In these uncertain times, the conversations we are having with our clients most often focus on macroeconomic and geopolitical headwinds and likely portfolio impacts.
Our base case remains that the U.S. economy will avoid a recession next year. Even if a recession were to take place, it should be relatively mild given robust underlying U.S. fundamentals.
While domestic inflation and the forward path of interest rates continue to be the most obvious near-term concerns, international factors such as the Russia-Ukraine conflict and China’s ongoing regional assertiveness are also weighing on investor sentiment.
However, based on our analysis of equity market conditions going back to 1945, history suggests that during periods of market volatility, investors are best placed to stay the course and remain invested.
Many clients have applied a defensive value-oriented tilt to their portfolios to better withstand the challenging late-cycle macroeconomic headwinds which investors currently face.
While valuations have substantially reset, particularly in growth-stage technology companies, there is apprehension that duration-sensitive stocks could suffer further losses with terminal interest rates nearing their highest levels in 15 years.
Investors who were over-indexed to growth equity ahead of this year’s downturn have been able to use negative returns through tax-loss harvesting strategies that monetize losses to offset other gains.
Conversely, investors choosing to retain or cautiously build exposure to growth equity names are mostly doing so in a more defensive way by using strategies that limit downside risk should markets slide further. Many are also coupling this equity exposure with larger-than-normal cash allocations.
Our conviction that investors should “stay the course” and cautiously maintain equity exposure is driven by two principal factors:
Gains achieved in the broad market rally since the 2008 Global Financial Crisis are often substantial, leading to large tax liabilities when stocks are sold.
Timing when to re-enter the market is notoriously difficult and often entails “missing out” on meaningful equity upside. The median equity gain in the year following past bear markets is more than 23%.
Instead, we advise that investors should avoid substantial equity allocation shifts and lean towards quality companies that fit with our key investing themes: U.S. preeminence, dollar strength, and healthy balance sheets.
Investors should focus on robust and stable margin profiles, coupled with durable, long-term cashflow generation, especially over earlier-stage companies with limited foresight to profitability.
With the Fed’s ongoing hiking cycle underpinning dollar strength, investors should exercise caution when investing in companies that source a large proportion of their revenues from abroad, creating possible currency exchange disadvantages when reporting earnings.
Geographically, we continue to believe the U.S. will fare better than other developed or emerging economies. This is underpinned by long-term structural factors such as higher labor productivity, greater EPS growth, favorable demographics, and greater innovation.
After this year’s sharp rise in interest rates, we have seen renewed investor interest in cash management and short-duration fixed income. Implementation strategies range from simple overnight and term deposits to short-duration corporate bonds and managed municipal bond portfolios. Since most of our clients are taxable investors, municipal band strategies also have tax-advantaged yield enhancement characteristics.
Clients looking for more duration exposure should consider selective opportunities in the corporate investment-grade space. And while we are cautious about downside risks to high-yield bonds in a recession scenario, our base case still implies positive returns for 2023.
On balance, our view is that market volatility can create interesting investment opportunities against the real possibility of a recession in 2023– a probability that jumped from 20-25% earlier this year to more even odds today, according to our estimates.
While 2022 has clearly been a challenging year, it is important to frame this year’s volatility in a longer-term context. Since the post-GFC lows in March 2009, U.S. equity investors have enjoyed a more than 675% return in the S&P 500, according to our analysis of Bloomberg data. Despite this year’s turbulence, that is a remarkable run that has moderate room for further upside.
Investors are better off staying in and riding out the tough days to reap the benefit of the good ones.
Sara Naison-Tarajano is global head of private wealth management capital markets and Goldman Sachs Apex Family Office.
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