Lara Castleton: Hello and thank you for joining another episode of Global Perspectives, a Janus Henderson podcast created to share insights from investment professionals and the implications that they have for investors. I’m your host for the day, Lara Castleton, US head of portfolio construction and strategy, and I am thrilled to be joined by two of our brightest, Greg Wilensky, U.S. head of fixed income and portfolio manager, and Jeremiah Buckley, large cap equity portfolio manager. Together they co-manage the Janus Henderson Balanced strategy. Gentlemen, thank you for being here.

I really am thrilled to speak with you both today. There has been no shortage of drama in both equity and fixed income markets this year. Somehow we are already in fall. I know this because everything smells of pumpkin spice and football is on our TVs again. So it really is timely to talk about where you see opportunities in both equities and fixed income heading into the end of the year as investors are really narrowing in on closing 2023 out strong.

Before we get to what’s ahead, I do think we need to recap what got us here today. So I’m going to go to you first, Greg. 2022 was not a great year for the 60-40 portfolio. And just level-set, why was that the case and do we think that those risks are broadly behind us now?

Greg Wilensky: I was hoping it was already behind me and I’d never have to speak of 2022 again. 2022, especially from the fixed income side, was either the worst year we’ve had in 40 years by some measures or, frankly, in an absolute return perspective, the worst year I think we’ve really ever seen in the modern era for fixed income. So what happened? It was, I think, a combination of factors.

One, obviously we’re dealing with an economic environment where we had inflation spiking quite dramatically as we came out from the COVID lockdowns and were still dealing with a combination of supply chain issues at the same time that we had strong demand, so that large imbalance of the supply and demand. That we’ve had occur several times in the past, but it happened also at a time where we started from such a low level of yields, whether we’re talking about nominal treasury yields that were starting the year below 2% or if you look at real or inflation-adjusted yields, which were actually negative.

So that was a really, if you will, nasty combination of dealing with a situation with extremely low starting yields and all that inflation pressure and then a Federal Reserve and other monetary authorities around the globe having to fight inflation all at once. So seeing absolute returns down in negative mid-teen type of levels, underperforming cash even by a little more than that, is just an environment we haven’t seen almost in my lifetime.

Castleton: And that is something that I had heard on client consultations last year. It really was fixed income not necessarily providing the ballast that they had hoped it would in a 60-40. So, again on that, do we find that that risk is broadly over? The Fed obviously raised rates over 500 basis points. We don’t know where they’ll go from here, but do we feel like we’re coming to an end of that major risk we saw?

Wilensky: Yes, absolutely. One of the beauties about fixed income is the linkage between – it worked against us in 2022 – of yields and prices, but the setup that it creates is much more attractive. As we’re experiencing those price declines, it means the starting yields, that thing that I said was essentially providing the tinder that could cause the negative reaction that we had last year, is now in a much better starting point. We’ve got nominal yields at levels that we haven’t seen since prior to the GFC, the last big crisis in 2008-2009. So those yields are much higher. Real yields on 10-year TIPS went from -1% to almost positive 2%.

To be honest, that’s higher than where I think they’ll be in the long run. So you’re at a much better starting point from a yield level, so that’s great. You’re going to be able to generate income from fixed income. That’s a nice combination or a nice idea there. Then, as you noted, if we’re not at the end of the Fed hiking cycle, we’re incredibly close. So I personally think we’re probably done, but even if it’s one, even if it’s two more hikes, which I don’t think will be happening, that pales in comparison to the 525 basis points in hikes that we’ve already had.

Castleton: Right. So…

Jeremiah Buckley: Can I just add on that?

Castleton: Yes, please.

Buckley: Just to close out the 2022 discussion, I think it’s important to note that it was an extremely rare supply chain situation. We had a pandemic. We had a war. So that led to this very unique year and event or environment where inflation was such a difficult factor for both markets. So, as a result of that, we saw this extremely rare positive correlation between bonds and stocks during the year, which we don’t see. Over time it fluctuates between no correlation to negative correlations. In most periods where we have economic difficulty or uncertainty, it’s usually demand shocks. In those cases, fixed income performs very well relative to equities. So those are the more usual volatility that we normally see that has helped 60-40 perform in those types of environments in the past. I think we need to chalk 2022 up as an extremely rare situation and that going forward, as Greg notes, the environment and the level of rates that we’re at today is in a much more favorable situation.

