Preparing for Opportunities Ahead
The Horizon is a quarterly report from our Chief Investment Office, exclusive to Merrill Private Wealth Management, intended to help high net-worth clients pursue their personal goals by addressing timely topics in areas such as macroeconomic trends, long-term investment themes, market dynamics, asset allocation and portfolio strategy as well as wealth structuring, planning and transfer.
In the second quarter of 2023, we saw a resolution to the ongoing debt ceiling standoff, the first Federal Reserve pause after 10 consecutive interest rate hikes, and the emergence of a new, technical bull market for the S&P 500 index. We believe we are still in a grind-it-out environment, with the impact of these factors, amongst others, on the investment strategy landscape likely to be more clear later this year. In this edition of Horizon we highlight trends within the Information Technology and Communication Services Equity sectors, factors behind the recent rally for a handful of big technology companies, and the importance of Fixed Income duration management with regard to a stakeholder’s investment timeframe.
“As long-term investors look for opportunities in the coming months, we think a neutral positioning to the Technology and Communication Services Equity sectors is desirable given their fundamental qualities, balance sheet strength, and long-term secular tailwinds.”
What’s in store for technology and media?
As long-term investors look for opportunities in the coming months, we think a neutral positioning to the Technology and Communication Services Equity sectors is desirable given their fundamental qualities, balance sheet strength, and long-term secular tailwinds. In “Technology, Media and Telecommunication’s Year of Efficiency,”1 we recap how these areas have performed given the relatively volatile macroeconomic backdrop and the trends investors should be aware of in the space moving forward. The Technology sector valuation level is currently above its prepandemic peak in early 2020, suggesting technology stocks are already pricing in a notable amount of Federal Reserve easing. The move in these stocks could appear counterintuitive, as they seem to be acting as “defensive growth,” an oxymoron. Some individuals might define the recent rebound, discussed in more detail later in this piece, as a flight to quality as concerns remained regarding regional banks and slower economic growth in 2023. Investors may be wondering whether there are any future innovative movers of technology worth pursuing. We believe there are three secular forces within the technology space that investors can benefit from: the declining cost of infrastructure, the decreasing cost of collecting and managing data, and the declining cost of development. Regarding Communication Services companies, historically they were not the market sanctuary they have become recently. Despite anxieties relating to regulation, competition for advertising, and the ongoing content battle, the sector is at or near trough valuation multiples and companies’ business models are being adjusted to refocus capex on artificial intelligence (AI). We highlight these two sectors given the importance of staying in higher-quality, larger-cap stocks, while also reducing exposure to lower-quality and smaller equities that may not have free cash flow or earnings potential.
Is the tech rally sustainable?
In our report “What’s Driving the Rally in Big Tech?”2 we hone in on the Information Technology sector, the elements that led to its recent upswing, and whether it can be sustainable going forward. Given that a handful of major tech companies account for heavy weightings in major equity indexes, the rally has significant implications for the wider market. Big Tech’s resurrection started earlier this year as many investors were charmed by perceived discounts following 2022’s selloff. Investor positioning in large tech stocks had declined in 2022 as performance dwindled over the year. The weakness offered a possible opportunity for investors who may have been underweight in 2022 to add to their positions. Also, the burst of excitement over AI and ChatGPT drew interest as many of the big tech companies develop AI-related software and services, alongside semiconductor chip makers that enable AI processes. They likely will be the beneficiaries of the expected future growth of AI. Additionally, regional banking sector stress bolstered the need for the Fed to pause its extensive interest rate hiking cycle at the June Federal Open Market Committee (FOMC) meeting, creating another boost for tech stocks as lower interest rates allow a more favorable backdrop for longer-duration, growth-oriented equities. Recently, as noted, the sector’s strong performance has sparked concerns about possible inflated valuations. The weak equity market breadth could potentially impede the rally. We believe long-term investors should look to add transformational and industry-leading businesses to offset any possible near-term market weakness. We think neutral positioning in the Information Technology sector is the right approach for now, with a lean towards high-quality and more fairly valued companies with strong free cash flows and solid balance sheets.
“Primarily, the main determinant of an investor’s [fixed income] duration should be their investment horizon as longer time frames should be tied to longer durations, and vice versa.”
The Inverted Yield Curve and Duration
As we look towards the Fixed Income arena, our current position within the business cycle is important to consider for active management within Fixed Income portfolios. In “Inversions, Recessions, Steepenings and Flattenings: Duration Management Through the Interest Rate Cycle”3, we consider how the current inversion of the yield curve, while severe, is a normal and expected feature of the latter stage of an economic expansion and indicates the expansion could be peaking. When inflation moves to significantly high levels, as it has done within the last year, the Federal Reserve may increase the fed funds rate so much that it becomes higher than the 10-year Treasury yield. This causes an “inversion” whereby long rates are lower than short rates. An inverted Federal Funds/10-year U.S. Treasury has preceded every recession over the last 50 years, suggesting a downturn may be expected. Looking ahead, once a recession occurs, the Fed typically reacts by cutting short-term policy rates, and the yield curve then steepens and normalizes as short rates move considerably lower than long rates. The CIO has used these historical yield curve patterns to help inform our duration management recommendations. Primarily, the main determinant of an investor’s duration should be their investment horizon as longer time frames should be tied to longer durations, and vice versa. Secondly, risk tolerance should influence duration, as longer duration securities have more potential price volatility. Lastly, the goal of Fixed Income is important; if an investor wants to hedge Equity risk, for example, longer duration may be more appropriate. Ultimately, the CIO has moved to extend duration to a slightly long position given the combination of increasing recessionary risk, a hawkish Fed focused on reducing liquidity and managing down inflation, and high nominal and inflation-adjusted yields.
Given the volatile macroeconomic backdrop, we believe it is important for investors to maintain their long-term investment strategy with the ability to make tactical changes along the way. Looking ahead, we think there are opportunities within both Equities and Fixed Income to help navigate this grind-it-out environment for the remainder of the year.