Portfolio construction themes

The economic backdrop that investors have been anticipating appears to be on the horizon — easing inflation and less aggressive central banks (although the U.S. Federal Reserve is likely to continue tightening, albeit at a more measured pace), but also an increasing likelihood of recession. Our 2023 portfolio construction themes center on seeking resilience through investments that can power through a cyclical downturn and provide the ballast that has eluded investors in 2022. And, at the same time, account for the damage in public markets and the consequential imbalance in private markets.

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

• Reduce cyclicality: We think inflation has peaked at last, but the descent might prove challenging. Price disinflation is likely to translate into lower corporate revenues, sparking another possible leg down for equities. Our preference for quality and dividend growth stocks reflects this scenario. In addition, we suggest reducing cyclicality by increasing exposure to infrastructure, which is often capable of growth through economic slowdowns thanks in part to inelastic demand for the necessary services it typically provides. As an asset class, infrastructure also appears primed to take advantage of a number of macroeconomic factors, such as green technologies and global energy scarcity.
• Strengthen the core: In 2022, we witnessed the unraveling of what had been a historically helpful (i.e., negative or low) stock/bond correlation. Looking ahead, with the bulk of rate hikes behind us and the Fed’s “slower but longer” approach taking shape, we think it makes sense to modestly increase duration through bolstering core bond allocations, especially in investment grade credit. We still like high yield (especially the higher quality segments), but anticipate some spread widening. Likewise, we see select opportunities in loans, but continue to be wary of default risks. Municipal bonds remain a favorite of ours, and look particularly undervalued given still-strong fundamentals.
• Assess the balance between private and public portfolio allocations: Given how far public markets fell in 2022, investors allocated across public and private assets may be facing an imbalance between the two compared to the beginning of the year.
  
  While acknowledging concerns about potential write-downs in some private valuations, we maintain a strong preference for private asset classes with compelling fundamentals. Private credit, for example, should remain particularly resilient, as these investments are rooted in defensive sectors such as health care, software and insurance brokers, with long-term capital insulated from market ups and downs and primary deals supported by strong operating models. Additionally, private credit terms look attractive, with senior debt yields at record highs, debt ratios low and covenants favorable. We also see solid opportunities in farmland amid continued high inflation levels. At the same time, we see some near-term risks in areas of private real estate, while we are finding solid opportunities in public REITs.

Significant changes in our views:

Growth risks have moved to the forefront. As painful as 2022 was, our Global Investment Committee remains cautious about taking on additional risk in portfolios heading into 2023 until we see more evidence of the negative economic impact of higher rates, including rising unemployment and lower nominal retail sales.

This sentiment is exhibited in our updated heat map, which shows our preference for rates-duration assets such as U.S. Treasuries and investment grade credit at the expense of senior loans and high yield. We also notably upgraded listed REITs, which are pricing in more of the bad economic news than their private counterparts.

Our highest-conviction views:

Higher quality corporate debt (+) offers compelling yields and spread levels as bright spots that should not be ignored. And their income provides a cushion against any negative price action resulting from spread widening. Investment grade credit offers a good option as recession risk concerns increase.

Infrastructure (+) appears well insulated from higher debt costs and elevated inflation. We favor U.S.-based utilities, midstream pipelines and waste management companies. For utilities, U.S. oriented operations and a supportive regulatory environment provide some insulation from geopolitical risks and allow inflation costs to be passed through to consumers. Additionally, the Inflation Reduction Act makes capital spending on green energy initiatives far more attractive. Midstream pipelines stand to benefit from the growing challenges of global energy scarcity as the world becomes more reliant on U.S. energy sources. Waste management companies should provide above-market growth thanks to unwavering demand for their operations, which translates to pricing power. Furthermore, infrastructure performance has historically been decoupled from economic growth (Figure 1).

Non-U.S. equities and debt (-) remain significant underweights. We believe risks remain concerning the strong U.S. dollar, uncertainty surrounding China, the ongoing Russia/Ukraine war and potential stagflation in the U.K. and Europe. In particular, we are most negative toward U.K. and European markets (where these risks are most concentrated) and slightly less negative toward emerging markets, which could improve if risks in China recede.