In a Multispeed Economy, Improving ROIC Guides the Way

John Hillenbrand, CPA

• We continue to believe that optimal portfolio positioning emphasizes 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.
• Key developments in 2Q 2023 have in aggregate supported CGIIX’s current risk profile, and we continue to reassess and reposition the portfolio as our views of expected returns change.
• We see attractive long-term upside in the US equity market from current market levels.

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 can 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. The events of 2Q 2023 (a 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. We continue to assess the investment opportunities within this environment with a further focus on real growth and return improvement areas. Areas within technology including productivity drivers have become more attractive during the quarter, whereas some of the stable companies in consumer staples have become less attractive. Finally, we continue to monitor security and asset class valuations to target appropriate returns in this volatile environment.

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 continue to see a divergence in growth in different parts of the economy and in corporate returns on capital for individual companies. Some parts of the economy have been slowing for several quarters and may be nearing their individual cyclic bottoms, while other parts of the economy are still showing improvement from pre-Covid levels. Many companies are focused on improving their returns on capital through improved efficiencies, normalized supply chains, clarity on the interest-rate environment, and in the case of multinationals, an improved currency environment. The pace of corporate cost-cutting and restructuring has increased over the past several months across several areas, providing more opportunities to identify companies with improving returns on capital. The dispersion of cost-cutting measures through time should also provide some cushion to overall economic growth. Over the short- and intermediate-term, improved real returns on capital should drive higher equity prices.

We believe several recent policy changes will be catalysts for future growth in certain parts of the economy. These policies include recently passed US legislation, such as the Infrastructure Investment and Jobs Act, the Inflation Reduction Act, and the CHIPS and Science Act, and increased US fiscal discipline from a divided federal government. Global policy shifts are also having an impact, including the reopening of Asian economies, and the slowing of global central bank interest rate increases. The potential for additional bank regulation and changes to the FDIC insurance limit could improve the stability of the banking industry while increasing compliance costs. Although these policies will take time to have a direct positive impact, we believe equities will reflect these positives in the short term.

We believe the best positioning for this environment is a defensive risk posture, with additional 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 been 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 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.