fall, your portfolio is whipsawed. It's a huge concern globally," and stock and bond markets will continue to be correlated, he said. "It's going to continue to be a huge issue in 2023."

Other factors contribute: Many S&P 500 companies have taken on large amounts of debt over the past 20 years. Mr. Hunstad found that 40% of S&P 500 component companies now have a negative tangible equity value, compared with 5% of the S&P 500 companies two decades ago.

"There's a large amount of leverage in these so-called safe companies. The effect is these equities behave like bonds."

In this climate, Northern Trust is expecting another year of outperformance from value strategies.

"We've seen two years of value outperformance. I see one more year ahead," Mr. Hunstad said.

Northern Trust Asset Management relies on six factors: value, dividend yield, quality, low volatility, momentum and size as key measures for stock-picking, and he added, "the first five do well in this climate of a macro slowdown and high interest rates. This is their prime time."

Institutional clients such as pension funds and retirement plans are "calling us with questions, and are most concerned about fixed income and what to do. We are currently recommending an overweight in high-yield bonds and cash, and an underweight in investment-grade credit."

In equities, he said the firm recommends an overweight to the U.S. stock market and listed infrastructure funds such as the firm's FlexShares STOXX Global Broad Infrastructure Index Fund and other alternative assets.

The Federal Reserve will likely raise interest rates beyond the December increase, and "bond yield inversions are going to get steeper," Mr. Hunstad said.

Currently, the 10-year Treasury is yielding 3.75%, and the federal funds rate will likely increase to around 5.125% by next year, he said.

That implies "inflation will cool in 2023 to some degree, and over the next five years we see that trending back to normal."