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.

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.

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.