A new investment era?

Portfolio construction in a slowing economic environment

February 22, 2023 | 6 min read
Todd Jablonski, CFA
Chief Investment Officer & Global Head of Multi-Asset and Quantitative Investments
Seema Shah
Chief Global Strategist
Download PDF
Share this article by:
mail icon linkedin icon link icon

Stimulus from global central banks has been a hallmark of the investment landscape since the Global Financial Crisis (GFC). In 2008, before the GFC had started, the four largest global central banks had a total of $6.5 trillion of assets on their balance sheets. By 2019, the G4 balance sheets had almost doubled to $12 trillion—and just two years later, in 2021, they had doubled yet again to $26 trillion!

The decade following the GFC was a golden period for investors, as central banks aggressively expanded their balance sheets in order to stimulate the economy. In fact, just owning the S&P 500 delivered a 16% per annum compound annual return from 2013 all the way through 2021. However, the golden period ended abruptly in 2022 as global central banks started to aggressively raise policy rates and shrink their balance sheets, moving decisively away from ultra-easy monetary policy in an attempt to combat surging inflation.

The reversal in global central bank policy has led an almost unrecognizable global investment landscape. Unlike the golden era of the past decade where low inflation and low interest rates were suppressing volatility and lifting asset prices, it seems possible that higher inflation and higher interest rates will be the primary forces dictating market dynamics in the decade ahead, irrespective of economic growth. Investor behavior will need to adjust: Expectations for returns need to be lowered, expectations for volatility need to be raised and, above all, additional investment discipline will be required.

At the onset of what is likely a new investment era, reallocating to address key risks will be crucial to potential outperformance. Investors today would be well suited to ensure their exposures to market, systematic and implementation risks allow them to take advantage of market inefficiencies and to minimize vulnerability to macro-driven threats.

Market risks

Decrease equity risk

Equity markets may have started 2023 well, but that may prove to be temporary respite. In 2023, not only are further rate hikes expected, but the Federal Reserve (Fed) is unlikely to deliver any rate cuts even as the economy falls into recession. As a result, markets will start shifting their attention to the next serious concern: Earnings recession. A conservative Principal Asset Allocation model points to an earnings contraction in 2023—a headwind that will, inevitably, renew and extend the equity market drawdown with the S&P 500 potentially re-testing its September 2022 lows.

Increase interest rate risk

After a particularly tough 2022, U.S. 10-year Treasury bonds now yield more than twice the estimated dividend yield of the S&P 500 Index. This presents investors with the opportunity to lock- in income with a less volatile asset. Additionally, with yields having risen, inflation slowing, and central banks closer to the end of their hiking cycle, bonds are positioned to provide risk mitigation during the coming economic slowdown. The negative correlation between stocks and bonds has reasserted itself, and the diversification benefit of fixed income has been restored.

Increase alternative beta

Alternatives have strong defensive characteristics which are important in today’s macro environment. In addition, they offer diversification benefits against traditional equity and fixed income. Not only do real assets, such as commodities and natural resources, offer inflation mitigation characteristics, but other alternative investments such as listed infrastructure provide stability of cash flows and exposure to the structural de-carbonization trend.

Neutralize currency risk

Central banks are entering a phase when markets are anticipating policy pivots, while resilient economic growth in certain segments of the globe are prompting questions about relative economic strength. Against this backdrop, sudden and inexplicable large movements between currencies are possible. Ultimately, given the already elevated volatility that the inflation and interest rate outlook will create, investors may want to focus on market risks they have a degree of confidence in and avoid the outsized, unintended negative risk that currency movements could bring.

Systematic risks

Avoid equity factor risk

Multi-factor investing was very mixed in 2022 with the difficult macro conditions making it tough to pick winners and losers. This year, there appears to be no obvious trend for growth versus value due to the unusual slowing growth/high policy rates combination. Similarly, the large- vs. small-cap story is unclear given contradictory signals from fundamentals and valuations. In fact, mid-cap equities offer to bridge the gap between small- and large-cap equities, not only trading at a meaningful discount to large caps, but their greater defensive sector exposure also means mid-caps are less vulnerable than small-caps to the tough economic backdrop.

Offset credit risk

With the days of cheap funding and abundant liquidity firmly in the past, and the economy slow- walking into recession, riskier credit segments will likely see fairly significant spread widening during 2023. Dialing down spread risk should be offset by increasing exposure to core fixed income, such as government bonds, investment grade, securitized debt. Not only should they have sufficient buffer to weather the storm, they are also now offering more attractive yields than in recent years.

