This is a time when investors are looking for a way forward. While headlines about US debt, the impact of artificial intelligence, US-China tensions and the war in Ukraine dominate the news, we believe the landscape for investing has the potential to evolve positively.
This is a time when investors are looking for a way forward. While headlines about US debt, the impact of artificial intelligence, US-China tensions and the war in Ukraine dominate the news, we believe the landscape for investing has the potential to evolve positively. Our view, reflected in our updated Strategic Return Estimates1 (See FIGURE 3: Recession, recovery: A journey unfinished), is that investors who stay invested and rotate their portfolios toward timely opportunities may be well-rewarded over the next decade.
At the moment, investor sentiment appears poor, and that creates potential opportunities. Bearishness, as measured by short equity interest, is at multi-decade highs while the amount of money in money funds and Treasury Bills (T-bills) is at a record high. Rates for short-term cash are at the highest level since 2007.2 All these factors suggest that investors are waiting for a decline in market indices before shifting assets into equities. This may be the most anticipated bear market ever. It is also an argument for why market timing will not work. If everyone is waiting, any decline may be brief and untradable.
Markets are up so far in 2023, which might seem surprising given all the bad economic news — from high interest rates to persistent inflation. But we are not surprised. We continue to suggest our clients stay invested. For the better part of 16 months, we have maintained our positions in conservative, income-oriented equities as well as in quality fixed income, leaning toward US assets. During 2022, the most consistent dividend payers in the US — our largest style overweight3 — lost 6.2% while the broad US equities lost 19.2%.4 Asset allocation clearly matters, as does diversification.
As we describe in this 2023 Mid-Year Outlook, the economic policy “hangover” from the COVID-19 shock, government intervention and subsequent rate hikes still reverberate across the world economy (See Recession, recovery: A journey unfinished). For the past 10 years, US dollar assets boomed, boosted by a flight to safety. Yet, the number of equity market leaders in 2023 is very concentrated. Since the beginning of 2023, more than 90% of US stock market appreciation can be attributed to just five stocks.
As these issues resolve, we see potential, global investment opportunities unfolding. Value creation is, in fact, underway — one reason why our SREs are higher (See FIGURE 3: Recession, recovery: A journey unfinished). When we look at the value of small- and mid-cap stocks (SMID), international equities and emerging markets broadly, we see many assets around the world that have become unusually cheap on a relative basis (FIGURE 1).
In our view, the landscape for investing suggests some major shifts in portfolios. We believe that active asset allocation may add value in the period just ahead. Below are some ways we see potential opportunities evolving:
With the resolution of the debt ceiling negotiations, we expect to see peak short-term interest rates. We anticipate that the US government will issue an unusually large amount of T-bills and bonds to refill its coffers. When that happens, this may crowd out deposits, drive up yields and increase the value of the US dollar.
Though investors will be tempted to concentrate assets in T-bills and money market funds, we think this will ultimately hurt their returns. A different strategy is to extend duration by buying intermediate duration corporate bonds, US municipal bonds and preferred equity securities. By doing so, investors can potentially retain higher yields for longer and may profit if and when interest rates fall, as they will likely do when the Federal Reserve reverses course and starts cutting rates.
The peaking US dollar, now near its highest level in 50 years, is likely to begin a gradual, uneven decline. This trajectory suggests that credit-worthy, non-US sovereign debt could be a solid addition to fixed income holdings (See As US dollar dominance ends, currencies may drive returns). Not only may these securities offer higher yields, but the falling dollar may provide a higher total return to maturity.
Non-US equities present good value. Non-US shares are trading at historically wide valuation discounts to US shares (FIGURE 2). At the same time, the prospects for growth outside the US suggest that non-US earnings may grow substantially. We have already increased our weighting to Asian, European and Latin American equity markets, while reducing some of our defensive equity exposures that outperformed during 2022, like large cap pharmaceuticals. As the global recovery unfolds, we will likely look to boost non-US equities further across a range of industries, focusing on sectors and companies with the potential for sustainable revenue growth and profits.
Within US markets, we believe there are areas of relative value worth investing in as we enter and recover from a rolling recession. An important area of note are SMID stocks, which currently trade at a 30% valuation discount to US large caps for profitable firms.5 SMID stocks generally perform best in the first year of a recovery when their earnings are expected to rebound.
