There’s a new reality taking shape that could define global markets over the next decade.
Although many investors are expecting a return to normal after inflation subsides and central banks stop raising interest rates, we believe markets are undergoing significant changes. Investors may need to reset expectations in this new environment.
One change that’s already underway is the shift from narrow to broad market leadership. A handful of tech stocks dominated markets for years, but we expect a much wider range of investments to drive portfolio returns going forward. That’s why we asked our investment team to highlight the trends they are most closely following today.
Here are 10 investment themes for 2023:
1. Dividend stocks could power portfolios for the next decade
2. Growth investing will require a new approach
3. Nimble multinational companies are becoming global champions
4. Innovation is leading to a golden age of health care
5. Industrial renaissance could benefit pick-and-shovel companies
6. Reshoring supply chains will create new opportunities across industries
7. Core bonds can provide strength when equities are weak
8. Credit fundamentals are making a comeback
9. High-yield bonds are earning their name again
10. 60/40 portfolios are alive and well
Dividend investing may have seemed downright dull over the last decade as tech titans dominated market returns, but today, boring is beautiful.
With growth slowing and the cost of capital rising, I expect dividends to be a more significant and stable contributor to total return going forward. Dividends accounted for only 16% of total return in the 2010s, but historically the average has hovered around 38%, peaking at 72% during the inflationary 1970s.
Expect dividends to account for a larger portion of total return
I’m finding many dividend opportunities across sectors, including industrials, utilities and health care. Pharmaceutical companies can be attractive in an inflationary environment, as many tend to have strong balance sheets and cash flows and are often able to raise prices even in a highly competitive marketplace. Several leading companies also have a dividend yield above 3%, including AbbVie (3.7% yield, as of December 31, 2022) and Gilead Sciences (3.4%).
Growth stocks have come under intense pressure, but for some companies I think the market is throwing the baby out with the bathwater.
As a growth investor, it’s essential to differentiate between companies that have reached the end of their runway or are facing stiffer competition with those that are simply in a cyclical slowdown. If you can find companies set to re-accelerate when the economy improves, you may find promising buying opportunities.
The pace of innovation around the world is picking up again. Several colleagues and I recently spent a few weeks in Silicon Valley meeting with public companies and venture capital firms, and I came away believing we are at an inflection point with artificial intelligence. Microsoft's $10 billion investment in ChatGPT creator OpenAI is a recent example, but the push to develop innovative uses of AI is happening all around.
The pace of adoption of new technologies is accelerating
This feels like the early days of mobile and cloud as they entered an era of hyper-charged growth. It’s an open-ended opportunity for companies that can leverage the technology to genuinely differentiate their product offerings and deliver enhanced productivity to customers. Despite the challenging environment, I remain excited about the long-term investment opportunities on the horizon.
It may seem like a challenging time to be a global investor, but I think this is when the best companies shine.
Investors are concerned about de-globalization and assume it is negative for portfolios. It can be, but changes in trade patterns generally favor global champions — what I call industry-leading multinationals that can adjust to the changing landscape. The COVID-19 crisis shed light on the importance of resilience over efficiency, and companies are responding by establishing redundancies in supply chains. That's creating opportunities for companies that help build factories and expand supply lines.
For example, Taiwan Semiconductor Manufacturing Company, the largest pure-play semiconductor maker, plans to build factories in Arizona and Japan and anticipates nearly half of its leading-edge chip production will happen outside of Taiwan in the years ahead. As new facilities are built, Caterpillar, the world's largest manufacturer of construction equipment, could see increased demand for its products.
A new breed of multinational companies has arrived
Global stocks should also benefit as two notable headwinds dissipate. It appears that the strong U.S. dollar may have peaked, which would support dollar-based returns of U.S. and international stocks alike. Also, the reopening of China’s economy should boost global economic growth, especially in emerging markets.
