High inflation is far from tamed, and profit margins are expected to deteriorate. Therefore, it is prudent to adopt a more defensive stance in portfolios, according to Christoph Schmidt, senior portfolio manager of DWS Concept Kaldemorgen, in a with Investment Officer.
Equities and other high-risk assets have performed well this year. Investors believe that inflation will continue to decline, central banks are almost done tightening their policies, and the economy will avoid a significant slowdown. However, Schmidt is more cautious. “Earlier this year, we also broadly assumed this scenario and positioned the portfolio accordingly. However, when the market started anticipating rate cuts in the second half of the year, we found it premature. After the recent rally, we believe that the upside potential for the stock market is limited. Therefore, we recently took some profits and reduced our net exposure to the equity market to less than 40 percent.”
In line with this strategy, positions in growth sectors such as technology and communication services have been reduced, while interests in more defensive sectors like healthcare, utilities, and telecommunications still represent approximately 50 percent of the equity portfolio. Schmidt stated, “We are preparing for increased volatility and have made the equity portion even more robust than it already was.”
Gradual reduction of risk
The gradual reduction of risk during periods of low volatility and rising stock prices is characteristic of Concept Kaldemorgen’s strategy. This multi-asset fund aims to allow investors to participate in rising markets while keeping the annual volatility and maximum loss below 10 percent.
To fulfill this promise, the fund always maintains a substantial cash position, which has recently been further increased to around 22 percent. “This enables us to take advantage of a market correction by increasing our equity exposure again at lower prices,” Schmidt said. Additionally, the fund has increased investments in short-term bonds. “We don’t expect a major downturn in the stock market, but we must always weigh the trade-off between return and risk. Due to the rising yields on the short end of the yield curve, short-term bonds are currently an attractive alternative to stocks.”
This was not the case for many years, leading the fund to invest more in defensive stocks and even short the bond market last year. Hence, the fund achieved positive returns on its bond portfolio in 2022. The current equity weight is still slightly above the historical average since the fund’s inception in 2011, according to Schmidt. “With the reduction of our equity positions, this will normalize again, but we are not very pessimistic about stocks. They are neither expensive nor cheap. It also strongly depends on the region and sector. Valuations in the tech sector are relatively high, but we still see value elsewhere. For example, in Europe, there are plenty of attractively valued, defensive stocks with good dividend yields.”
Closely monitoring earnings
One of the reasons why Schmidt is more cautious than the market is the ongoing high cost inflation and its potential impact on profit margins. “Corporate profits are still holding up well for now, but we are closely monitoring this situation. Profit margins are already starting to deteriorate, and we expect this trend to continue. Rising labor costs and interest expenses make it harder for companies to pass on these costs. Moreover, the effects of interest rate hikes are yet to fully impact the economy. For a multi-asset investor, it makes sense to reduce some equity risk and still benefit from safe short-term bonds that offer an attractive yield. In Europe, the overnight rate is 3.4 percent, and in the United States, it’s over 5 percent.”
Though not his base scenario, should the economy enter a deep recession, Schmidt believes the Federal Reserve has ample room to cut interest rates. However, he thinks investors are currently too optimistic about possible rate cuts next year. “While inflation is coming down due to cyclical factors like falling energy prices, structural factors such as tight labor markets, deglobalization, and the energy transition are likely to keep inflation high in the medium term. In the 1970s, central banks eased monetary policies too early, and inflation resurfaced. They don’t want to make that mistake again. Therefore, policy rates will likely remain elevated for a long time until central banks are certain that their policies are effective. They accept the risk of a recession.”
This article was originally published in Dutch on InvestmentOfficer.nl.