The S&P MidCap 4006 and the S&P SmallCap 6007 are two additional categories that may provide profit opportunity. Focusing on profitable small- and medium-sized companies is advisable when the Fed reduces rates to fight unemployment, as we believe it will soon.
Early in the pandemic, from 2020-2021, the valuations of large tech stocks surged. Then, in 2022, we saw a reversal. Valuations of growth shares dropped as the Fed increased the Fed Funds rate at an unprecedented pace.
But as the yield curve inverted, investors have started to refocus their attention to technology companies with strong balance sheets and growth prospects. Even though US industries have powerful and promising growth prospects, 2023’s tech gains have been limited to a handful of companies. Large Cap US IT is up 37% year to-date.8 Firms providing the infrastructure for a new form of artificial intelligence, known as generative AI (See Generative AI: The beginning of (another) technological revolution) are responsible for a lot of that gain. And while we will add further exposure to generative AI, many other future portfolio opportunities may lie in small- and medium-sized tech companies whose valuations do not yet reflect their future growth potential.
Finally, we see an opportunity within alternative investments for qualified investors. A shortage of capital now exists in private credit. Banks have pulled back their lending due to deposit woes and an overexposure to commercial real estate assets, like office space. The Fed is continuing quantitative tightening, while the Treasury is ramping up borrowing and investors are hoarding cash and short-term investments. For qualified investors, it may be possible to earn equity-like rates of return in selected debt securities.
Loans for private equity buy-outs, lending to later stage venture companies, mezzanine debt for real estate refinancings and other similar lending opportunities are yielding more than 10% per annum.9 Unlike in 2008-09, we do not see a credit collapse on the horizon. Corporate balance sheets are in good shape with future credit problems likely to be concentrated in commercial real estate. Capital shortages do not occur frequently, so this is an area where qualified private investors may benefit for the next three to five years.
The double-digit declines in both stocks and bonds in 2022 — the worst combined return for 60/40 portfolios since 193110 — reset valuations and the relative value of different portfolio investments. In anticipation of poor market conditions in 2022, we doubled up on defensive investments in 2021.
Though we prefer the long-term return properties of dividend growth shares, we expect to return to a normal weighting. And while we currently enjoy a high yield on short-term high-grade bonds, we will rotate from them to intermediate US and emerging market credit to continue to seek income and potentially benefit if and when rates fall. We will move from defensive to overweight risk assets as a result of valuation improvements and market dislocations as they arise.
The US Treasury hit its debt ceiling at the start of 2023 and took emergency steps to limit debt issuance. Now, we expect $1.3 trillion in new borrowings, likely by the end of the third quarter of 2023. When the Treasury needs to raise a huge amount of capital and the Fed continues to tighten, we anticipate that fears about more Fed policy tightening will lower prices of already attractive assets.
One of the reasons we are seeking to diversify equity exposures from the S&P 500 is that large-cap stocks have performed above expectations over the past two years yet actual S&P 500 earnings per share has declined in 2023. This means we see them as expensive on a relative basis. While they may rise in value in 2024, US large cap shares are less likely to lead the market higher.
To capture the potential of our new Strategic Return Estimates,1 we will consider rotating toward different risk assets, geographies and strategies in the second half of 2023 and into 2024. We may diversify our equity selections and “go overweight” across equity strategies as potential opportunities become apparent.
We expect US bonds to act as a foundation for portfolios, seeking positive real yields and negative correlation to reduce portfolio volatility. Here we will seek diversification to non-US bonds and to longer dated securities, but as we expect rates to decline, we see a reallocation to equities as likely.
When T-bill rates and cash balances are high, it is tempting to do nothing. In the near-term, that may seem safe, but looking out one year, we believe that those who do not own core portfolios may be less well-off. After the double market shocks of the pandemic and an overly reactive Fed, the next decade looks like one where returns may be above average. Those who stay in cash will not see returns when markets are recovering.
Market timing hurts portfolio returns. The worst and best days in a market often occur near one another, and you cannot afford to miss the big up days. What investors should focus on is the value of active asset allocation, which is about choosing what to invest in and when.
Over the coming months, we strongly urge investors to reduce their exposure to cash as an asset class. Extending duration should be an investor’s first step. While we may be early when buying certain equities or bonds, our goal is to capture the “total return” of an underperforming asset class. This requires foresight and a willingness to act.
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