Stay in the game: Investing in a late-cycle world

October 31, 2023 06:00
Photo: Reuters

While concerns of inflation, monetary policy and a possible recession continue from the previous quarter into the fourth quarter of 2023, an important variable has changed: The economic cycle is further along, with the game clock running down. A winning investment strategy in this environment calls for getting off the sidelines and positioning portfolios for attractive late-cycle opportunities while they’re still in play. Fortunately, investors still looking to transition from benchwarmer to potential benchmark-beater still have time to get their head — and their portfolio — in the game.

It is too soon to know whether the exact nature and timing of the cycle’s resolution will be a foregone conclusion or an odds-defying upset, but markets haven’t been shy about placing their bets and cheering (or jeering) from the stands. Over the summer and leading up to the US Federal Reserve’s decision to hold rates steady in September, our outlook has differed from the consensus on two key points. Firstly, we believe inflation and interest rates will stay higher for longer, and, secondly, we don’t expect US rate cuts in early 2024. For now, these views remain aligned with the Fed’s actions and rhetoric, including the possibility of one more rate hike in 2023. This backdrop suggests a few prominent portfolio themes.

You can’t win if you don’t play

No team wants to forfeit a game by not showing up or by failing to put their best foot forward. And once play begins, victory is more likely if the lineup that’s best-suited to execute specific offensive or defensive maneuvers is on the field when needed most. In investment portfolios, cash can play a useful role, but it isn’t the ideal “go-to” asset class for achieving late-cycle outcomes.

While investors should keep a portion of their portfolios in cash or cash equivalents, strategically overweighting cash is rarely wise, particularly now. Many investors say they are intentionally sitting on large levels of cash, waiting for better opportunities. Or, in a related issue, institutional investors are putting off asset allocation decisions or delaying policy rebalancing until more clarity emerges.

Historically, however, investors have moved to cash at precisely the wrong times — when rising short-term interest rates were near their peaks— and in doing so have often missed out on opportunities to generate portfolio returns above the risk-free rate.

Relatively high cash yields are tempting some investors to maintain elevated cash allocations. But they’ll also need to stay focused on the risks — especially the risk of forgone gains. Historically, long-term yields peak just as the Fed completes a hiking cycle. This presents an argument for investors to modestly extend duration rather than overallocate to cash.

We expect global economic growth to slow over the coming quarters, with inflation and rates moderating. Cash yields would likely fall during this time as a result. In our view, investors would be better off rethinking their income strategies and seeking areas of the global financial market offering compelling risk/return profiles.

Not all income can be scored the same way

Income generation in the current climate will likely require a number of potential contributors, starting with duration. Most markets (including the US) appear to be near the end of their interest rate hiking cycles. Rates should become less volatile, with fixed income yields remaining in a trading range for at least several quarters before we begin to see interest rate cuts. This suggests investors would benefit from modestly extending duration to lock in attractive yields and position for an eventual fall in rates.

Additionally, generating yield in three different categories — defensive, alternative, and credit— allows investors to diversify income sources to meet specific portfolio needs. Defensive income portfolios seek traditional and more conservative income highly correlated with interest rates. Such a portfolio would be overweight investment grade corporates, municipals and securitized assets. Alternative income portfolios seek low correlation to economic factors. They include a broadly diversified range of investments — including preferred securities, real estate, private credit and farmland — balanced with more traditional short-term fixed income. Credit income portfolios seek greater yield per unit of risk and are intentionally highly correlated to credit risk. They could include heavier allocations to high yield credit and municipals, private credit and senior loans.

Cover the entire field, naturally

Beyond certain fixed income opportunities, our favored investments for late-cycle portfolios include global natural capital. Farmland, timberland and agribusiness typically offer steady, long-term cash flows and illiquid profiles that keep them relatively insulated from short-term market dynamics. There is compelling long-term potential in projects focused on protecting global environmental health broadly and biodiversity in particular. Among our favored areas are row crops (especially in the US) with high farm margins and strong demand. And some permanent crops, including grapes in Australia and Chile, offer compelling geographic and asset type diversification.

The global economy is strongly linked to the overall health of the global environment, and the world is investing heavily to restore the Earth’s biodiversity via agreements such as the COP15 Global Biodiversity Framework. The proliferation and sophistication of ESG data, coupled with natural capital frameworks, disclosures and engagement initiatives, brings these investment projects to the forefront of responsible investing opportunities.

In our view, focusing on natural capital investments that can protect, improve and restore natural capital assets such as freshwater and soil while also lowering greenhouse gas emissions can improve the resilience of farmland returns, as well as drive additional uncorrelated sources of revenue from ecosystem service payments.

Play it defensive across the equity spectrum

The public equity market has been propelled higher for much of 2023 by a handful of technology companies. While markets have broadened recently, broad public equity markets present a less-than-compelling risk/reward profile at current valuations. Solid opportunities exist in dividend-paying US equities and select emerging markets, but overall we suggest a defensive, neutral stance. Shifting to private equities, many clients are asking when conditions are likely to improve. Deal flow has remained depressed due to concerns around issues such as rising input costs and supply chain disruptions that have been impacting margins of private businesses. Bright spots are emerging in motivated/distressed sellers or in smaller, highly opportunistic deals, but it is expected that it will take a couple of quarters for the overall market to substantially improve.

We remain neutral toward public equities, although differentiation is growing within and across markets. Stocks have rallied over the last few months, thanks in part to diminishing recession fears, but a narrow slice of the technology sector has driven much of the increase. We’re not ready to call an end to the rally, but the headwinds of high interest rates, persistent inflation and geopolitical uncertainty create risks. Equity valuations looked rich even before the rally, and investors should remain wary of possible earnings deteriorations. Continued volatility is likely, and overall defensive positioning combined with select risk taking is recommended.

We prefer listed infrastructure and US large cap stocks, especially dividend-growers and high-quality growth companies within tech industries like software and semiconductors. As for risk taking, there are opportunities in select emerging markets that feature relatively attractive valuations, improving earnings and a potential boost should the US dollar weaken. Brazil and Mexico are particularly appealing, based on valuations and a better inflation outlook.

In contrast, we’re less favorable toward non-US developed markets, many of which are still hiking interest rates and facing economic weakness (Germany is already in a recession). Additionally, we’re not yet comfortable enough to upgrade our view on US small caps, although this segment tends to perform well coming out of a recession. We see more value and opportunities within private equity and expect deal volume to climb in the coming quarters.

Keep your eye on the ball

Private credit remains a favored area. Investor demand is high and investment fundamentals look strong. More resilient areas such as healthcare, software and insurance brokers are relatively well-positioned to withstand economic downturns. Infrastructure should hold up relatively well amid prospects for slowing economic growth. Both public and private infrastructure look compelling, especially the attractive valuations within public infrastructure. Municipals should see ongoing tailwinds from high demand and solid fundamentals. The market’s relatively long duration profile also creates potential advantages in the shifting interest rate environment.

We believe the advantages of remaining fully invested through an uncertain environment outweigh the risks of staying on the sidelines. To be sure, the backdrop is tricky. While inflation is slowly moderating, economic growth is slowing as well, and the risk of a hard economic landing cannot be ruled out. Most markets are probably close to the end of policy tightening, but that doesn’t mean easing is on the near-term horizon. It may be tempting to allocate more to cash and wait for further clarity, but we believe investors should stay in the game and continue seeking opportunities for portfolio growth and income generation, even if that means looking in unexpected areas.

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Chief Investment Officer, Nuveen