Stocking up on defensive positioning

Bottom line up top

An end to the hiking cycle? In sight. Financial conditions? Still tight. One of the biggest surprises of 2023 has been the resilience of U.S. equities. From their bottom in October 2022 until the July 2023 peak, the S&P 500 Index recovered a whopping 28%. Even after a down third quarter, the index today stands nearly 20% above its 2022 trough, having weathered a fresh burst of headwinds this year — including a regional banking crisis and a Fed that continues to insist that tight makes right. And investors continue to fret about improving economic data, fearing it will prolong restrictive monetary policy and ultimately result in a more severe recession down the road. We expect this reactionary market behavior to continue. Just last week, equity markets recoiled and U.S. Treasury yields jumped in part on news that retail sales grew for the sixth consecutive month. That said, the healthy consumer landscape is beginning to show some fault lines, such as rising credit card delinquencies (Figure 1).

Equity investors worried about macro tremors have options for seeking steadier ground. Higher-for-longer rates and sticky inflation aren’t the only reasons investors may feel compelled to shun risk assets these days, with geopolitical tensions and hostilities reaching new heights and a U.S. election on the horizon. As always, we advise against market timing and maintain our mantra, “stay invested.” Of course, staying invested isn’t the same thing as standing still. Equity market participants have opportunities to adjust allocation positions to seek to mitigate volatility, generate income and — perhaps most importantly — capture potential returns that a recovering market may provide.

Portfolio considerations

Global equity markets have produced healthy returns across most regions year-to-date, with particularly strong results in the first half of 2023. Given the risks of a global economic slowdown and concerns around consumer balance sheets, we believe a defensive equity allocation — designed to withstand still-elevated inflation, interest rates and market volatility — may serve investors well. Such a posture would focus on high quality, cash flow generation and dividend growth.

U.S. dividend growers are supported by positive fundamentals, sustainable growth potential, sound balance sheets and ample free cash flows, which together enhance their capital flexibility to return more cash to shareholders via increasing dividend payments. This income may help investors mitigate the impact of inflation and higher-for-longer rates on their portfolios. Additionally, dividend growing companies have historically demonstrated resilience amid heightened volatility and market drawdowns, as well as during periods following Fed rate-hiking cycles.

Additionally, we believe the global infrastructure sector benefits from consistent demand for the basic necessary services these companies provide, offering a possible buffer during an economic slowdown. This part of the equity market tends to be relatively well-insulated from higher debt costs (i.e., interest rates) and persistent inflation, thanks to inflation escalators built into underlying contracts.

We compared a 50/50 blended portfolio of dividend growth and global infrastructure stocks to the broader global equity market (Figure 2). While the portfolios offer similar valuations (forward P/E ratios), the 50/50 blend offers a sizable current dividend yield advantage (3.5% vs 2.3%) and has been less volatile over the past decade. For investors focused on risks to the macroeconomic environment and who are looking to potentially temper the effects of volatility while still generating income in their equity allocations, we believe a tilt toward dividend growers and global infrastructure could be a compelling approach.

To subscribe to our weekly commentary, click here.