Portfolio construction themes

Our portfolio construction themes center on acknowledging that downside risks to the economy remain, capitalizing on shifts in market valuations, and balancing risks across and between public and private markets. While growth remains solid (for now), we do seem to be in the “higher-for-longer” interest rate environment and inflation remains a concern. This perpetuates what has been a tricky investment environment.

Asset class “heat map”

Our cross-asset class views indicate where we see the best relative opportunities within global financial markets. These are not intended to represent a specific portfolio, but rather to answer the question: “What are our highest conviction views when it comes to putting new money to work?” These views assume a U.S. dollar-based investor seeking long-term growth and represent a one-year time horizon.

Portfolio themes

• Prepare for landing: We still think it makes sense to be selective with cyclicality and continue playing defense in diversified portfolios. Given downside risks, we expect to see a mild recession either this year or next.
  
  This leads us to emphasize dividend-paying equities (for their more defensive and income-generating characteristics) as well as infrastructure investments that can weather a combination of slowing economic growth and volatile interest rates. Additionally, we have a common preference for relatively higher quality investments across asset classes (including fixed income, private equity and real assets).
• Don’t put your portfolio on autopilot: Now may be a good time to consider taking profits in some areas and adding to risk in others. Many public market valuations have shifted noticeably since we published our year-ahead outlook in December. And cross-asset risk profiles have evolved as well.
  
  In the former category, we would point to areas such as investment grade fixed income, public REITs and investment grade municipal bonds. We continue to believe these areas offer compelling fundamentals, but all three have enjoyed strong rallies that have made valuations less compelling than they were a few months ago. In the latter category, we’re seeing opportunities to add some risk and beta to portfolios by focusing on emerging markets (particularly emerging markets equities). We also continue to like high yield municipals.
• Balance the public/private predicament: Many investors fear that last year’s sharp selloff in public markets is still going to come due for slower-acting private markets. And some are concerned that they may be overweight in private assets due to pricing imbalances.
  
  From our vantage point, we do see technical risks, such as in some areas of private real estate. And we also anticipate near-term deal flow hurdles in areas such as private equity. And the failure of Silicon Valley Bank highlights the importance of dependable financing sources. But other areas within private markets look quite compelling. We’d point to private credit (particularly middle market loans) given that private credit investments typically focus on more defensive sectors and that deal structures look solid.

Significant changes in our views:

Value is emerging in emerging markets: Amid an overall preference for less cyclicality and more defensive positioning, we think it makes sense to balance this stance by taking a closer look at emerging markets. A key catalyst for this change is a better environment in China. That country is seeing improved economic growth, thanks largely to a significant policy turnaround with the end of its zero-covid stance.

Both emerging markets equity and debt investments offer more attractive valuations than they did a few months ago, and U.S. dollar strength is less of a headwind. EME investments in particular should benefit from a flexible and active approach, as correlations between countries continue to fall (Figure 1). In addition to favoring China, we also see good relative value in Mexico, Brazil and Indonesia.

Diversify credit risk exposures: We believe bond yields will moderate and gradually fall over the course of 2023. Across taxable fixed income markets, we think better opportunities exist by taking on credit risk rather than duration risk (although we still favor higher duration in municipals where ongoing inflows should support the longer end of the curve).

We see value across credit sectors, especially in high yield and loans, and would emphasize that we generally favor relatively higher quality segments within individual credit sectors. We also have a favorable view toward preferred securities. Although recent banking sector turmoil has weighed on the issuer base, it has also made valuations more attractive. Barring much more extensive financial sector contagion than we expect, we continue to see select areas of value in this space.

Our highest-conviction views:

Infrastructure (+) remains a particularly favored area for us. While inflation appears to be easing, it remains a risk. Infrastructure investments (such as regulated utilities) are usually able to pass along higher costs to consumers. At the same time, infrastructure is an asset class that tends to be resilient in the face of slowing economic growth. We have a modest preference for listed over private infrastructure, as the latter may still experience some “price lag” effects as privates catch up to what happened to public markets last year.

Private credit (+) fundamentals remain sound. These investments tend to be focused on more resilient areas of the market such as health care, software and insurance brokers that are relatively well positioned to withstand economic downturns. The strong price appreciation across public fixed income markets since the end of last year also makes private credit relatively more attractive.

Treasuries (-) offer higher current yields than they did a year ago, but, simply put, we see much better places to put cash to work.