Finding Opportunities in a More Muted Growth Environment

John Hillenbrand, CPA

• The continued slowing of the US economy and more balance between opposing growth forces warrant a neutral risk positioning for the fund, in our view.
• We believe optimal portfolio positioning includes selective risk positioning in areas that have real growth tailwinds, in companies with improving returns on capital in 2024, and in equities and fixed income with valuations at favorable expected risk-adjusted returns.
• As the growth outlook for many parts of the US economy shifts, we also seek to capitalize on shorter-term cyclical growth themes.
• Over the short- and intermediate-term, improved real returns on capital can drive higher equity prices, and we see attractive long-term upside in the US equity market from current market levels, which we believe are at fair value for a majority of US companies.

At the beginning of 2023, we outlined the case for increasing the risk in the fund, focusing on selective areas of the economy that we believed should show improving economic growth in 2023 and 2024 as well as on companies that could improve returns on capital during that time. Our premise to selectively add risk was based on several factors, including our conviction in the long-term US economic growth trajectory, positive policy changes, and improvement in certain parts of the economy, despite some opposing forces that were slowing growth down in other economic sectors. The events of the first three quarters of 2023 (the slowing of central bank rate increases, continued moderate slowing of inflation and economic growth, corporate cost-cutting measures, and the acceleration of spending in AI-related areas) have in aggregate supported that risk profile. Risk asset returns were positive during this time, although there was a significant dispersion of returns across sectors and industries.

As we look forward to the end of 2023 and into 2024, the growth outlook appears more muted than at the beginning of 2023. Opposing economic forces have become more balanced as policy shifts (elimination of some government policies and a cost-cutting agenda in the US Congress) are balancing out positive end-demand trends at the consumer and corporate levels. We continue to see slowing but positive economic growth over the next year, but the timing for a reacceleration in growth is more difficult to predict. In addition to this more balanced growth view, the growth outlook for many parts of the US economy continues to shift (for example, due to rising energy prices in recent months versus a decline in the first part of the year, and a slowing of travel consumption from the fast pace over the summer). Therefore, we remain vigilant in our effort to identify short-term cyclical investment themes. We continue to assess the investment opportunities within this environment with a further focus on real growth and return improvement areas. Finally, we continue to monitor security and asset-class valuations to target appropriate returns in this volatile environment.

In addition to areas with favorable cyclical factors, we believe companies that can improve profitability in a slower-growth environment are good investments. Many companies are focused on improving their returns on capital through improved efficiencies, normalized supply chains, and revised investment strategies based on the current interest-rate environment. The pace of corporate cost-cutting and restructuring has increased over the past several quarters across several areas, providing more opportunities to identify companies with improving returns on capital. Over the short and intermediate term, improved real returns on capital should drive higher equity prices.

We remain confident that the positive long-term growth trajectory of the US economy and the cash flow generation capabilities of US companies are intact. The ability of management teams to identify emerging short- and long-term trends and the adaptability of business models and cost structures are central to our long-term favorable view. We see attractive long-term upside in the US equity market from current market levels, which we believe are at fair value for a majority of US companies.

We believe the best positioning for this environment is a defensive risk posture, with added risk in specific areas that have real growth tailwinds, in companies with improving returns on capital in 2024, and in equities and fixed income with valuations at favorable expected risk-adjusted returns. We see compelling prospects for companies that have exposure to new products and geographic growth opportunities (examples can be found in healthcare, electric vehicles, and AI-related infrastructure and software), specific infrastructure spending areas (in materials and industrial sectors), and the normalization of supply chains and parts of the service economy.

We are still favoring higher-credit-quality companies with improving free cash flow. We are selectively using options and convertible bonds to gain exposure to some higher-risk industries. From an asset-class perspective, cash and short-term Treasuries remain useful tools to lower volatility in a multi-asset-class portfolio given their yields.