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Q4 2022 Asset Allocation Viewpoints & Positioning

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Macro Landscape: Q4 2022

The Last Dominoes to Fall

  • With the Federal Reserve nearing the end of their hiking cycle, leading indicators are pointing to a growth contraction. However, with high inflation and an unyielding labor market, the lessons of the 1970s will prevent the Fed from adjusting course before it’s too late. The likelihood of a recession is high and our base case for 2023.
  • Our Business Cycle Index is now in Contraction and leading indicators including PMIs, lending standards, the yield curve, money supply and housing corroborate this signal. It’s not whether the unemployment rate will increase but when and by how much.
  • Inflation is past its peak, but elevated service sector prices and high wages make for an uncertain terminal inflation rate in 2023. Risk management suggests the Fed will keep policy tight, despite the disinflationary trends in goods, rental indices, and commodities.
  • U.S. consumers are near exhaustion with savings rates declining and credit utilization rising as the persistent gap between inflation and nominal wages since the pandemic is creating an affordability crisis. Housing market activity is in freefall, meanwhile increasing retail inventories and more frequent price cuts are clear signs of waning demand.
  • Corporate earnings are far above trend growth and over earners during the pandemic are most at risk. We do not think this cycle will be any different; the Fed will see to that.
  • We see two scenarios as most likely in the next 12 months: 1) inflation comes down to target as policy tightening will be sufficient to cause a recession (long term bond yields fall along with earnings), or 2) inflation moderates from peak but the magnitude of tightening is not sufficient to reach 2% inflation durably thus leading the Fed to tighten beyond what is currently priced (higher bond yields and more resilient earnings). We believe risk assets offer limited upside in either scenario.

Tactical Asset Allocation & Market Themes

Asset Allocation Action Items:

  • Retain equity underweight, modal outcome is recession
  • Increased exposure to low volatility within equities
  • Prefer core fixed income exposure primarily through moderate duration investment grade
  • Precious metals are preferred exposure within commodities given safe-haven status

Source: Harbor MAST; Positioning as of December 2022

Equity Markets

We continue to believe that the forward outlook for broad equity returns will be challenging, given the combination of slowing aggregate demand, tighter liquidity conditions, and unattractive starting valuations. We believe the next stage of this cycle will result in downward revisions to earnings and thus look to tilt into higher-quality equity exposures with relatively more attractive fundamentals. We take a mosaic approach to equity market valuations and ultimately conclude that markets have yet to price a widening of risk premia that we believe will come in the event of continued headwinds to global growth and higher for longer policy rates.

Over the course of the fourth quarter, we tactically reduced our nominal equity underweight, though offset this risk reduction with additions to lower volatility, high-quality sectors within equities. In a more challenging environment for fundamentals, defensive sectors should lead especially considering valuations, while expensive, do not seem demanding to us given our view on growth.

The risk of a recession over the next twelve months is high. There remains a path to a soft landing, but our expected outcome is for a recession in the second half of 2023. Risks to asset returns are tilted to the downside, with the potential for additional exogenous risks coming from continued geopolitical tension and a credit cycle that will likely become more challenging as the year moves on.

Fixed Income

Clear signs that inflation is waning should deliver positive returns to fixed income in 2023. And while more inflation surprises may be in store, we think the hiking cycle ends in Q1 ‘23 before a prolonged stay at 5%. The end of the hiking cycle comes with elevated recession risk so investors must be nimble when positioning on the curve. We think a barbell approach is best as the back-end of the curve hedges against a more severe slowdown, while the front-end offers high income with low duration risk. Whether it’s a soft-landing or a recession in 2023, we expect the curve to steepen over the second half of the year.

Credit Markets

Current credit valuations offer little compensation relative to the elevated risk of a recession. However, we will use any sustained widening in credit spreads to re-engage as we anticipate a benign default cycle compared to recent recessions.

Key Macro Views and Portfolio Implications

  • Policy will remain tight despite deteriorating growth. There’s a path to a soft landing, but the path of least resistance leads to a recession.
  • The surprising resilience of the labor market is under threat as both consumers and companies find it more difficult to make ends meet in the current status quo.
  • If financial conditions tighten further, it will come from risk premia rather than interest rates. In that environment, quality, whether in earnings or balance sheets, becomes the most important differentiator. However, in either case, valuations in equities and credit suggest little upside from here.
  • At current yield levels, we prefer core fixed income to risk assets such as equities and credit. Investment grade bonds offer a very attractive yield with negligible default risk. We think the risk to higher yields is limited as the hiking cycle ends, but the potential cost to the business cycle means interest rate outcomes are skewed to the downside.
  • We prefer to allocate more of our risk budget to an equity underweight rather than high yield at this stage. If it takes 9 to 12 months for a recession to materialize, we would rather collect the attractive carry of HY bonds than own equities. We continue to dislike HY bonds in an absolute sense as spreads are biased wider from here due to rising default rates in our base case.
  • U.S. equities are losing their sheen as they trade at an elevated premium relative to their foreign peers. Europe’s outlook has improved as the region appears set to avoid the worst-case energy scenario. Japan looks very cheap on our normalized valuation approach, meanwhile China’s reopening is lifting the floor for growth in emerging markets.
  • Commodities are stuck between limited supply, China re-opening, and the prospects of a synchronized growth slowdown. While our bets are on a slowdown, the case for a structural allocation to commodities remains strong as diversification benefits and relative value opportunities make the space ripe for alpha.

Asset Allocation Views: The Bottom Line

Source: Harbor MAST, Bloomberg L.P., data as of December 2022; Excess Labor Demand is (demand for labor) –(supply of labor) / (supply of labor); Nominal Income Proxy is (YOY Wage Growth) + (YOY Employment Growth) + (YOY Hours Worked Growth)

Source: Harbor MAST, Bloomberg L.P., data as of December 2022

Source: Harbor MAST, Bloomberg L.P., Factset; Data as of December 2022

Important Information

The views expressed herein are those of the Harbor Multi Asset Solutions Team at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. These views are not necessarily those of the Harbor Investment Team and should not be construed as such. The information provided is for informational purposes only.

Past performance is no guarantee of future results.

The information shown relates to the past. Past performance is not a guide to the future.

All investments are subject to market risk, including the possible loss of principal. Stock prices can fall because of weakness in the broad market, a particular industry, or specific holdings. Bonds may decline in response to rising interest rates, a credit rating downgrade or failure of the issue to make timely payments of interest or principal. International investments can be riskier than U.S. investments due to the adverse affects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets.

Fixed income securities fluctuate in price in response to various factors, including changes in interest rates, changes in market conditions and issuer-specific events, and the value of an investment may go down. This means potential to lose money.

As interest rates rise, the values of fixed income securities are likely to decrease and reduce the value of a portfolio. Securities with longer durations tend to be more sensitive to changes in interest rates and are usually more volatile than securities with shorter durations. Interest rates in the U.S. are near historic lows, which may increase exposure to risks associated with rising rates. Additionally, rising interest rates may lead to increased redemptions, increased volatility and decreased liquidity in the fixed income markets.

Certain forecasts, estimates and returns are based on hypothetical assumptions. It is for informational and illustrative purposes only. This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. The forecasts, estimates and return presented do not represent the results that any particular investor may actually attain. Actual performance results will differ, and may differ substantially, from the hypothetical information provided.

Indices listed are unmanaged, and unless otherwise noted, do not reflect fees and expenses and are not available for direct investment.

Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses.

Diversification does not assure a profit or protect against loss in a declining market.

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