The midyear economic and investment outlook is a mixed bag, according to portfolio managers at L.A.-based Capital Group.

There's reason for optimism because central banks are almost finished fighting inflation, consumers seem undeterred in their spending and payrolls are strong, company managers said in a webinar yesterday. But they added that inflation has been stubborn, and companies are hampered by their debt burdens.

“So 2023 has been a very challenging year to be a macro analyst and investor,” said Pramod Atluri, a Capital Group fixed-income portfolio manager. “There have been a lot of crosscurrents.”

He reminded the audience that optimism at the beginning of the year was dampened by a banking crisis, an ongoing housing recession, a floundering commercial real estate sector, an expected credit crunch and the effects of tightened monetary policy.

“There are a lot of negatives in the economy today,” he said.

But all is not doom and gloom, he continued. Just recently the housing recession started to improve, consumers have been incredibly resilient, the recession has been pushed off for now and payrolls have strengthened.

“I, myself, am on the more bullish end of the spectrum,” Atluri said. “The fact that the consumer and payrolls have remained resilient in the face of all of those headwinds means that the economy is stronger than we thought it was.”

Inflation also is falling globally, even if in spots it rises a bit, such as in the U.K., the Nordic countries and Canada, he said, and even if the rate of decline is slower than central banks would like.

If that continues, Atluri said he expects the Fed to end its rate hikes sometime this year.

“By the time they do two more rate hikes, we will see inflation that will have fallen to 4% or below with the very clear trend to lower, and that could lead the Fed to be able to pause,” he said, adding that the next move would likely be rate cuts, although he expects rates to remain higher for longer overall.

Atluri said he expects a soft landing, with growth slowing for the rest of the year and then improving in 2024. But, he admitted, there are still plenty of risks that could skew the picture to the downside.

“Everything that I talked about as a risk that I think the economy is strong enough to handle, well, we’re just going to have to see if that’s the case,” he said, admitting that plenty of the Capital Group colleagues are still expecting a mild recession.

What this means for Atluri is he has shifted his portfolio back to a neutral interest rate duration, and interest rate risk, from being underweight.

“My view is rates could probably move a little higher from here, maybe 25 basis points, in order to fairly price in the Fed hiking one or two more times,” he said.

Right now the two-year Treasury interest rate is around 4.75%, and the 10-year Treasury is around 3.75%, he said.

“I think if we got to 4% on 10s and 5% on twos, those look like very good buys given what we know and expect,” Atluri said. “And if the economy does worse than I expect and the Fed turns more dovish, I think there’s probably more upside from there.”

Caroline Randall, an equit portfolio manager, said she didn’t quite agree with Atluri’s perspective.

“In true Capital style, I have a different outlook to promote, and I’m probably slightly more on the bearish side of the spectrum,” she said. “Maybe we’re going to see only one or two more rate hikes, but the level we got to in terms of interest rates and the speed at which they increased, trouble me.”

Inflation will be more stubborn than people think, she said, and some recessionary consequences may yet emerge.

“The thing I’m focused on is earnings growth and, therefore, the headwinds that earnings growth could face given that rising debt cost,” Randall said.

Another factor that concerns her is increased intervention by politicians, especially in the U.S. She suggested the Inflation Reduction Act should be renamed the Inflation Enhancement Act, as the additional investment right now is seen by her and companies she speaks to as an inflation enabler, not a reduction mechanism.

“If you look at what the equity market has done so far this year, the market leadership has been incredibly narrow,” she said. “So even with that slightly gloomy outlook that I have, I think that there are still some really interesting investment opportunities for us to be looking at.”

Fixed Income 
Atluri said a hawkish central bank regime globally still exists, and that creates volatility.

“It’s not time yet for investors to go all in on risk. In 2022, money left fixed income for cash, a lot of money,” he said, calculating that money market funds hold more than $5.5 trillion.

“Bonds now offer much higher yields, much better diversification potential, than we’ve seen in a long time,” he said. “I think fixed income is looking like a really, really attractive alternative.”

So far this year, $100 billion has returned to fixed income because of this expanded return opportunity over the next couple of years and diversification benefits, Atluri said, and that's come in while the Fed has still been hiking.

“Those are early movers,” he said. “Once the Fed pauses, I expect those flows to accelerate.”

The most important decision an investor has to make is whether they think the economy is headed for a soft landing or for a recession, he said, as the investments that will do well in one scenario will not do well in the other.

Aside from duration, investors should look at investment grade corporate bond and high-yield bonds as sectors that will do well in a soft landing, but not so well in recession. Valuations have moved much higher since the banking crisis in March, and don’t seem to be compensating for recession risk, Atluri said.

In addition, emerging markets also show some opportunity, but it’s not a monolith, and investors need to be very thoughtful, he said.

Equities 
Among the four primary opportunities Randall named—utilities, healthcare, industrials and defense—she said utilities are her favorite.

“If you think about the importance that utilities are going to provide in an era of energy transition and electrification, utilities have been described as the silent giant of the energy transition era,” she said.

In order to be able to transition to cleaner energy, there will have to be increased investment in wires for connectivity, and smarter grids, she said. The investment here will produce higher returns, and when returns rise, so do earnings and dividends, she said.

Another area she said she likes is healthcare, which is still benefiting from post-Covid tailwinds. It will see significantly lower supply-chain inflation than other sectors, valuations are very attractive, balance sheets very strong, trading is around 12 to 14 times P/E multiples, and dividend yields are 3% to 4%. Medical and surgical devices in particular seem attractive, she said.

Then there’s industrials, the beneficiaries of the Inflation Reduction Act—anything investing in energy efficiency, infrastructure growth, manufacturing capabilities, Randall said.

“These companies will continue to do well,” she said, “Demand is holding up OK, volume is holding up OK, they have pricing power, and there some new tailwinds emerging for these companies.”

And finally, there’s defense.

“This is obviously a key area that did incredibly well last year,” she said. “Now no one would wish for the kind of environment we find ourselves in geopolitically, and where defense companies continue to be strong.”

But these are interesting opportunities that should become only more interesting in the months ahead, Randall concluded.