With increasing economic uncertainty and market volatility in the first quarter of 2023, the probability of a mild recession beginning in the second half of the year or early next continues to rise. Investors and asset managers alike have been forced to navigate an increasingly complex environment, searching for reliable investment opportunities and recession-resistant sectors.

Among the many risks investors face, inflation has proven to be more resilient (or sticky) than most imagined, suggesting that the Federal Reserve may not be finished tightening monetary policy in the months ahead. Likewise, the approaching debt ceiling showdown and longer-term trends toward deglobalization threaten to undermine U.S. economic growth, underpin inflation expectations, and weigh on investor sentiment. However, there are opportunities—even in this challenging economic environment—that asset managers are taking advantage of including private credit, international equities, and real assets.

On the immediate horizon, the following risks should be top of mind for investors as they navigate this challenging environment.

Unprecedented pace of rate hikes pressures banks

After ten straight rate hikes over the past fourteen months, the Fed has found itself in a conundrum of its own making. The yield curve has been inverted since July of 2022 (short-term rates higher than long-term rates), signaling that monetary policy has not only become restrictive but possibly overly so. In fact, much of the pressure on local and regional banks is attributable to the dramatic rise in short-term interest rates, which exposed sizeable duration mismatches between bank assets (loans & securities) and liabilities (deposits & borrowings). While the “borrow short & lend long” model is a pillar of bank profitability, it can lead to disastrous outcomes when rate volatility explodes higher.

Many banks face a tough combination of longer duration bond holdings, financed with short duration, higher yielding deposits—a recipe for disaster as the Fed raises interest rates. The Fed’s most recent 25 basis point rate hike on May 3—and any additional rate hikes should the Fed not decide to pause—will further intensify this problem, accelerating deposit flight in search of higher yields and putting extra pressure on poorly managed banks.

Implications of the debt ceiling deadline debates

While there are some asset management industry implications stemming from the looming U.S. debt ceiling deadline, the surrounding debates are essentially political theater that will play out in the global media. Ultimately, the debt ceiling is not the most significant risk facing the U.S. economy because a true default is not a realistic option. The situation can and will be resolved. While a “technical default” in the form of delayed and prioritized payments (closing national parks, for example) is possible, the debt ceiling will inevitably be raised, even if only for some time to solve the immediate problem. All parties understand that a real U.S. default scenario would bring down the global financial system—it’s unthinkable and won’t be allowed to happen.

Potential long-term consequences of a U.S. pivot to deglobalization

Global supply chain disruptions stemming from the COVID-19 pandemic and the Russia/Ukraine conflict have shifted U.S. industrial policy. Both the U.S. government and many U.S. corporations have begun prioritizing supply chain security over the cost and efficiency benefits of the modern global supply chain. With rising geopolitical tensions, the administration has become increasingly concerned about national economic security, particularly regarding critically sensitive technologies such as semi-conductors. Policy initiatives such as the $280B Chips Act are already reshaping the semi-conductor landscape, incentivizing the buildout and expansion of multiple U.S.-based chip facilities. While economic growth and job creation from these facilities are near-term positives, deglobalization initiatives are likely a step in the wrong direction over the long term. Globalization, supply chain efficiency, and technological innovation have dampened inflationary pressure for decades – deglobalization would only serve to underpin long-term inflationary pressures.

Despite this mixed bag of threats and turbulence, asset managers still have ample opportunities in today’s challenging market environment.

Optimism in private credit and high-quality fixed income

Despite the likelihood of a recession this year, the private credit markets are very attractively valued. In fact, investors may look back on the 2023 private credit vintage as one of the best in many years. There are three key factors for this optimism: 1) markedly higher yields (now over 12%) in the lower middle market, 2) dramatically tighter covenant protection, and 3) rationing of credit by banks and direct lenders, allowing only the recession-resistant, higher-quality companies to compete for financing. With the rise in rates and widening risk premia, attractive yields can also be found in more traditional, public fixed income markets. In particular, high-quality fixed income products such as Treasuries, municipal bonds, agency mortgage-backed securities, and investment-grade corporates represent compelling values that investors should consider as part of a balanced portfolio.

International diversification offers a better value proposition

While the U.S. equity markets have yet to fully factor in the recessionary environment that many believe is near, the European equity markets appear to be on a better trajectory, with more favorable valuations and a greater likelihood of upward earning revisions than many U.S. counterparts. Likewise, emerging market equities are trading at deep discounts to developed markets and appear well-insulated from U.S. banking woes. With China now back online, investors have a window of opportunity to consider allocations to much faster-growing emerging markets before valuations fully reflect their improving economic circumstances. Once the Fed easing cycle begins, the U.S. dollar will likely weaken, and emerging markets should be positioned to generate returns exceeding those earned in the developed markets.

A unique opportunity within real assets

Though inflation appears to be decelerating with tighter monetary policy and slowing economic growth, the longer-term inflationary backdrop may not be as benign as the past decade. The possibility that inflation will be higher than “normal” in the years ahead suggests investors should begin to build up their inflation-resistant allocations, such as real assets. While purchasing an office building might not be the right move right now—though there are plenty for sale—there are pockets within the commercial real estate market where capital can be deployed with a margin of safety. One example is investment in data centers. As artificial intelligence and cloud computing come to the forefront for businesses, so does increased data that must be stored and accessed. As a result, data centers are emerging across the county with very compelling economics and a profile that insulates them from many of the challenges of more traditional commercial real estate markets.

Many investors are searching for infrastructure assets due to their safe, reliable cash flow characteristics and inherent inflation mitigation. While private infrastructure investments make tremendous sense, the challenge of putting large sums of money to work in a timely and diversified manner remains a limiting feature of the asset class. Investors interested in making infrastructure allocations might consider investments in listed infrastructure as temporary placeholders until private investments can be sourced or as a long-term complimentary allocation. Listed infrastructure carries many desirable characteristics of the private markets and appears well-positioned to perform as the U.S. rate cycle ends.

What to expect for the rest of 2023

As this year plays out, investors will likely continue to see signs of banking stress, a contraction in credit availability, a continued deceleration in U.S. economic growth, and a mild recessionary environment taking hold toward the end of the year or early next. However, while a severe recession is unlikely, a mild decline in earnings coinciding with slightly negative GDP growth and followed by a recovery in 2024 should be expected. Ultimately, investors can navigate this environment by staying aware of potential risks and opportunities, while increasing their diversification across public and private markets.

For additional insights from David Blake, CFA and other subject matter experts, watch their discussion at the recent 2023 Milken Global Conference.