Prepare for rising rates — We continue to favor shortening duration in fixed income, given our expectation for higher longer-term yields and wider credit spreads. Where appropriate, investors might consider pursuing fixed income opportunities that can increase return potential without adding undue duration risk (e.g., convertibles, bank loans, CLOs).
Stay the course with equities — Given ongoing geopolitical uncertainty, we expect to see risk premiums in the global equity and credit markets, particularly in Europe and EMs. However, given the asset repricing we’ve already seen, the likelihood of less hawkish developed market central banks, and extremely bearish investor sentiment, we expect global equities to outperform bonds over a 12-month horizon. Again, we generally prefer Japanese and US equities.
Inflation risks: Higher for longer — Shortages of some commodities and supply-chain disruptions stemming from the Russia/Ukraine situation could drive commodity prices even higher. Allocators may thus want to consider adding greater exposure to commodities, the asset class that has historically been the most sensitive to higher inflation. We think Treasury Inflation-Protected Securities (TIPS) are likely to outperform US Treasuries in the period ahead. Higher yields and inflation should support value stocks, but on the other hand, weaker economic growth would favor growth stocks. Tapping into the inflation protection that may be available in some areas of the REITs market could be an attractive strategy as a liquid complement to an insurer’s private real estate portfolio.
Consider defensive assets — US equities, unhedged Japanese equities, and gold are likely to hold up relatively well should global growth weaken amid geopolitical uncertainty. In addition, high-quality government bonds may regain some of their portfolio diversification role during bouts of turmoil. Within equities, we think the focus should be on quality: Domestically oriented firms, service companies, and profitable businesses with growth potential may be more insulated from geopolitics. Greater military spending by Europe is likely and may warrant a closer look at defense stocks (though ESG considerations could limit such allocations).
Active management may play a role — In an environment of increased market volatility, higher dispersion of returns, and likely worse liquidity, active investment managers have the opportunity to distinguish between “winners” and “losers” and can seek to take advantage of price dislocations that may not be justified by underlying fundamentals at both the country and individual company levels.