The Australian sharemarket has had a flying start to the year, with the S&P/ASX 200 sitting within reach of an all time high.

That was, until Wednesday's hotter-than-expected inflation data dampened investor sentiment, sending shares down and bond yields up on expectations the RBA will again raise the cash rate when it meets in February. 

defensive assets

Defensive assets can provide some insulation to market volatility.

It serves as a reminder that the volatility of 2022 isn't done yet - global central banks have further to go, and the aftermath of their prior actions will impact household and business sectors throughout the year.

For investors keen to shield their portfolio from the tough market conditions, defensive assets can play an important role. But ANZ Private Bank's head of investment strategy Lakshman Anantakrishnan says there's scope for nearly all asset classes to stage a recovery at some stage in 2023. 

"While the macro outlook remains challenging, unlike 2022 there should be ample opportunity for investors this year. Where and when remains the question," Anantakrishnan says.

Bonds are back in the defensive game

"Bonds are back." That's the view of both Anantakrishnan and John Flahive, BNY Mellon Wealth Management's head of fixed income investments, after a "painful" year when bonds didn't play their traditional defensive role in portfolios.

Flahive says fixed income has the potential to provide positive returns in 2023.

"As bad as 2022 was, it left yields at their highest levels in almost 10 years," he says.

"Bonds are finally able to behave like bonds again, by providing enough income-producing yield to act as ballast against equity volatility in diversified investment portfolios."

BNY Mellon is increasing the overall fixed income allocations in its portfolios, while ANZ Private Bank also has a defensive stance across its portfolios.

"Bonds - It is here where we see the greatest likelihood of outperformance over the first half of the year and where we expect to deploy more capital, if as expected, we trim risk positions further in the months ahead," Anantakrishnan says in ANZ Private's 2023 Global Market Outlook.

"This isn’t to say the outlook for fixed income is all blue sky; but given we are in the latter stage of this tightening cycle, even if yields do push higher from here we would expect fixed income assets to present a better risk-adjusted return than equities."

Defensive plays underway in stocks

According to UBS, investors favour defensive and value stocks in early 2023 given high inflation, rising rates and slowing growth expectations.

Its Year Ahead 2023 report says defensive sectors such as consumer staples and healthcare should prove to be relatively insulated from a weakening economy, while value stocks tend to perform well when inflation is high.

"More attractive opportunities to buy cyclical and growth stocks may emerge later in the year, as inflation slows and global growth picks up."

Morningstar's head of Australasia equity research, Peter Warnes, says investors should ensure their equity portfolios are diversified with a defensive bias and that they have cash holdings to take advantage of likely opportunities later in the year.

"While central banks will pivot and reduce the pace of interest rate hikes, they will still be in tightening mode for most of the first half," Warnes says. 

"Despite the flying start to 2023 there are eleven months to go. Be prepared for both uncertainty and volatility. Bouts of optimism will occur, and perhaps even be justified, but it would be wise to remain aware and prudent in decision making."

See Morningstar's 11 Australian stock picks for 2023.

AMP chief economist Shane Oliver says investors want defensive stocks in their portfolio during a recession as they're less likely to fall given people will still be spending on utilities, supermarket items and telecommunications.

But he suggests cyclical stocks may perform better, particularly in Australia which he expects will avoid a recession and stands to benefit from China's reopening.

"I think value stocks will benefit from lower interest rates, but it's not necessarily the case that defensive stocks are going to do that well.

"If the broader trend in the sharemarket is up, which I think it will be along with a bit of volatility, then defensive stocks may not do as well. That may constrain things like utilities and consumer staples."

"I think that cyclical stocks - materials, industrials - will probably do better in this environment because I think ultimately investors will be less concerned about recession and more focused on improving growth ahead."

Opportunities for real estate investors

With housing prices falling and rents rising amid high demand and insufficient supply of rental properties, real estate could present opportunities for investors.

Yet many property investors are sitting on the sidelines given they face higher mortgage interest costs.

Empower Wealth managing director Ben Kingsley says budding property investors remain cautious due to high rates and anti-investor sentiment during the rental crisis, although experienced investors are seeing opportunities to build out their portfolios.

"For the astute investor, there really doesn't get a much better time to be buying property if you have a long-term view," Kingsley says.

"If you've got a 5-, 10-, 20-year view on property, you'll be patting yourself on the back with regards to making a decision this year if you did take the leap."

That's because there is less competition in the market, and getting closer to the end of the tightening phase also means getting closer to the bottom of price declines, he explains.

Gross rental yields fell during the pandemic as property prices rose at a faster pace than rents. But yields started rising over recent months as prices fell and rents increased, PropTrack's latest rental report notes.

"We anticipate that yields will continue to climb in 2023 as rental growth outpaces property price growth," PropTrack director of economic research Cameron Kusher says.

"Rental yields remain historically low and in many cases are offering investors very little premium over term deposit rates while property prices reduce."

Kingsley, who is also chair of the Property Investors Council of Australia, expects continued strong growth in rents and rising yields this year but says the next wave of investor demand will likely come when rates decline.