Global inflation has gradually eased from its peak in 2022. However, central banks — especially in developed economies — have adopted the “higher for longer” strategy of increasing interest rates. With rates creeping higher instead of easing as expected, the US and Eurozone are facing greater pressure on growth. This troubled macro environment has led to a surplus of cash “sitting on the sidelines”, with investors intending to time the market, says Citi Global Wealth Investments in its Mid-Year Outlook 2023.
However, chief economist and chief investment strategist Steven Wieting warned investors that as inflation continues to ease following a period of rapid Federal Reserve (Fed) rate hikes, keeping portfolios fully invested is imperative. He believes plenty can be done to ready investment portfolios for the changes and potential opportunities while preserving and growing assets in the interim.
“There have been warnings about a recession for 18 months now, with all of this apprehension leading to investors thinking that if a collapse is going to happen, they’ll know just when to invest again — short equities, long cash,” says Wieting at a recent briefing of Citi’s mid-year report titled Opportunities on the Horizon: Investing Through a Slowing Economy. “But it’s very hard to get that to work if that’s everybody’s play.”
He says that although 2023 has brought about its fair share of challenges, he sees the remainder of the year as an opportunity for investors. Though a global economic recovery is only on the horizon, the Citi economist expects markets to refocus on longer-term market opportunities.
Although his current asset allocation strategy remains defensive, he sees numerous opportunities for investors to stay in the market and adjust their portfolios over time. As the Fed shifts from rate hikes to cuts, he adds that current markets will lead to a “meaningful potential recovery” from next year.
Currencies could drive returns
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The Fed’s aggressive tightening cycle and global shocks contributed to the strength of the US dollar last year, which reached its second-highest value in history and, according to Wieting, its peak.
A decade after Citi’s prediction that the US dollar would achieve far greater value and that the US would attract more investment — which came true — Wieting now says he sees a “reversal” of the US dollar reversal at hand. He expects the Fed to unwind half its tightening steps in the next two years while other central banks remain relatively steady.
Wieting says the near-record-high US dollar means that there is an “embedded expectation” that the US will have stronger real economic growth and less inflation than other countries in the years ahead. “The Fed’s aggressive interest rate hikes attracted inflows from international investors seeking yield. Those inflows will likely slow during the upcoming Fed easing cycle, weakening the dollar.”
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He adds that the appreciation of the US dollar supported inflows into US stocks, now trading at a historically high valuation premium to international equities.
While there will be “periodic rallies”, he expects to see a weaker US dollar ahead, creating value potential in non-US dollar investments, including non-US equities and unhedged bonds, and making currency diversification more important.
“We believe the dollar is likely entering a secular bear market, its third in the past 50 years. As expressed in dollar holdings worldwide, confidence is peaking, and so is the relative valuation of US equities,” he explains that non-US equity returns are poised to gain from currencies when they appreciate against the US dollar.
Bonds back in play
Considering the decline of US-dollar dominance, bonds — relatively overlooked while rates were low — are now regaining favour. Wieting believes there is new potential to diversify bond portfolios, add to duration, diversify risk and earn potentially higher yields in fixed-income opportunities.
He is calling for investors to build “dynamic portfolios” which would be ready to pivot as potential opportunities unfold. This includes quality investments amid the present volatility and exposure to the sources of long-term growth as these uncertainties resolve.
Although Wieting believes that equity market sentiments “remain bearish” and “too soon” to price in a recovery, significant valuation improvements point to higher long-term returns, making it possible to put cash to work in a slowing economy. “Investors may benefit from income-generating assets while investing in long-term growth opportunities,” he says.
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Divergent equity markets, with very narrow breadth, are creating strong valuation opportunities in certain categories of US and non-US markets for the future, explains Wieting, whose expectation is for policy interest rates to decline by year-end. He favours quality investments, such as longer-duration bonds and investment-grade corporate or municipal bonds that could offset potential credit spread widening. Wieting says numerous opportunities exist to diversify bond portfolios, add to duration and possibly earn higher total returns. “This is a time for portfolio action in the fixed income space,” adds Wieting, who is overweight on US government issues and investment-grade corporate bonds.
He also notes that the return in the bond market last year, in particular, came from an “overvalued pace” with a 13% decline in global fixed income across all categories and durations — the worst decline ever recorded. “In many respects, after the rising yield and drop in equities, markets are less risky now than they were [in 2021] when the booming stock and bond market felt wonderful but were riskier.”
“Across bonds and stocks, after the drop of 2022 and the beginning of 2023, you can see that the returns and opportunities that we have based on the next 10 years at this lower valuation level are much higher.”
Non-US equities
Although he acknowledges that the short-term performance of stocks and bonds remains an unknown quantity, he points out that if yields have risen 300 or 400 basis points across the curve and unprofitable tech companies are down 70% in price, the significantly lower market means that their performance in the short term is not critical for future gains.
Wieting emphasises that bond portfolios are supposed to deliver some income and offset other risks and portfolios over all durations and that he sees building opportunities. For example, emerging market debt has yields that are almost twice that of US Treasury yields, which has led Citi to shift 4% of its total portfolio outside of US equities.
Citi favours “defensive equities”, emphasising dividend growers and companies with strong balance sheets, adding that some small and mid-sized firms in the US and some emerging markets are becoming “undervalued”. “A good deal of that comes from the fact that non-US equities are trading about 12 times expected earnings compared to large cap US equities at 19.5 times,” he says.
Meanwhile, profitable small and mid-cap companies are trading at around 14.5 times earnings, which has created a “massive valuation gap” because investors are looking to avoid risks. “Right now, very defensive large cap stable companies are offering neither value nor growth, they’re just flatlining,” says Wieting. “That [play] is lagging behind the market and is not the way to recover portfolio value and growth.”
“We are seeing increasing opportunities in all of the US equities left behind besides a few large caps driven by AI.”
Tech still an ‘unstoppable trend’
Despite how Wieting views these AI-driven large-cap companies, he believes that the world is likely living through another technological revolution and that the potential of technology as an investment will be broader than the “immediate beneficiaries” of the build-out of AI infrastructure.
Generative AI, which can create an entire suite of content based on a few prompts, has the potential to be a transformative technology driving enormous productivity gains, incremental economic growth and disruption in the process, he says.
Even with the long-term prospects of AI, Wieting notes that there aren’t many “pure play” AI opportunities in public markets. “The majority of AI development is occurring in larger companies with varied interests beyond AI,” he explains. For example, Microsoft is the largest shareholder of OpenAI, the company behind the AI chatbot ChatGPT.
Still, he sees growth potential in companies that facilitate its infrastructure, such as hardware manufacturers and cloud computing vendors, that provide the essential computing and infrastructure that support AI as the new technology is integrated into everyday life.
Wieting adds that other parts of the ecosystem to watch for include semiconductor capital equipment makers as well as cyber security companies — a deeply underrated beneficiary of the rapid growth in AI to come as risks related to regulation and data privacy rear their heads in the new industry.
These new areas of growth potential are part of his recommendation for investors to begin their pivot away from a portfolio that consists only of defensive equities. “Everyone’s still waiting for the bad news to happen, but look at what’s happened this year with double-digit gains in equities,” says Wieting. “If you didn’t stay invested for that period, think about what that can mean for your performance versus the benchmark.”
