The Shifting Sands of Sentiment
Hi, I’m John Escario, an investment specialist in the Portfolio Construction Solutions group here at T. Rowe Price.
Today, we’re discussing the Summer 2023 edition of Portfolio Construction Pulse – The Shifting Sands of Sentiment – a biannual survey of financial professional model portfolios based on thousands of client interactions in our proprietary database.
There’s a lot more to unpack in the Pulse report, but today, we’ll stick to three important topics:
- High-level asset allocation positioning in client portfolios
- A closer look at equity and fixed income asset class exposures
- And finally, we’ll look at some potential investment approaches to portfolio construction to prepare for the months ahead.
First, let’s look at the asset allocation level.
At the onset of 2023, investor sentiment was decidedly cautious with the threat of recession a key concern. At the same time, many portfolios were positioned for inflation and rising rates, suggesting a potential paradox that exposed portfolios to greater risk than expected.
Over the past year, overall portfolio risk has declined – 5-year portfolio beta (a common measure of portfolio volatility) fell from 1.05 to 1.00 in the year ended June 30. Clients lowered equity and fixed income positions to reduce overall portfolio risk and, in the case of cash, to capture higher yields.
We’ve also seen more interest in alternative investments, with many clients moving toward hedged equity strategies, which seek to limit downside risk but consequently limit upside opportunity. While allocations to real asset alternatives – which include natural resources, energy, real estate and the like, fell overall, the likelihood of inclusion in portfolios increased, indicating wider use and a desire for protection should inflation prove stickier than expected.
Now, let’s focus a little deeper on equity and fixed income allocations.
- Clients increased exposure to cyclical areas of the market, moving into value strategies and out of growth across all market capitalizations.
- As already noted, clients added to existing allocations and increased the use of cyclical, real asset-oriented sectors like energy and natural resources.
- Exposure to international equities continued to decline, particularly in the global large-cap growth and emerging markets categories.
In fixed income:
- With short-term interest rates above 5%, clients took advantage of the rise in yields and added nearly 7% to shorter duration strategies (particularly cash) over the past year, which reduced overall duration (a measure of a bond portfolio’s sensitive to interest rates).
- Additionally, this trend and a reduction in bank loan exposure contributed to improved credit quality.
- Interestingly, there was a notable rise in high yield exposures, suggesting that some clients seeking yield or those concerned that equities have limited short-term upside potential may find better return opportunities in high yield strategies.
Finally, let’s look at some potential approaches to portfolio construction.
Increasingly, our clients have inquired about adding risk and putting cash back to work in client portfolios. In times of shifting sentiment, we suggest adopting a more balanced approach to growth and value style allocations and adding diversification.
- This could include adding back to growth strategies. Equity valuations remain elevated, but earnings expectations appear to be improving and momentum around artificial intelligence could provide a structural tailwind to growth.
- Clients still looking for downside protection could add diversification through defensive equity strategies, such as dividend growth.
Within fixed income:
- Certain low to uncorrelated options in the nontraditional bond space may offer an alternative means of diversification, while a more traditional approach could entail modestly extending duration.
- Clients concerned about the potential stickiness of inflation could consider inflation-sensitive equities, such as real-asset strategies, alongside their core equity positions.
- Investors looking to deploy cash back into the markets have options. Those seeking to take advantage of attractive yields could consider high yield bonds (outside of a scenario involving a deep global recession). Within equities, investor could also look at high quality small cap strategies with favorable valuations or use cash to balance out exposure between growth and value equity exposures.
If you have questions about your portfolio positioning, we encourage you to view the full Portfolio Construction Pulse – The Shifting Sands of Sentiment – now available on the T. Rowe Price website or contact your T. Rowe Price Sales representative and set up a consultation with one of our Portfolio Construction Specialists. We’re here to help.
At the onset of 2023, clients were positioned for inflation and rising rates, but many were exposed to higher risk. Sentiment was decidedly cautious with the threat of recession a key concern. So far, we have avoided recession, but the implications of an inverted yield curve remain to be seen. Capital markets have posted positive results for the first half of the year but are not out of the woods yet. Over the last year, the Portfolio Construction Solutions team observed a steady decline in portfolio risk. Higher use of hedged equity strategies in place of traditional equities and higher cash allocations lent to this more conservative posture. Portfolios continued to be more exposed to cyclical areas of the equity market emphasizing value-oriented strategies. In fixed income, durations trended lower. Meanwhile, many clients inquired about adding risk and putting cash back to work in client portfolios.