In the portfolios that I manage, I focus primarily on “supertankers” — dominant companies that generate solid cash flow, enjoy strong competitive moats and have the ability to fund their own growth — in industries such as health care, semiconductors and insurance.
Innovation is at an all-time high in health care. The macro environment may have topped investor concerns over the last year, but innovation is what has ultimately driven long-term value creation.
Pharmaceutical companies have invested heavily in drug discovery in recent years and, as a result, deep pipelines of pioneering treatments are being developed to tackle some of the world’s biggest health issues. Eli Lilly and Novo Nordisk, for example, have developed obesity treatments with the potential to reduce body weight by as much as 25%. AstraZeneca has become an oncology leader with advanced therapies for lung, bladder and breast cancer.
Gene sequencing is another key innovation with major health and investment implications. In the future, we may be able to pair genetic sequencing with gene-based interventions to deliver personalized, precision medicine. Imagine replacing defective or missing genes with normal, healthy ones. That future is not far off, in my view.
I find opportunities in health care services equally exciting. Most doctors operate in a traditional fee-for-service model, getting paid based on volume. But companies like UnitedHealth and Humana are instead rewarding doctors for keeping patients heathy through new payment models. These models seek to achieve the so-called “quadruple aim” in health care — better outcomes, higher patient satisfaction and higher physician satisfaction at a lower cost per capita. Achieving all four is now a real possibility.
CapEx is on the rise, and it could be setting the stage for an industrial renaissance.
I’m paying close attention to how increased capital expenditures will benefit suppliers across industries — what I call pick-and-shovel companies. Investors sometimes overlook these businesses, but they often have more stable cash flows and lower risk profiles compared to the companies they service.
Record-breaking cash flow over the last 12 months has left oil producers with some of the strongest balance sheets in history. When energy companies profit, they typically expand exploration and production, which requires more machinery and services. This could be a source of growth for companies that provide technology, products and services to the energy industry.
Four trends could contribute to an industrial renaissance
Another interesting trend is how much money has flowed into health care research and development (R&D). Pharmaceutical companies that successfully developed vaccines and anti-viral treatments like Pfizer piled up cash. Much of this capital will likely be funneled into more R&D for companies that support the biopharma industry, such as Danaher and Thermo Fisher Scientific.
Supply chain disruptions during the pandemic and mounting geopolitical tensions prompted many companies to rethink their global sourcing capabilities. The strategy now focuses on balancing efficiency, reliability and security — with the intention to diversify by reshoring and onshoring manufacturing.
There’s a common misconception that this trend will displace China as the world’s largest manufacturing base. Rather, many companies are shifting to a “China +1 strategy” by maintaining operations in the country while adding facilities elsewhere. Incremental investments in China will focus primarily on the domestic market, while additional investments in other locations will serve the rest of the world.
Southeast Asia, Mexico, India and the United States are some of the top relocation destinations. Companies that facilitate this transition — like Japanese automation enablers or REITs in India — may be well positioned to take advantage of this trend.
Southeast Asia is well positioned for the rewiring of global supply chains
It could take a decade for companies to fully transition, but the process is certainly underway. I believe it will be one of the more important investment themes of the 2020s.
Strong income opportunities and a potential economic slowdown could make core bonds the star of a well-diversified portfolio.
You can’t read the news these days without seeing the word recession. While slowing growth may be a headwind for many asset classes, for core bonds, it’s nirvana. Slowing growth, declining inflation, higher yields and a Federal Reserve nearing the end of its hiking cycle all add up to a fantastic opportunity for core bond funds to generate mid-single-digit total returns and, once again, provide ballast to a portfolio.
The starting yield of core bonds hovers around 4.7% (as measured by the Bloomberg U.S. Aggregate Index, as of December 31, 2022), which is a good indicator of long-term return expectations. As an active manager, I seek to add excess return by managing interest rate sensitivity, sector allocation, security selection and other levers.
