CIO Roundtable: Risk-On in 2023? When, Not If

Rising interest rates and elevated inflation cost the breakdown last year of age-old negative correlation between equities and fixed income. Will it last, and how do asset allocators manage asset class exposures going forward?

At the same time, high inflation and interest rates continue to trouble markets. How should investors factor slowing economic growth, declining corporate earnings and rising recession risks into investment decision making—and is there a light at the end of the tunnel?

Hear our CIOs’ thoughts on what they expect will move markets, asset classes and sectors. Read key takeaways from the replay below.

Pondering a Pivot: Markets Have Been Wrong

The markets have been pricing in two rate cuts later this year. We think many people have been underestimating the Fed’s resolve, although that now appears to be changing. We haven’t anticipated any rate cuts in 2023. Rather, we expect the Fed to push rates on the front end to 5%-5.25% and hold there through the end of the year.

Fed Reluctant to Rush to Declare Victory on Inflation

We believe inflation may have peaked, but long-term, structural inflation forces remain entrenched. The war in Ukraine, conflict with China, supply chain repositioning, a tight labor market and higher energy prices are all factors that could keep structural inflation higher for longer.

No Mistake About It: The Slowdown Is Here

Recent economic data from various sectors confirm that the economy is slowing, and in late January, the Commerce Department reported that the U.S. annualized GDP slowed to 2.9% in the fourth quarter. Moreover, the Federal Reserve Bank of Atlanta projected that the annualized GDP rate would slip to 0.7% in the first quarter.

We believe it’s even more likely that the economy slides into a recession the longer the Fed holds short rates high. Our current analysis points to a 70% chance of recession and a 20% chance of stagflation. The key question for us is how long and deep will the downturn be?

Optimistic About Bond Returns

Bond yields today are much higher than this time last year—actually, higher than any time in nearly two decades—and there are attractive opportunities across the yield curve. One of our fixed-income team’s highest conviction trades is being overweight duration since the last quarter of last year. We believe the potential for rates to decline is greater now. And if the economy slides into a recession, the 10-year yield has the potential to decline from current levels and produce positive returns for bond investors. A barbell strategy might be beneficial in this environment.

We’re cautious on credit risk, and credit spreads could widen late this year or early next year.

Still Bullish on Value Style

Value stocks typically have outperformed during inflationary environments. But in our view, the value style has more going for it than just current central bank policy. First, valuation spreads are still relatively wide. Second, dividends, which historically have represented about 40% of total returns (in some decades, the majority of the returns), could be more important this year.

Health care is currently one of our biggest overweights across all the portfolios that we manage. In general, health care is less cyclical than other industries and has been more durable during periods of economic slowdown and recession. Additionally, industries like medical devices and pharmaceuticals typically have a handful of large competitors with strong balance sheets dominating market share, which tends to lead to stable pricing and high return on capital.

Quality Stands Out

Quality has been an integral part of our value discipline since inception nearly 30 years ago. While we’re admittedly a bit biased, we believe quality has a long runway ahead of it. Empirical evidence and our experience suggest higher-quality stocks should outperform lower-quality stocks in a recession or amid stagflation. In general, higher-quality companies with higher return on capital, higher margins, less leverage, more protected market share and healthy free cash flow have an easier time weathering both environments.

And if the Fed doesn't have the flexibility to get as accommodative as it would like in the next recession due to lingering inflation, then we could see a wider spread than usual in the outperformance of higher quality versus lower quality.

What About the Dollar?

We are mindful that dollar valuation is still very high and is subject to markets’ pricing of the U.S. inflation and recession. We think the dollar is likely to be under more pressure moving into the second half of the year as growth slows and it becomes clearer when interest rates could fall.

Risk On: When, Not If

In our multi-asset strategies, we remain conservatively positioned at the margin, underweighting equities and REITs in favor of high-quality fixed income and cash. Current yields on high-quality fixed-income instruments simply make sense in light of all the economic, financial and political uncertainty. Plus, price/earnings ratios on the S&P around 17-18 times earnings mean there’s potential for further downside, particularly when you consider an earnings recession.

However, risky assets tend to lead the economic cycle, and we’re prepared to rotate from the more defensive sectors to financials, real estate and other early cycle industries in the equity markets. REITs, domestic equities and non-U.S. equities, especially emerging markets, could end the year with strong returns, assuming a recession is not atypically long or deep.

China's fiscal position and economic model are weak, which could be a drag on a recovery. But that said, emerging markets debt could fare well, particularly if dollar strength turns its way.

Timing is tricky, but we believe we could see a rebound in risky assets this year—possibly presenting some of the best buying opportunities in maybe a decade.