A glance at the current US economy certainly doesn't paint a very rosy picture for investors. Alongside a yield curve that's been inverted since 2022, in recent weeks a slew of additional recession indicators have also begun to flash warning signals.
There's no doubt that an economic downturn will have global repercussions for Wall Street and average consumers alike. But investors who are zeroed in on forecasting the next inflation, interest rates, and recession trajectories are missing the broader picture, said Marta Norton, the chief investment officer of Morningstar Wealth's Americas division. Globally, Morningstar Investment Management currently oversees around $246 billion in assets under advisem*nt and management.
An upcoming recession isn't at the top of the list of near-term concerns for Norton, who believes that a range of outcomes might be plausible — from a mild economic slowdown with minimal consequences to a full-blown recession in 2023 or 2024.
"We want to build portfolios that are resilient across the range of outcomes that can occur, and really use valuation as the button to push to determine where we're invested," Norton explained in a recent interview with Insider. "We're very sensitive to what we think an asset class is worth and where it's priced today — that's the driving force behind how we position our portfolios."
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Selloffs in 2023 are likely to be contained
Both the fixed income and equity market started 2022 at very expensive levels — so while last year's massive stock market correction was certainly "painful," it also helped put investors in a much better position in 2023 to generate returns, Norton said.
"Very long term return prospects across equities and fixed income are better today than they were a year ago, but markets still aren't priced to really attractive levels," she added. "If we take a look at the equity market — both US non-US stocks — they're still closer to fair value than screamingly attractive."
On the other hand, Norton said that bond market valuations currently look a little more attractive — but although prices are looking better, they're still not attractive enough to completely ignore the market's headwinds in 2023.
"Are we going to test the lows of the market?" Norton asked. "I think last year was really the popping of the balloon."
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While another year like 2022 isn't completely off the table, Norton believes that it's much more likely that any potential selloffs this year are contained to certain sectors that are especially vulnerable to surprises. Consumer discretionary names would fall into this category, since stocks there still seem expensive and there's also less of a margin of safety.
A portfolio optimized for a range of outcomes
Norton's valuation framework pairs two sets of macroeconomic factors — high or low growth with high or low inflation — for a total of four different economic outcomes that might occur in 2023.
Norton's investing strategy then revolves around building an optimal portfolio that would be protected in all four of these situations. "We're looking at these different regimes — what does well in that environment and what is the market not really pricing in — and that allows us to position portfolios for a range of different outcomes," she explained.
For instance, both treasury inflation-protected securities and energy names have historically fared well in a stagflationary environment, or one characterized by low growth and high inflation.
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On the other hand, value-oriented asset classes including energy, financials, and other lower-priced companies have generally outperformed growth names in a disinflationary environment. While opportunities in energy have narrowed following the sector's extraordinary rally over the last few years, Norton noted she's overweight both European energy names and master limited partnerships, or MLPs.
Since other developed markets might be trapped in a similar inflationary narrative as the US, Norton also suggested investing in emerging markets or other overseas markets like China for broader diversification. "China seems to be at a really different spot from an inflation standpoint than the US and Europe broadly … It's one of the reasons why we have some exposure overseas," she said. Other nations Norton also owns include Germany, South Korea for its attractive valuation, and Brazil for its high yield.
Globally, Norton is also bullish on the communication services due to the sector's attractive valuations and diversification benefits, since some companies have both value and growth characteristics. Due to their valuations and healthy fundamentals, she also views US financials — particularly large US banks — as relatively strong investments.
"The companies look attractive to us, but there's no question that there's economic sensitivity built into them," she added. "The good thing about that though is that as they sell off, they're getting increasingly attractive."
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Norton is also overweight healthcare and consumer staples, two defensive sectors that are more resilient to market volatility and earnings declines. While they currently don't look overly cheap, she described them as a nice ballast in a portfolio against more sensitive sectors like financials or energy.