And if a recession does hit, bringing inflation down faster than expected, further upside is possible. Interest rates would likely decline, leading to meaningful bond price appreciation. For example, a 50-basis-point decline in rates would translate to a roughly 3% gain for core bonds (as described above).
Credit fundamentals may soon be back in the driver’s seat as inflation cools and rate hikes slow.
While consistent cash flows and strong balance sheets are always important, they become essential during periods of falling growth when corporate bonds are often impacted unevenly across industries and asset classes. Our analysts are focused on identifying companies that can deftly navigate such an environment.
For bond investors, finding companies that are inventing the next big thing is less important than determining if they can meet their debt obligations. For example, established social media companies may be facing stiff competition for younger users, but they are also very creditworthy when measured by profitability, free cash flow and relatively low debt levels.
Credit fundamentals vary greatly across individual industries and issuers
Today’s starting yields for higher income bond sectors such as investment grade (BBB/Baa and above), high yield, emerging markets and securitized debt offer attractive entry points for long-term investors. The total return opportunity is also more appealing compared to recent years, as these higher yields may help buffer bond market volatility.
Spreads for investment-grade and high-yield corporate bonds may not scream “buy,” but our analysts are finding attractive valuations in select issuers and industries.
At today’s yields, high-yield bonds can provide attractive income to an investor’s portfolio.
Yields in the neighborhood of 8% help provide a buffer against bond market volatility, so the likelihood of earning a positive return is higher. History shows that when high-yield bonds yielded in the 7% to 8% range, the average two-year annualized forward return was 9.2%, and the average three-year annualized forward return was 7.9%. Yields have also jumped for high-yield municipal bonds, whose tax-exempt status adds to their allure.
Strong returns typically followed periods of elevated yields
While we are aware of the possibility of a contraction, I don’t expect the same level of price volatility in the high-yield market that followed the global financial crisis or the onset of the pandemic. The U.S. high-yield bond market is higher quality now (as defined by credit ratings) with just 11% of bonds rated CCC-or-below (as of December 31, 2022) versus 20% in December 2007.
Ask your favorite search engine, “Is the 60/40 portfolio dead?” and it will generate about half a million results. Such skepticism is understandable following a year in which stocks and bonds both declined for the first time in decades. Despite the poor year, I believe the concept of a well-balanced portfolio — whether a 60/40 or 65/35 equity/fixed income split — is indeed alive and well.
For the first time in years, it’s possible to seek total returns in the high single digits by investing in core bonds and proven dividend-paying stocks without taking undue risk or reaching for yield. With the yield on the Bloomberg U.S. Aggregate Index currently above 4%, many core bonds can provide a consistent return in the mid-single digits. That’s something we haven’t seen since 2008. Investors who are comfortable taking a little more risk by including investment-grade and high-yield corporate bonds can look for their bond portfolios to potentially contribute even more.
Companies that pay a dividend can contribute to an attractive return picture with yields north of 3% and the potential for capital appreciation. For example, Broadcom has raised its dividend 12 consecutive years and had a 3.3% yield (as of December 31, 2022).
A balanced portfolio would have outpaced other strategies over the past 15 years
Traditional asset allocation is not a broken or failed strategy. It will always make sense to think about balance, diversification and risk. A one-size-fits-all approach doesn’t work for every investor. It’s about building portfolios from the bottom up that align with investor goals.
My colleagues may be able to look at the future and imagine new products and emerging trends, but the investment theme closest to my heart is one that doesn’t change. Despite all the transformations in the world, I believe the nature of my job and focus as a portfolio manager will continue to be exactly the same.
In 2023, just as we did in 2013 and 2003, we will come upon individual companies that do interesting things. We’ll try to buy them at reasonable prices and hold them so that any returns we see may be better than if we were to buy every company. That is my true north.
Some companies will get it right, and some will get it wrong. Our job is to find those most likely to get it right and create wealth over time so that our investors may benefit. Not that we’ll be perfect, but I’m optimistic that we can get more companies right than wrong and continue to add value for our clients.
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