Mitigate inflation risk

Until 2021, inflation had remained so low across the global economy that investors hadn’t needed to consider including inflation mitigating assets in portfolios. But now, with inflation unlikely to decelerate sufficiently to reach central bank targets this year, and potentially even re-surge if labor market supply-demand conditions remain so tight, inflation mitigation has become a defining portfolio trait. Asset classes which have a positive relationship to inflation, such as commodities and infrastructure, should sustain strong performance throughout this year.

Decrease liquidity risk

The tightening of financial conditions is removing the easy access to capital and, as a result, liquidity risk has increased over the past year, posing risks to financial stability. This has recently been underscored by the stress in the UK government bond market which required the Bank of England to intervene in order to avoid a national pension crisis. Prioritizing exposure to asset classes that can be liquidated easily in the event of spiking systemic risk concerns is advised. Equally, exposure to liquid assets can also enable a swift increase in exposure to riskier assets as valuations become more attractive and conditions eventually improve.

Implementation risks

Increase idiosyncratic selection risk

Without easy monetary conditions to lift the broad market and economic weakness likely to make conditions very challenging during 2023, manager selection in this environment is of increased importance for investors. Managers who, instead of trying to bet on a market or an industry, understand company specific components and are able to distinguish winners from losers based on core strengths, balance sheets, and exposure to important structural trends, will likely yield favorable results in this environment.

Increase manager tracking error

In this environment, with interest rate and economic growth risks stacking up, investors may believe it is better to hug the benchmark. Yet, the opposite is true. Now is the time to focus on managers that have strong views and conviction and are willing to increase active risk where they can be rewarded to do so in order to capitalize on market inefficiencies. When markets are challenging, that is the time to focus on true issue selection and increased budget for manager alpha.

Portfolio implications

The investment landscape today is much changed from the golden era of the last decade. With central banks no longer carrying all asset prices higher, investors need to thoughtfully reconsider their portfolio construction process and reallocate their risks to both take advantage of market inefficiencies and to minimize exposure to macro-driven threats. This new era is one where strong conviction and deep understanding of company and sector will be prized, and outperformance will be driven by discipline, diversification and active management.

Asset allocation
Equities
Fixed income
Disclosure

Risk considerations
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Equity investments involve greater risk, including higher volatility, than fixed-income investments. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation/protection strategy will be successful.

Important Information
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.

This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

This material is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.

This document is intent for use in:

  • The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission.
  • Europe by Principal Global Investors (EU) Limited, Sobo Works, Windmill Lane, Dublin D02 K156, Ireland. Principal Global Investors (EU) Limited is regulated by the Central Bank of Ireland. In Europe, this document is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by the MiFID). The contents of the document have been approved by the relevant entity. Clients that do not directly contract with Principal Global Investors (Europe) Limited (“PGIE”) or Principal Global Investors (EU) Limited (“PGI EU”) will not benefit from the protections offered by the rules and regulations of the Financial Conduct Authority or the Central Bank of Ireland, including those enacted under MiFID II. Further, where clients do contract with PGIE or PGI EU, PGIE or PGI EU may delegate management authority to affiliates that are not authorized and regulated within Europe and in any such case, the client may not benefit from all protections offered by the rules and regulations of the Financial Conduct Authority ,or the Central Bank of Ireland.
  • United Kingdom by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London, EC2V 7 JB, registered in England, No. 03819986, which is authorized and regulated by the Financial Conduct Authority ("FCA").
  • United Arab Emirates by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization.
  • Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act 2001. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.
  • Australia by Principal Global Investors (Australia) Limited (ABN 45 102 488 068, AFS License No. 225385), which is regulated by the Australian Securities and Investments Commission. This document is intended for sophisticated institutional investors only.
  • This document is marketing material and is issued in Switzerland by Principal Global Investors (Switzerland) GmbH.
  • Hong Kong SAR (China) by Principal Asset Management Company (Asia) Limited, which is regulated by the Securities and Futures Commission and is directed exclusively at professional investors as defined by the Securities and Futures Ordinance. Other APAC Countries, this material is issued for institutional investors only (or professional/sophisticated/qualified investors, as such term may apply in local jurisdictions) and is delivered on an individual basis to the recipient and should not be passed on, used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
  • Nothing in this document is, and shall not be considered as, an offer of financial products or services in Brazil. This presentation has been prepared for informational purposes only and is intended only for the designated recipients hereof. Principal Global Investors is not a Brazilian financial institution and is not licensed to and does not operate as a financial institution in Brazil.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800 547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc., and Principal Securities are members of the Principal Financial Group®, Des Moines, IA50392.

© 2023, Principal Financial Services, Inc. Principal Asset ManagementSM is a trade name of Principal Global Investors, LLC. Principal®, Principal Financial Group®, Principal Asset Management, and Principal and the logomark design are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company, in various countries around the world and may be used only with the permission of Principal Financial Services, Inc.

2728338
About the author