Morgan Stanley
  • Research
  • Jan 10, 2023

Why Valuation May Be Key to Defensive Investing in 2023

In 2022, both U.S. stocks and long-term bonds declined more than 10% for the first time since the 1870s. This reminder that correlations can change offers lessons for the year ahead.

The investing landscape in 2022 was notable not only for the severity of losses but also their breadth: It was the first year, since at least the 1870s, that U.S. stocks and long-term bonds both fell by more than 10%.

That historical anomaly hints at a broader theme: The notion of "safety” as it relates to investments did not always apply as usual. Some traditional defensive assets worked as expected. However, some traits associated with higher risk actually protected portfolios. It was a good reminder that correlations can change, and it offers some important lessons for the year ahead.

First, let’s look at the assets that stuck to the script. In a poor year for equity returns, defensive stocks—companies with relatively steady demand for their products—outperformed as expected. U.S. defensives returned 6% (with dividends) over the last 12 months while the broader market was down 17%. Morgan Stanley Research expects continued strong performance from U.S. defensive stocks, while we remain cautious on European cyclicals, which we anticipate will remain more volatile than the overall market.

The U.S. dollar, a traditional “safe haven,” also behaved as expected, offering diversification for investors’ portfolios with a negative correlation to global equities throughout 2022. Indeed, despite the dollar’s recent weakness, its diversifying power has been increasing, with the 120-day correlation between the dollar and U.S. stocks at its lowest level since April 2012.

But there were also plenty of areas where traditional correlations were less predictable:

  • ·Small cap and value equities, often noted for their volatility, outperformed in a year in which markets fell considerably. The same goes for stocks in Europe and Japan, which declined significantly less than U.S. stocks last year, after hedging currency risk.
  • Energy was the only sector that did better than defensives. This typically volatile sector rose 64% in the U.S. and 30% in Europe in 2022. Financials, another risky sector, was the second-best performer in Europe, Japan and emerging markets.
  • In Mexico and Brazil, Latin America’s two largest economies, equities are up over the last 12 months (in USD terms), and both countries' currencies are stronger against the mighty U.S. dollar.
  • High-quality bonds were riskier than generally expected. The Bloomberg US Aggregate 10yr+ bond index, the definition of a “safe” asset with an average credit rating of AA-, is down more than 20% over the last 12 months, more than the S&P 500.

Lessons for 2023

What should investors take away from these contrarian results as they look at the year ahead?

First, a year like 2022 doesn’t come around very often. But it is a good reminder that concepts like “volatility” and “defensiveness” aren't as cast iron as they may seem. Correlations can change.

Second, some of those seemingly reliable diversifiers remain important. We continue to prefer defensives over cyclicals in the U.S. and Europe. And while we anticipate that the dollar will continue to weaken, it still provides diversification and high “carry” (the return generated by holding an asset).  

Third, a common theme among market outliers was valuation. Energy, financials and Mexican and Brazilian equities performed relatively well because of low valuations.  Bonds, which did poorly, were at some of their richest valuations in centuries (though real yields have now normalized significantly).

Keep the importance of valuation in mind. In a still-tough U.S. equity environment, equities in the rest of the world are likely to do better, boosted by attractive relative valuation. In fact, high-grade bonds could outperform equities in the U.S. and Europe and return to a much more diversifying role within cross-asset portfolios.