Commentary
The market’s fixation on inflation and the Fed’s interest rate moves appears, at least for now, over.
We’re moving onto real concerns such as an economic recession, and for investors, a corporate earnings and growth decline as a result of said recession.
This column isn’t going to predict where the S&P 500 will end next year. Nobody knows. In fact, few investors alive today have experience dealing with the confluence of factors impacting the current economy. The most successful of us will need to effectively navigate through a series of known unknowns (How bad is the recession? When will rates plateau? Will the Fed pivot to QE?) and unknown unknowns (Geopolitics? War escalation? Another pandemic? And how does all this impact the economy and markets?)
Despite this ominous introduction, not all is lost. Investors should be prepared to use a few tools depending on how the year unfolds.
Be Defensive
This is partially math. Let’s say you have two portfolios, one fairly defensive and one aggressively growth-oriented, with $100 in each account to start. The defensive portfolio makes a modest 7 percent total return in 12 months (e.g. 5 percent appreciation and 2 percent dividend yield), ending at $107. The aggressive portfolio loses 10 percent in the first six months. It would need to gain an additional 19 percent the rest of the way to achieve parity at the end of the year with the defensive portfolio (to end at $107).Put differently, in the long term it’s usually better to pass up higher returns than to suffer losses.
What are defensive stocks? It generally refers to industries that are less economically sensitive such as consumer staples (food and drinks, household products, grocery stores), healthcare (people need medicine and treatments regardless of the economy), defense and infrastructure (usually funded by government budgets), and utilities (your local electricity distributor). There are certain companies in other industries that tend to perform well in economic downturns such as off-price retailer TJX Companies, department-store Walmart, tobacco company Philip Morris International, among others.
Even with companies in the right industries, prioritize firms with solid balance sheets (e.g. low debt burden), records of positive profits, long-tenured management teams, and those who pay dividends—but make sure those dividends are well-funded by positive earnings.
Don’t Depend on Index Funds
The last decade-plus has given rise to so-called “index funds” that track the market, or a particular index. This has been popularized by funds and ETFs (exchange-traded funds) managed by Vanguard, State Street / SPDR ETFs, BlackRock / iShares, among others. Its idea was that a rising tide lifts all boats and investors were content with riding along with the market.Well, the tide is receding and performance differentiation is now critical. Investors should consider funds managed by active managers who have a positive track record, experience investing in downturns, and longevity. Index funds are cheaper and more preferable in rising markets, but in choppy markets with violent price swings, 50 basis points of “lower expenses” isn’t going to make a difference.
As a side note, investors should treat most social media investing “influencers” as what they are: entertainers. During the last two years, anyone could shill NFTs and meme stocks which were all going through the roof. Prioritize guidance from real professionals with decades of experience in the business.
Prioritize Income
After an atypical year where both bonds and equities fell, many experts predict bonds will show a good return in 2023.“With the bulk of rate hikes behind us and the Fed’s “slower but longer” approach taking shape, we think it makes sense to modestly increase duration through bolstering core bond allocations, especially in investment grade credit,” Nuveen Asset Management wrote in its 2023 preview for clients. The firm has the highest conviction in high-quality corporate bonds.
The risk/reward tradeoff for bonds has significantly improved, and the current market environment represents a very compelling entry point. Even if benchmark rates continue to go up, its impact on bond valuations should be more muted than on equities.
MacQuarie Asset Management agrees. It recommends developed markets government bonds and corporate bonds but urges investors to stay away from emerging markets debt as some of the underlying fundamentals are much weaker, the firm wrote in its “2023 Outlook.”
Keep an Eye on the Future
Despite the overall defensive positioning it’s still wise to place a few secular, thematic bets.One theme is deglobalization and onshoring. This is caused by rising labor costs in emerging markets but also due to geopolitics as China and Russia continue to isolate themselves. Setting up new production capabilities requires a significant source of raw materials, commodities, and energy. Think of miners such as BHP Group, chemical companies such as Dow, and energy firms such as ExxonMobil.
Another shift is the world’s aging demographics. Boomers are retiring or retired, and there’s a significant demand for medical services, affordable drugs, etc. Investors can look at real estate investment trusts (REITs) that own senior housing, dialysis and care centers, and medical offices. The healthcare industry, aside from being defensive in nature, also benefits from an aging population.
War preparation and defense is another secular trend. The ongoing conflict in Ukraine has highlighted to many countries the importance of investing in self-defense and defending allies. Germany and the EU are increasing their budgets, as is Japan. China’s belligerent stance against Taiwan is another wake-up call. Aside from these new risks, many countries’ military equipment is in desperate need of upgrade. Defense and aerospace firms such as Lockheed Martin, Raytheon, and Northrop Grumman are some of those that could benefit.
These are long-term trends not just for 2023. But as the country tips into a recession, market valuations next year can offer a good entry point for a long-term investment.
