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By Portfolio Solutions Group | Nov. 14, 2023

Portfolio Solutions Group (PSG), a division of Canada Life Investment Management, provides an overview of how major asset classes can react during an economic slowdown and how it’s currently positioning portfolios.

What’s in this article:

For over a year, economists and strategists have been cautioning investors about the potential of a slowdown or recession. Warning signs have included inverted yield curves in both Canada and the U.S., the U.S. inventory cycle, consumer sentiment and indicators from the global Institute of Supply Management (ISM) Purchasing Managers’ Indices. Related concerns are adding to this chatter, with an increasing focus on oil prices, the willingness of financial institutions to lend and the ability of consumers and corporations to withstand higher borrowing costs and indebtedness. 

However, there are also more optimistic signs. These include low unemployment numbers, increasing labour force participation and second quarter U.S. earnings that exceeded expectations. Equity market returns are typically seen as a leading economic indicator, and in both Canada and the U.S. year-to-date returns remain positive as we enter the fourth quarter.

The steady rise of inflation and subsequent increase of interest rates by central bankers throughout the world has started to impact economic data points such as gross domestic product growth, earnings and bond yields. While we believe peak inflation is behind us, the path of lower inflation isn’t clear, and the mixed data raises questions about the next phase of the business cycle and how to best position investment portfolios. Potential economic deceleration scenarios – such as a soft landing, a deeper and longer recession or stagflation (low economic growth, high unemployment and rising inflation) – are being discussed by pundits around the world.

A key question many investors are asking: how should I position my portfolio in the event of a slowdown? While we believe long-term strategic asset allocation and manager selection are primarily what will drive success, considering the economic environment and taking advantage of tactical tilts cannot and should not be ignored.

During an economic slowdown, equity and fixed-income markets tend to experience certain regular patterns and trends.

Stock prices generally face downward pressure and heightened turbulence. Investors expect lower corporate earnings and pressure on free cash flow, are generally more pessimistic, and may sell stocks to avoid market risks. Market volatility tends to increase with greater economic uncertainty and changes in investors’ expectations. Defensive sectors of the market that offer essential goods and services – for example, consumer staples, utilities and healthcare – tend to provide more resiliency to portfolios. More cyclical sectors may face greater challenges, such as consumer discretionary and manufacturing.

Fixed-income markets tend to do well during an economic slowdown. As economies weaken, central banks typically lower their overnight rates to stimulate the economy. At the same time, demand for government bonds often increases as investors look for safe-haven investments. This increases the price of the bonds and lowers the yield, driving positive returns and supplementing the coupon earned on the bond. The additional yield investors demand to hold corporate bonds is known as a credit spread. Traditionally, credit spreads widen when the underlying company’s fundamentals weaken and credit risk increases, leading to underperformance of corporate bonds compared to government bonds.

Alternative asset classes, such as real estate and private credit, provide portfolios with diversification, income generation and capital preservation during economic contractions, but can vary widely based on factors such as the specific type of asset, geographic location and management approach. Importantly, these diversification benefits don’t disappear during an economic slowdown. Since alternatives provide returns that have a low correlation with traditional asset classes, like stocks and bonds, they’re an attractive tool to improve a portfolio’s stability and reduce volatility. 

Real estate and private credit investments often provide steady income streams through rental income or interest payments, which can offset declines in other parts of a portfolio.  Alternatives can also help with capital preservation of a portfolio, since property values tend to be less volatile than stock prices and private credit investments will often prioritize the return of principal. 

Portfolio construction and positioning depend on the blend of strategic asset allocation and tactical positioning. In the context of today’s financial landscape and the potential for a slowdown, PSG’s mandates are positioned tactically to adjust to the economic environment.

Due to the heightened uncertainty of the path of the economy, we’ve generally maintained a neutral asset mix relative to the benchmark when it comes to stocks and bonds. By holding a balance between the two asset classes, we seek to mitigate downside risk while preserving the potential for upside gains. 

In equity portfolios, the positioning remains diversified geographically and across sectors and market capitalizations. Notably, portfolios have had a lower allocation to U.S. equities as valuation levels in the U.S. remain elevated relative to historic levels and other regions. Economic slowdowns often coincide with reduced consumer spending and declining corporate earnings, which is why reduced exposure to U.S. equities should shield the portfolios from the full force of these adverse developments.

From a style perspective, we’ve maintained our style-neutral approach, not favouring growth or value. This allows us to capture returns from dividend-producing value stocks, which are typically lower valued, as well as from companies that can continue accelerating earnings growth despite the economic environment. 

In fixed-income portfolios, we have diverse exposure by credit type, region and across the yield curve. Our efforts are supported by the active management of investment managers that steward the underlying funds. These managers bring unique expertise to bear and tactically position portfolio duration and credit exposure based on market outlooks. Despite the risk to corporate spreads, corporate bonds still provide an attractive yield for portfolios. By overweighting corporate bonds and private credit funds, we aim to capture higher yields while still managing credit risk prudently.

Our portfolios add value through strategic asset allocation, strong manager selection, tactical tilts and the underlying managers’ active management. Our current approach to asset allocation, risk management and yield generation positions PSG-managed portfolios as a compelling option for investors seeking to navigate assets throughout a business cycle. As economic conditions wax and wain, our portfolios are designed to endure today’s complexities and deliver strong risk-adjusted returns.

The views expressed in this commentary are those of Portfolio Solutions Group as of Oct. 13, 2023 and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice.

Canada Life and design, Canada Life Investment Management and design, and other marks followed by the TM symbol at first time of use are trademarks of The Canada Life Assurance Company (“Canada Life”). Other marks displayed in this piece are trademarks of a third party, and used with permission or under license. Canada Life Investment Management Ltd. is a subsidiary of Canada Life.