Three investment themes you need to know for the rest of 2023

Investment theme 1: Prepare for near-term equity volatility amidst uncertainty.

Investment theme 2: Buying bonds is one thing; buying the right bonds is another.

Investment theme 3: Position your portfolios for tomorrow, not just today.

The recession has been postponed, but it’s not time to pop the champagne.

Soft landing, hard landing, no landing? These terms seem to be front and centre in the financial media, and many aren’t even sure what they mean. In essence, the question is whether we’ll experience a recession or not in the U.S. and Canada. Year to date, despite economies absorbing the aggressive policy tightening we’ve seen so far, economic activity in developed economies have proved to be more resilient and avoided recessions amid potential job hoarding, pent-up savings, and a rebound in the services sector.

At this point in the cycle, the key for us is to try and identify where the balance of risks lies. Our best tool remains the same as we’ve used in the past: our table of recession indicators. While not perfect, the trend in economic data points helps to paint either a picture of improving or weakening economic health. We prefer to use a “traffic light” signal-based system; green is good, yellow is slowing, and red is full stop, indicating recessionary levels. We further break down the signals to whether they tend to lead the economy, occur at the same time, or lag. Given the economic data that we look at, it seems to suggest that the recession has been postponed but not canceled.

Inflation is trending lower but interest rates will likely stay higher for longer …

From energy to food to shipping, many of the factors that drove inflation higher over the past couple of years have eased considerably this year, this has been largely a result of base effects. However, core inflation remains stubbornly high—a result of a strong labour market and resilient consumer, which points to the risk that inflation doesn’t fall within central bank targets in the near term. As a result, we are led to believe:

• The market is premature in its pricing of dovish pivots from central banks (in the U.S., markets are pricing in six cuts for next year), both in terms of timing and magnitude. As a result, markets need to reassess the central bank put for asset prices.
• There’s a risk that even if the U.S. Federal Reserve pauses in coming months, the next move could be more tightening, not easing, due to the current dynamics of inflation.

Investment theme 1: Prepare for near-term equity volatility amidst uncertainty.

While we’re constructive longer term, there’s much uncertainty in the near term. We believe that equities are “priced for perfection,” with markets pricing in a soft landing, inflation that will trend lower in a linear fashion, and central banks cutting interest rates materially next year. In this environment, any headline surprises that may speak otherwise create the potential for downside risks.

Look no further than the recent negative market reaction following the headlines out of China and comments about the pace of inflation by the Fed at their most recent meeting. The fragility of the real estate market in China is top of mind for investors again with the recent news from Country Garden Holdings (one of China’s largest real estate developers) and the lack of positive impact on the Chinese economy from it reopening. Strong U.S. retail sales has illustrated the strength of the U.S. consumer, which has led Federal Reserve officials to express their concerns that further interest hikes may be necessary.

Although earnings have generally surprised to the upside, relative to expectations, in absolute terms, they’ve been weak. Given the indicators that we follow, we believe lackluster earnings growth is likely to continue moving forward. In the U.S., there’s a very strong relationship between the health of manufacturing and earnings. The weakness in manufacturing could put additional pressure on forward earnings. Corporations are also dealing with increased cost of goods, higher interest rates, and wages, which will provide headwinds to profit margins. This environment isn’t unique to the U.S. Year over year, South Korean export growth has historically had a strong relationship with both international and emerging market earnings growth. Currently, South Korea export growth has declined by nearly 16%, which illustrates the lack of near-term upside catalysts for global earnings.

And finally, we’re entering a historically weak period for markets, which could compound the impact of any negative headline news.

In environments such as these, it’s often best to look at individual security selection rather than specific geographies or sectors. Further, a well-diversified portfolio could help smooth out the ride should we experience choppy waters over the near term.

Investment theme 2: Buying bonds is one thing; buying the right bonds is another.

The opportunity in bonds is arguably the best it has been in 15 years, going back to the Global Financial Crisis. While there’s no denying this, we believe it’s more important to not just invest in bonds but the right bonds, at the right time. As we’ve written in the past, we believe the opportunity in fixed income is likely to unfold in three phases: clipping the coupon, duration is your friend, and take on risk.

The first phase has continued to play out well. Last year’s pain in fixed income provided an opportunity going forward—yields across most, if not all, fixed-income instruments, regardless of maturity, type, or credit quality, haven’t been this high in quite some time. This has allowed investors to benefit from the yield provided by the bond or “clipping the coupon.” We believe the sweet spot is currently in investment-grade bonds, those rated BBB or above, in Canada or the U.S. For these bonds, it's not just about the yield but about the potential for capital gains, given that the average price is approximately $88 and the majority mature at $100.

As noted above, we expect economic conditions to weaken, and we’re likely going to see a recession in both Canada and the U.S. We’re also getting close to the end of the Bank of Canada and the Fed rate-tightening cycles. Although, there’s no specific transition from one phase to the other, the weaker economic data is signaling that we’re nearing the second phase.

In this second phase, we want to begin embracing longer-duration and higher-quality fixed-income instruments, such as 10-year U.S. Treasury bonds. As the market starts to expect an elevated risk of recession, yields tend to fall. Since 1976, when the U.S. was in a recession, the 10-year U.S. Treasury yield fell by 35% on average. This means that the duration risk that was a headwind to bond returns as yields rose (remember that there’s an inverse correlation between yields and price) eventually becomes a tailwind. This is when the bond math kicks in, as the combination of longer duration and increase in price as yields fall tends to enhance bond returns.

In phase two, by increasing duration and quality while transitioning to longer-dated government bonds, investors could potentially be mitigating risk while also likely increasing their return opportunity. However, the elevated levels of volatility in the Treasury curve, show how important it is to be flexible and active when managing fixed income. It’s not as simple as choosing to be short or long duration.

High-yield corporate credit has been one of the best-performing fixed-income asset classes year to date. However, we believe investors should exercise caution here. While there are attractive individual opportunities, the broad asset class isn’t reflecting the weaker economic environment.

The U.S. Conference Board’s Leading Economic Index (LEI) is now at levels not seen since COVID and the Global Financial Crisis before that. Historically, at these levels of LEI, high-yield spreads have been closer to 1000 bps, not below 400 bps where they find themselves today.

If the weak economic environment continues, the risk of high-yield defaults is likely to increase, leading to wider spreads, which would result in downward pressure on prices. While current yields are attractive, the risk in low-quality credit at this point in the cycle doesn’t seem worth it. During the third phase, once spreads widen out, there’ll be a time to reallocate to high yield; this just isn’t it.

Investment theme 3:  Position portfolios for tomorrow, not just today.

There have been many surprises year to date from both an economic and market perspective. However, given the data that we follow, we believe it’s premature to pop the champagne and declare victory over a recession. While we’re constructive on the longer-term outlook for equities, we believe it’s prudent to overweight fixed income over the near term, relative to a traditional 60/40 portfolio (equities/fixed income). The risk-adjusted return opportunity is currently more attractive for bonds than equities.

Within a context of a slowing global economy, geopolitical risks that remain heightened, falling but sticky inflation, and central banks that are committed to higher-for-longer interest rates, a lack of equity market volatility can give investors a false sense of security. This environment may cause near-term choppiness in equities. A kneejerk reaction to either jump on a bandwagon or out of the markets based on shorter-term market movements could quickly push an investor off course. A portfolio that’s properly positioned for what comes next will help investors remain focused on their longer-term goals.