The economy has been resilient so far this year, but we are starting to see the impact of higher borrowing costs and tighter financial conditions weigh on activity. What are the implications for financial markets and investors? In this Q&A, Sarah Riopelle shares her views on the current environment and how she has positioned her multi-asset and balanced portfolios for the second half of the year given the range of possible scenarios that could unfold.

The end of aggressive rate hikes from central banks appears to be coming into view. What can we expect from central banks going forward? What are the implications for bond markets?

A massive amount of monetary tightening has already been delivered and policy rates are now restrictive in most major developed economies. The key factors that drove inflation to its highest level in four decades are all turning.

As a result, we believe that further aggressive rate hikes are becoming less warranted. The Fed has already raised short-term interest rates by 500 basis points since the beginning of 2022. So, while we could see rates inch a bit higher still, we are likely approaching the finish line in the current rate-hiking cycle.

Central banks hike policy rates to fight inflation

As of 06/22/2023. Sources: Haver Analytics, RBC GAM

Additionally, the relentless increase in bond yields from last year has eased and investors have been conditioned to a higher interest-rate environment. As inflation soared, investors embedded a higher inflation premium into bonds. Our models suggest that the reverse will be true as inflation moderates.

Our view is that at today’s higher yields, and with the prospect of central bank rate cuts, sovereign bonds offer their greatest return potential in many years. Valuation risk is limited and fixed income is poised to provide greater ballast for portfolios against equity-market weakness should a downturn materialize.

Despite several headwinds on the horizon, equity markets have risen considerably. What is your outlook for equities? Is this rally sustainable?

The rally was initially broad-based across regions but returns in recent months have been concentrated in a narrow set of U.S. mega-cap technology stocks. When you look beneath the surface and beyond the U.S. large-cap market, most major indices were flat or down for the quarter. While the S&P 500 rose 8.9% in the five months ending May 31, 2023, the equal-weighted version which normalizes the weight of large tech stocks was down 1.4%. There hasn’t been a lot of breadth in the market, which is something that we would like to see to confirm a healthy, durable bull market.

The bigger threat to the stock market is the sustainability of corporate profits, which have been struggling and will be vulnerable if the economy falls into recession. Our view places the odds of a recession at 80%. We believe that developed economies will fall into a recession within the next few quarters. That said, we expect any recession to be of mild to middling in depth and fairly short, at just two to three quarters.

S&P500 index and S&P500 equal-weight index

Four week moving average

Note: as of 5/31/2023. Source: Bloomberg, RBC GAM

How have you been positioning your multi-asset and balanced portfolios in light of the current environment?

Our goal in managing the asset mix of our portfolios is to balance the risks and opportunities given a variety of scenarios for the economy and financial markets. Historically, we have tended to run at least a mild tilt toward stocks to capture the risk premium versus bonds over the long term.

But that premium is currently small. Given our base case that the economy is headed for a recession over the next year, we are reluctant to hold an overweight position in stocks at this time relative to our strategic neutral weight. Notably, our allocations to stocks, bonds and cash, are now all in line with our strategic neutral levels.

While we no longer have any tactical risk in our asset mix, we can’t ignore the fact that the economy has not yet stumbled and that there are pathways to a soft landing. As always, we are monitoring things closely and will adjust as necessary.

What is your key message for clients as we continue to digest all that happened over the last 18 months?

Investors have become nervous about the future prospects for markets, and this has led many to deviate from their long-term investment plans, instead choosing to remain in cash or to sell and move their investments to cash. While this may be an appropriate strategy for some clients, those with long time horizons or the need for higher returns could be putting themselves in a position where they can’t meet their investment goals. I find myself reminding investors often that they should focus on where markets are going, not on where they have been.

Investing success has less to do with the day-to-day or month-to-month ups and downs of markets. It’s more to do with how you react to periods of volatility. Being aware of how your emotions can impact your investment decisions during these periods can help you avoid making poorly timed changes to your portfolio.