Selective Risk Exposure Remains Our Target

John Hillenbrand, CPA

• We continue to believe the optimal portfolio positioning includes selective risk positioning in specific areas that have real growth tailwinds, in companies with improving returns on capital in 2023 and 2024, and in equities and fixed income with valuations at favorable expected risk-adjusted returns.
• The events during 1Q 2023 have in aggregate supported CGIIX’s current risk profile but have also increased our selectivity in risk taking.
• We see attractive long-term upside in the US equity market from current market levels.

Last quarter, we outlined the case for modestly increasing the risk in the fund focused on selective areas of the economy that we believe should show improving economic growth in 2023 and 2024 as well as on companies that can improve returns of 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, as well as improvement in certain parts of the economy. The events of 1Q 2023 (banking issues, a slowing of central bank rate increases, continued moderate slowing of inflation and economic growth, and corporate cost-cutting measures) have in aggregate supported our current risk profile, but have also increased our selectivity in risk taking with a further focus on growth and return improvement areas. Finally, we combine our risk profile with a focus on security valuation to target an appropriate return for the risk 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 or below fair value for a majority of US companies.

Policy changes are often a catalyst for economic improvement, although that improvement may require time to appear. Positive policy changes that occur toward the end of an economic slowdown have historically caused equity markets to rally even though the economy continues to deteriorate during that time. 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 government. There is also the potential for additional bank regulation and FDIC insurance limits changes that could improve the stability of the banking industry while increasing compliance costs. Global policy shifts are also having an impact, most notably, China’s decision to lift Covid restrictions and reopen its economy, and the slowing of global central bank interest rate increases. Although these policies will take time to have a direct positive impact, we believe equities will reflect these positives in the short term.

Finally, we continue to identify a divergence in growth in different parts of the economy as well as in corporate returns on capital. Some parts of the economy have been slowing for quarters and may be nearing their individual cyclic bottom, 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 the best positioning for this environment still begins with a defensive posture with additional risk in specific areas that have real growth tailwinds, in companies with improving returns on capital in 2023 and 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, specific infrastructure spending areas and policy change areas (including companies with exposure to China), 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 areas. 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.