Where to go from here: Insights from three experienced investors
In thinking about the possibility that we are in a late-stage world and may, in time, need to navigate a market downturn, I’m reminded of a quote often attributed to John Maynard Keynes: “Markets can remain irrational longer than you can remain solvent.” I think that speaks to the need to find a middle ground between what is rational on the one hand and the potential for markets to go to extremes on the other. With that in mind, I want to share insights from several Wellington portfolio managers on navigating a late-cycle environment.
Insights from a value manager
Adam Illfelder, a value equity portfolio manager, offered a number of thoughtful points:
The start of a recession and the bottom of a market may line up — This is a reason to consider preparing for a recession ahead of time. By the time the recession starts, the market may already have bottomed. On the other hand, Adam reminded me of a quote from the economist Paul Samuelson: “The stock market has predicted nine out of the last five recessions.” In other words, markets can sell off for the wrong reasons, a point worth factoring into portfolio decisions at this stage.
We may be in a rolling recession by industry — Adam first observed this in the industrials and durables space — coming out of the pandemic and the related supply chain issues, these sectors in particular were feeling earnings pressure. Then came the challenges faced by banks and other financials in early 2023. This past summer, the consumer discretionary sector was caught up in concerns about weakening consumer spending — given the return of student loan payments, for example. And most recently, the utilities industry has been roiled by rising interest rates.
What to do now?
All in all, Adam’s outlook is better than might be expected. He thinks the “rolling” nature of the recession to date suggests that any broader recession that arrives is likely to be shallow. In addition, he notes that not many industries have been over-earning recently, which should mitigate the chance of a sharp downturn from here. Finally, if mega-cap stocks are excluded, he believes valuations, at right around median, are not overly extended.
With all of this in mind, Adam is trying to be sensitive to the potential timing of a recession and a market bottom by being careful in portfolio decisions not to “pick up nickels in front of a steamroller.” He’s focused on bottom-up analysis and finding stocks that are already discounting a recession. He is also remaining wary of traditional defensive positions — areas like utilities and REITs that might struggle if interest rates remain higher for longer — and focusing on quality.
Insights from a diversified global equity manager
Kenny Abrams, a 37-year Wellington veteran who manages small-cap and large-cap strategies, focused on the market concentration concern:
Today’s very narrow market is not sustainable — Under the surface, Kenny sees a number of risks that could change the picture, including reduced spending on technology if companies don’t think the productivity gains are there. He also sees regulatory risk driven by the dominance of the “Magnificent Seven,” and he points out that, as he’s seen in previous regimes, even just a change in market leadership can be the catalyst for a bear market.
What to do now?
Kenny is averse to timing the market, preferring to stay fully invested and focus on picking his spots with resilient companies that don’t need to raise equity or debt to deliver on their growth. With companies he already owns, he’s repricing their debt stack at current rates to make sure the business model still works. He’s also being careful about making sector and country bets, which could pose more risk than intended if we end up in a meaningful bear market.
Notwithstanding Kenny’s market concerns, he believes we are entering a “golden age of active management” — a period in which fundamentals truly matter and can point to clear differentiation between winners and losers in the market. Given how much the cost of funding has risen and the need many companies will find they have to deleverage, this could be a moment when active managers can shine at finding those truly resilient companies.
Insights from a fixed income portfolio manager
Brij Khurana, who manages opportunistic fixed income strategies, offered a number of differentiated views:
Consider buying market leadership until there is high confidence a recession is materializing — Brij believes that market leadership continues until the cycle has ended. He’s less concerned about narrow market leadership, arguing that’s how cycles work, as prices deviate from fundamentals. That said, Brij believes a recession is imminent and, therefore, that now may be the time to sell market leadership.
Time to position for the next cycle? — In Brij’s view, the current cycle started in September 2020 and the message was “stay out of bonds,” while mega-cap stocks and energy were the big winners. He thinks now is the time to position for the next cycle and sees a clear case for bonds. Part of what’s driving his view on bonds is a belief that there’s a greater risk of a bad economic outcome than is reflected in the markets. While consumer and business balance sheets may be strong, Brij argues they have been propped up by government spending, which is expected to soften. He also worries about the Fed’s reliance on lagging indicators, which could lead the central bank to overtighten or, in the case of an economic slowdown, cut less aggressively than required. Either outcome runs the risk of a significant recession.
What to do now?
Brij believes this is a time for fixed income investors to add duration. He thinks inflation-linked bonds are attractive, particularly if real yields fall — a possibility in a world without much economic growth or productivity. He also favors duration, especially outside of the US, where markets have tightened more and government spending has been less stimulative.
Final thoughts and implementation ideas
I’m not quite as bearish as Brij. I agree that businesses and consumers have benefited from government support but think we could see another year or two of reasonably strong fiscal spending — enough to postpone a downturn. This suggests that allocators should be prepared for a late-cycle world that persists. That means taking yield-curve inversion with a grain of salt. It’s been 18 months since the curve inverted and we haven’t had a recession yet. It’s certainly possible we could go another 18 months. In terms of specific implementation ideas, I’d offer the following:
Don’t be afraid to react to market concentration — Equity market leadership could remain very concentrated for some time to come. Allocators may want to consider active extension strategies (sometimes called 130/30 strategies). They have the flexibility to short stocks, which means portfolio managers can overweight the stocks they favor without having to underweight (on average) the largest names in the index to source capital. Similarly, long/short strategies that are balanced long and short don’t have the problem of underweighting the mega-cap stocks in order to pick the stocks they want to hold. Lastly, I think there is room for allocators who have the wherewithal to hedge some mega-cap exposure — not to make a timing call, but to make sure their managers’ best security selection ideas are shining through.
Be cautious about big cycle bets — As I’ve noted, the current bull market could easily have a second leg. On the other hand, Brij could be right in his concern that the Fed has tightened too much. So things could swing either way, suggesting this isn’t a moment for big cycle bets.
Focus instead on security selection — Portfolio managers I spoke to made a compelling case for resiliency, whether that means picking stocks where the recession’s priced in or where there’s compelling evidence that a new cycle is already starting. Finally, I think that playing “defense” is always an important idea in the late stage of the cycle, but that may look different today given the unique nature of the market and macro environment. So, allocators should ask their managers how they’re thinking about defense at a time when a more nuanced approach may be in order.