Treading carefully: A balancing act in 2023
The Portfolio Construction and Strategy (PCS) Team introduce the latest Trends and Opportunities report, which outlines key themes for the next stage of this market cycle and their nuanced implications across global asset classes.
- As we enter a new era characterized by structurally higher rates and fresh discounts across major global asset classes, investors will need to tread carefully.
- However, while we think volatility will continue in the year ahead, we also believe that volatility may present a silver lining for those who are bold enough to forge ahead.
- The portfolio solutions we highlight in this edition have the potential help navigate this new environment and address the ubiquitous asset allocation gaps and concentrations we see in investor portfolios.
Global Portfolio Construction and Strategy Team
PCS Trends and Opportunities Video
Severe, unprecedented market shocks of slowing growth, inflation and a historic interest rate reset. That was 2022. Now we enter a new era with structurally higher interest rates and fresh discounts across major global asset classes.
To help investors venture into this new territory. We're pleased to announce our latest Trends and Opportunities Report, where we outline the next stage of this market cycle and its nuanced implications across global asset classes.
This edition is called Treading Carefully, which could mean a few things. Will 2023 be the year that investors fight to stay afloat in murky economic waters? Or will it be one in which they will be rewarded for carefully pushing through uncertainty and volatility?
We think treading carefully is a matter of balancing both of those interpretations. So we designed this edition to be the appropriate mix of defense and offense to balance portfolios in 2023.
Let's start with equities. One of 2022’s many mind benders was that duration wasn't just the typical fixed income risk, it was a major risk driver in equities. And so the historic speed and magnitude of interest rate increases was the main driver of losses for the S&P 500.
The silver lining being that the S&P 500 entered 2023 with a forward P/E of roughly 17-and-a-half. That's in line with its long term historical average valuation.
So now the focus for U.S. large cap investors shifts from the P to the E, which means finding resilient earnings amid an economic slowdown. Meanwhile, U.S. small- and mid-cap stocks historically outperformed large-caps during the early stages of recoveries, which is arguably the stage we're in now.
Looking further afield, unlike U.S. stocks, ex-U.S. developed market equities carry a better valuation discount, potentially offering a better margin of safety to help absorb some earnings weaknesses.
Couple this discount with a more cyclical, higher yielding characteristics and ex-U.S. equities present strong upside potential.
Looking across all global equity sectors, health care was the second-best performer in 2022, trailing only the energy sector. While we are looking to health care as a whole for its resiliency, we also see biotech as an important subsector that is offering attractive discounts as it potentially recovers from a severe drawdown.
European Equities present a fascinating opportunity. It's widely expected that a large proportion of the global economy will move into what is hopefully a shallow recession in 2023. So we want to think about where the beneficiaries of that recovery are going to come from. European equities are generally much more cyclical than other markets, which should position the region well for recovery. At the same time, Europe is showing lower relative valuations and a greater discount to history compared to the U.S.
2022 was a year that most fixed income investors would love to forget. But the worst generational sell-off and bonds now leave some obvious silver linings, namely the return of yield cushion. On the short end of the curve, many global yield curves are inverted, meaning investors get higher yields than their intermediate duration counterparts without having to take on as much duration risk.
But the longer end of the curve is also looking attractive. After the rerating in 2022, intermediate duration bonds now offer more of a buffer against potential future rate volatility, while also providing the opportunity for capital preservation should equity volatility persist and rates come down.
Finally, credit is offering some extremely compelling opportunities after the reset in rates and moderate spread widening in 2022. If spreads widen ahead of a global economic slowdown, the higher starting yields can provide a cushion against potential losses.
Treading carefully requires that delicate balance of defense and offense. So we're focused on providing balanced, realistic portfolio solutions not just for this environment, but also for the common gaps and concentrations we see in client portfolios during our custom consultations. We hope you find our latest edition of Trends and Opportunities useful as you navigate these markets. Please visit our website to view and download the report.