Even with sunny days in the forecast, investors should be dressed for rain. What does it take to get your capital ready for anything? We offer some simple guidelines for a potentially resilient core portfolio.
It seems like it was just yesterday when we launched into 2023, still feeling the pain of the bear market in equities and fixed income from 2022. The first half of 2023 brought some relief to investors’ portfolios, but uncertainty remains high. Will the Fed finally pause rate increases and declare victory in its war with inflation? Will the long fight over the debt ceiling put handcuffs on fiscal policy going forward? Are more surprises lurking in the financials of regional banks? These concerns and more are weighing on investors’ minds as we head into the second half of the year.
Amid all this uncertainty, the forecasters who were bearish at the beginning of 2023 are for the most part doubling down on their dire market predictions. Might they be correct this time? It’s hard to know the level of conviction associated with these predictions. Rather than listening to the siren song of storytelling in the form of another market forecast to inform the construction of their portfolio, investors might be better served by building a resilient portfolio that doesn’t depend on a forecast.
How well are 2023 market forecasts holding up?
To the frustration of many market pundits, equity markets exhibited strong performance in the first five months of 2023, with heavily beaten-down tech stocks leading the way. Despite generally strong showings, fears of a recession and a corresponding equity market sell-off continue to dominate investor conversations. These conversations are motivated in part by the still-inverted yield curve, with the two-year Treasury note trading at a 0.77% positive spread to the 10-year note. Research indicates that an inverted yield curve is a powerful predictor of future recessions. Specifically, all else equal, the expectation of an easing of future monetary policy contains a recession signal. That’s the exact situation we find ourselves in today.
YTD index performance, January 2023–May 2023 (USD)
Source: Bloomberg, 6/1/2023. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
Treasury yield curve
Source: Refinitiv, 6/1/2023. For illustrative purposes only. Not a recommendation to buy or sell any security.
As director of quantitative research and portfolio management Bernie Scozzafava noted in a recent blog post, higher yields have attracted assets to the front end of the yield curve. However, this approach introduces reinvestment risk, or the risk that rates will be lower when the investor needs to reinvest proceeds from a maturing bond. While front-end investing can work in the short term, it will likely face challenges in the long term.
As if the inverted yield curve wasn’t enough to elevate investor anxiety, bank failures that became commonplace in the wake of the global financial crisis returned to prominence during the first five months of 2023. Three regional banks failed over a period of just five days in March, followed up by the forced purchase of Credit Suisse later in the month and the failure of First Republic Bank in May. In each case, a declining deposit base combined with realized losses on investments doomed the fate of the bank. Although no depositor lost money, equity and bondholders of the failed banks realized significant losses in each case.
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How can investors build portfolios for the future?
The second half of 2023 promises more twists and turns in what’s become the overarching narrative that describes the post-COVID-19 economic recovery. The Fed’s progress on inflation remains at the top of the investor wall of worry. But the impact of the debt ceiling deal, ongoing stress in the banking sector, and the continued growth of the broader US economy are all bricks in that wall.
At similar times of high uncertainty, we’ve often seen investors turn to their favorite market forecaster to drive their decision-making. That outcome can be problematic because market forecasts often fail to acknowledge the complexity of their subject matter. Complex systems that exhibit high degrees of interconnectedness and emergent behavior drive the US economy, how it interacts with the broader global economy, and how any specific economic outcome plays out in the financial markets—which is ultimately what investors care about. There’s far less predictability around us than we care to believe. If those who offer these market forecasts were to acknowledge this complexity, it would ultimately lead them to further acknowledge a low conviction in their forecast. As humans, we seek comfort in a predictable narrative, and that makes us susceptible to good storytelling. Unfortunately, storytelling often leads to subpar portfolio returns.
An alternative approach for investors to consider is to construct a diversified, cost-efficient, and resilient core portfolio to anchor their investment assets. A resilient core portfolio ideally contains the following:
- Global multisector equity exposure
- Fixed income exposure in the form of Treasury, municipal, or investment-grade corporate bonds
- An allocation to a diversified basket of commodities that works to protect against unexpected inflation
- Regular rebalancing that can maintain an appropriate risk profile
- Active tax management that strives to minimize gains and realize losses for taxable investors
- Sufficient liquidity and transparency to support portfolio adjustments
Investors can use a core with these attributes as the ballast for their overall portfolio. If they have high conviction about a particular strategy or exposure, they can fund and monitor it in a separate satellite allocation. This type of construction isolates tactical exposures, making them transparent and easier to evaluate, and avoids disrupting the core that does the heavy lifting.
The bottom line
We live in uncertain times, and that’s not likely to change in the future. Investors can deal with this uncertainty by building a resilient and highly efficient core portfolio, reserving more tactical high-conviction active bets for satellites. Parametric stands ready to assist investors in the construction of a diversified portfolio that can meet their specific needs in all market environments.
