Staying focused on the long term, mitigating risks, managing opportunity costs, and seizing attractive potential returns will be among the key challenges for investors in the months ahead. (UBS)

The first quar­ter of 2023 brought stronger-than-expected economic growth in the US, a faster-than-expected reopening in China, and confirmation that Europe had sufficient energy supplies to avoid a sharp contraction. But inflation has failed to fall as quickly as hoped, and the sudden turbu­lence in the global banking system demonstrates that higher interest rates are having unintended consequences.

As we approach inflection points in interest rates and eco­nomic growth, staying focused on the long term, mitigating risks, managing opportunity costs, and seizing attractive potential returns will be among the key challenges for investors in the months ahead.

What should investors do?

First, manage liquidity as rates peak. Many investors have held more cash than usual in anticipation of higher interest rates. But rates could now be approaching a peak. Investors should stay or be sufficiently invested and diversi­fied, act soon to lock in attractive yields, and avoid unnec­essary deleveraging.

Second, buy quality bonds. We see attractive opportuni­ties in high-quality fixed income given decent yields and the scope for capital gains should an economic slowdown occur. We prefer bonds relative to equities, and prefer high grade (government), investment grade, and sustainable bonds relative to high yield bonds. We also like emerging market bonds. Investors who actively manage their bond portfolios have the potential to take full advantage of the opportunities.

Third, diversify beyond the US and growth. We think the outlook for US equities is challenged amid tighter financial conditions, declining corporate earnings, and relatively high valuations. By contrast, we see low-teen total returns from emerging market stocks over the remainder of the year, powered by strong earnings growth, China’s reopening, and relatively cheap valuations. We expect growth stocks to underperform value and quality income and see select opportunities in Europe.

Fourth, position for dollar weakness. We do not expect the US dollar’s recent strength to be sustained as the US economy's growth and interest rate premium relative to the rest of the world erodes. Investors looking to position for a weaker dollar should diversify their dollar cash or fixed income holdings. They could also reduce allocations to US equities, hedge outright, or position in options or struc­tured strategies that could deliver positive returns in the event of dollar weakness. On a relative basis, we prefer the Australian dollar as well as the Swiss franc, euro, pound, yen, and gold.

Fifth, diversify with alternatives. Alternative assets pro­vide investors with the opportunity to diversify sources of return at a time of heightened uncertainty in global markets. In hedge funds, we like macro strategies, which can profit from inflections in economic trends. Meanwhile, private market secondaries and distressed strategies could be well positioned to buy distressed assets at attractive valuations.

Sixth, invest in real assets. Exposure to “real assets”— including commodities, infrastructure, and select core real estate—can provide investors with additional portfolio diversification and income, as well as the potential for long-term inflation mitigation. We currently see particular appeal in direct and indirect infrastructure exposure and direct commodity exposure. We stay selective in real estate.

Last but not least, go sustainable. Green investment is stepping up in response to the US Inflation Reduction Act, the EU Green Deal, and similar domestic spending plans in China and around the world. This should particularly bene­fit innovative companies focused on improving resource efficiency, including energy and water, as well as those actively addressing the circular economy and decarboniza­tion. Meanwhile, sustainable bonds offer high-quality fixed income exposure. We also see a growing opportunity set to implement hedge funds and private markets within sustain­able investment strategies, for example in the areas of edu­cation and health.

For more, see the 2Q Outlook: Stability amid uncertainty, 23 March, 2023.

Watch a short video on these themes here.