Are we there yet?

Bottom line up top:

Stop us if you’ve heard this one before. Markets are navigating pricing pressures that ultimately may prove transitory. No, it is not 2021. In 2023, transitory describes recent disinflationary trends that have led to increased volatility. Fueling investor concern is a sequence of economic data, starting with January’s jolting payroll data that revealed persistent tightness in labor markets and elevated wage growth, followed by the Consumer and Producer Price Index reports that both showed higherthan-expected inflation. Combined with the upward surprise in January’s PCE data, we contend the U.S. Federal Reserve has not yet arrived at a rate restrictive enough to reestablish price stability.

Factoring in higher rates. Volatility struck equity markets acutely over the past two weeks, given the rally of early 2023 fueled by investor optimism for a pause in rate hikes by mid-2023, at a lower terminal rate than central bankers had suggested. As a result, from a factor perspective, the biggest winners were those most sensitive to movement in risk-free rates including volatility, momentum, growth and sentiment.

As evidence mounts supporting a higher-for-longer rate cycle, performance among those factors has sharply reversed (Figure 1). We expect this vacillation in trading to continue and delaying the risk of a recession rather than eliminating it. Rather than attempt to time market gyrations, we suggest investors seek companies better suited for the uncertainty ahead.

Portfolio considerations:

Given the macro backdrop, we advocate for a defensive tilt that is balanced with selective beta exposure in order to protect against the downside risk of a recession, while minimizing underperformance should the global economy surprise to the upside.

In the U.S., we prefer the qualities of defensive equities, including dividend growers and infrastructure. U.S. infrastructure tends to be less cyclical and remains an attractive inflation hedge while dividend growers have historically provided total and risk-adjusted returns over full market cycles, aiding with capital preservation during challenging market environments.

Currently, we believe investors may benefit from seeking beta exposure outside the U.S., favoring emerging markets over international developed equities. Trading at approximately 11.5x their blended forward priceto-earnings ratio, emerging markets equities are attractive on a relative valuation basis and are currently forecasted to exceed their U.S. and non-U.S. developed counterparts in terms of earnings per share growth. Further supporting our case for increased emerging markets exposure is the ongoing reopening of the Chinese economy, as well as geopolitical risks that we think are less significant than investors believe.

Within alternatives, we continue to find farmland attractive. The asset class has historically provided diversification benefits and been a strong hedge against inflation (Figure 2), while providing income stability associated with longer-term leases.

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