As of June 30, 2023
Top-level allocation moves appeared to indicate risk avoidance as clients lowered exposure to both equities and fixed income in their portfolios, while adding to alternative investments and cash.
MODEL ALLOCATIONS (AVERAGE)
Data sourced from model portfolios submitted by financial professionals and reviewed by our Portfolio Construction Solutions team.
1 For financial professionals, alternatives includes investment strategies in the following categories: Commodities, MLPs, Real Estate, Global Real Estate, Multistrategy, Options Trading, Long-Short Equity, Relative Value Arbitrage, Event Driven, Systematic Trend, Macro Trading, Derivative Income, and Equity Market Neutral. Alternatives play a defined role in T. Rowe Price multi-asset portfolios, serving as an illiquid cash-plus alternative that is carved out of fixed income.
INTERNATIONAL ALLOCATIONS RECEDED, WHILE VALUE GAINED3
International equity continued to fall out of favor, declining from 24.9% to 20.2% over the last three years. Reduced allocations to emerging markets and global growth strategies were the primary drivers.
Value allocations rose from 25.8% to 37.1% over the last three years, and growth allocations fell. While style bets are a popular tactical approach, our analysis suggests that a balanced approach incorporating value, blend, and growth showed better returns, more efficient performance, and improved long-term return consistency.
FINANCIAL PROFESSIONAL MODEL PORTFOLIOS: Equity Allocations
3 Based on Morningstar categories.
4 As percentage of total equity.
5 Includes both small-cap and mid-cap equities.
6 As percentage of U.S. equity.
DURATION TRENDED LOWER, WHILE HIGH YIELD EXPOSURE ROSE7
Combined exposure in cash and short-term rose from 23.7% to 30.7% since June 2021, contributing to lower duration. However, our analysis suggests that higher duration instruments like core bonds, for example, historically outperformed shorter duration as the Fed rate cycle transitions from hikes to a pause. Consider adopting a more balanced approach in fixed income.
Allocations to diversifiers remained largely stable, but there was a notable rise in high yield. Clients seeking yield or those concerned that equities have limited short-term upside potential may find better return opportunities in high yield bonds.
FINANCIAL PROFESSIONAL MODEL PORTFOLIOS: Fixed Income Allocations
FINANCIAL PROFESSIONAL MODEL PORTFOLIOS: Diversifiers9,10
7 Based on Morningstar categories.
8 As percentage of total fixed income.
9 Diversifiers include fixed income strategies that offer diversification to traditional core fixed income. This includes: Bank Loan, Convertibles, Emerging Markets Bond, Emerging Markets Local-Currency Bond, High Yield Bond, High Yield Muni, Multisector Bond, Nontraditional Bond, Preferred Stock, and World Bond. For select T. Rowe Price multi-asset portfolios, the firm’s nontraditional bond fund is used as a liquid cash-plus alternative that is carved out of the cash position in fixed income allocations.
10 As percentage of diversifiers.
In times of shifting sentiment, consider adopting a more balanced approach to growth and value style allocations and adding diversification. Within equities, this may include adding back to growth in light of the move to value. While equity valuations are elevated, earnings expectations appear to be improving and momentum around artificial intelligence could provide a structural tailwind to growth.
Clients still desiring downside protection could add diversification by adding defensive equity strategies, such as dividend growth. Within fixed income, certain low to uncorrelated options in the nontraditional bond space may offer an alternative means of diversification, while a more traditional approach may entail modestly extending duration to gain potential safeguard.
Clients concerned about the potential stickiness of inflation may wish to add inflation-sensitive equities alongside their core equity positions utilizing real asset strategies.
Clients seeking to deploy cash positions back into the markets have options. Those seeking to take advantage of attractive yields could consider high yield bonds (outside of a scenario involving a deep global recession). For equities, clients could also seek to take advantage of favorable valuations by adding selectively to higher-quality small-cap stocks or by using cash to balance out exposure between growth and value.
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