Investment portfolio construction themes: three things we know
A volatile start to the year underscored the adage that “markets do not like uncertainty.” We are not going to pretend that making portfolio construction decisions is easy right now. Because of this, we anchor our views on the premise that taking a longer-term view has proven to provide the right perspective. And we suggest investors focus on the knowns, rather than the many unknowns.
1. The Fed has embarked on a tightening cycle
- Rate-sensitive asset classes remain vulnerable: Our Global Investment Committee members agreed that asset classes with duration risk should continue feeling pressure. As such, we advocate an underweight duration posture to mitigate negative capital appreciation as yields rise. Instead, we continue to favor credit risk, specifically broadly syndicated loans and high yield, where yields are attractive, fundamentals are sound and we expect default rates to remain very low. This view will evolve as rates increase, but for now we don’t think it makes sense to add duration risk.
- Equities have historically performed well through tightening cycles (even when the yield curve inverts), albeit not without volatility (Figure 1). At our recent GIC discussion, we spent quite a bit of time debating the question, “If an investor has cash available to put to work, where do we see the best opportunities?” We were unanimous that U.S. large cap equities look attractive, especially after their recent selloff. As a group, we were divided on the growth vs. value debate, which leads us to suggest a balanced approach (select growth names are looking inexpensive compared to our long-term profit forecasts; sectors more heavily weighted in the value complex may do well in an environment of higher inflation). The U.S. is still trading at a premium compared to international equities, offering investors a relative safe haven from geopolitical and economic disruption.
There are many unknowns. Let’s focus on the knowns.
2. Market volatility will continue to be friend and foe
- Markets are typically skittish later in an economic cycle, but geopolitical risk magnifies this. All of our GIC members expect volatility to remain elevated — especially in public markets. Volatility reflects concerns of a precarious backdrop of low starting yields and high inflation — questioning whether the economy can handle the Fed’s next move. And it’s not surprising that market volatility has been particularly acute in Treasuries — even more so than in stocks and broadly syndicated loans (Figure 2).
We see two ways to approach this volatility:
Participate in it:Hold tight to strategic asset allocations (rebalancing prudently), while using extra or new cash to take advantage of the incredible pullbacks we’ve witnessed year-to-date. For example, we see contrarian opportunities in distressed and undervalued areas such as emerging markets debt, but would stop short of adding to areas that still present too much risk due to ongoing turmoil caused by the Russian invasion. These latter areas include European equities, European infrastructure and emerging markets equities.
Shield portfolios:Investors seeking safe harbor from market volatility should consider incorporating (or increasing) less liquid investments into their portfolios. In our experience, investors tend to overestimate the amount of portfolio liquidity they need, potentially sacrificing better risk-adjusted returns by underinvesting in private assets. Private assets may add to diversification through illiquidity premiums and idiosyncratic risks. For those investors looking to increase portfolio yield, private credit (specifically, middle market direct lending) offers healthy levels of income with low volatility as the demand for private equity deal financing shows no signs of slowing. In fact, committed-but-unallocated global private equity capital stood near all-time highs at $1.78 trillion in February as institutional investors continue to embrace the asset class as a potential antidote for lower long-term return expectations.
We don’t expect a worst-case scenario for inflation.
3. Inflation protection
- We believe the economic expansion will continue contributing to above average inflation, but demand will soften, supply shocks will dissipate and inflation will eventually moderate. This stands in contrast to a worst-case scenario of persistently higher inflation and a Fed unable to tame it, sending the economy into a tailspin.
- We favor long-term inflation protection in the form of productive, cash-flow-generating assets, such as equities, real estate and real assets (Figure 3). While broad global equities have an outstanding track record of growing real, after-inflation wealth, the profit outlook for certain sectors and regions has improved dramatically against the backdrop of elevated commodity prices and more persistent inflation. In addition, real estate can offer capital appreciation and income despite higher inflation; many leases have built-in rent escalators that protect real income generation. Higher nominal wages can lead to bigger budgets for housing, which has been in short supply since the Global Financial Crisis, a trend exacerbated by COVID-induced migration and higher costs of materials slowing the pace of new inventory.
All market and economic data from Bloomberg, FactSet and Morningstar.
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A word on risk
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not appropriate for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy.
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