Castleton: Yes. We don’t want to rehash 2022 too much, but that was an extremely helpful backdrop. We know inflation and fixed income don’t mix and that inflation and duration in equities don’t really mix that well either. We’re starting from a much better level today. Heading into equities, this year, we have seen a very strong year. Is that because last year was so painful – is that why, 2022 – and the S&P has been doing so well? What would you chalk this year up to?

Buckley: Yes. That’s certainly part of it. So if we look at 2022, we had substantial decline in equity markets. Almost all of that was multiple-related. We did have earnings estimates come down for 2023 and we’re looking at flat to modestly up earnings in 2023 relative to 2022. The original expectation in 2022 was that we were going to have 10% growth. 2023 estimates came down, but multiples also came down. As we finished 2022, the multiple was actually below what we’ve seen in recent history for the equity market.

We were bullish coming into the year on equities and thought that the outlook was positive. We thought the outlook for both asset classes was positive coming into the year. As we’ve gone through the year and as inflation has come down to much more manageable levels – we’re not certainly to the point where the Fed is satisfied yet – but it’s down to more manageable levels, and it’s come with less of a demand destruction than everyone feared.

Obviously there are a lot of forecasts for a recession this year. We just got second-quarter GDP of up 2%. A lot of forecasts are for a positive GDP growth again. The recession that a lot had forecast for this year hasn’t come to fruition. As a result of that, earnings for companies have been better than expected. Part of that has been, the supply chain has started to normalize. We’ve seen labor markets starting to get back to more normal levels, still not to where the Fed would be again happy with, but we’re getting there. Then the other piece that’s helped the S&P 500 up 17% so far this year is this budding technology called artificial intelligence.

Castleton: Never heard of it.

Buckley: And accelerated computing. While we were all aware of this and thought that this was a long-term opportunity and innovation that will help drive both technology spending but also productivity and efficiency, I think it really hit that asymptote and accelerated this year to help drive both equity markets but also the thought that we have this innovation that’s going to drive a lot of productivity, that can help solve these long-term labor issues, can help bring inflation down as a result of that. That’s been very beneficial and we’re still very optimistic about the potential of that technology and what it’s done. In the short term it has accelerated technology spending when we thought higher interest rates might lead to a decline in technology and capital spending that would lead to this recession. Instead, we have an area that’s driving growth going forward.

Castleton: And then, just to dig into that a little bit more and then we’ll transition back to fixed income, for listeners who know what my team does, we consult with client portfolios daily. Most of the clients that I’ve spoken with this year have either been underweight risk because of that most anticipated recession ever, but they definitely probably have been underweight the top seven within the index. It sounds like the outlook for equities, how you would approach taking equity risk in this market today, is just being a little bit more focused on earnings. Are there elements of hearing this rolling recession running around? Tech was in a recession absolutely last year, so is it just being more picky with opportunities? What would you say to equity risk in this market today?

Buckley: Yes. I think it’s an environment where security selection is extremely important because, to your point, I think we’re having these rolling recessions, which I think has the potential to keep us out of an overall recession but certainly has pain for certain sectors. We’ve certainly seen that, whether it be consumer goods or electronics and components, which has certainly seen difficulties this year.

To your point, a good portion of the equity gains this year have been driven by a small number of stocks that have benefited from this artificial intelligence theme that we’ve talked about, but when we look at those, we think a number of them, the earnings have supported the growth in the stock prices and we think valuations there are still reasonable. There are certain examples within that group, though, that we’re also concerned about from a valuation standpoint. We think that they could be ahead of themselves.

I think it’s very important, given the multiple expansion we’ve seen in the Nasdaq, that we need to be very careful on how we select securities within that artificial intelligence theme and try to identify the haves and the have-nots. If you take out those top seven and some of those high-flying tech names and you look at the rest of the market, the valuation on the rest of the market, we think, is still reasonable. We think a lot of the top companies, the companies that have the best scale, leading in their industries, have the ability to use artificial intelligence to improve their business and make themselves more productive and efficient going forward.

We think there are opportunities finding the beneficiaries, not just the companies that are benefiting from the technology spending and the capital spending today but those companies that, through the practice of artificial intelligence, can improve over time. We still think there are opportunities in the equity market. I think again we have to be careful because the valuations are at a different point than they were at the end of 2022 and that’s why security selection here is so important.

Castleton: Super-helpful. Good message for clients who have just been having to defend owning a diversified portfolio and not just seven names this year. Going back to fixed income, Greg, obviously the winning strategy over the last year and a half has been to just have no interest rate risk. Should investors still be afraid of duration?

Wilensky:  I absolutely agree that in the last year and a half or so, avoiding interest rate risk was the way to go. The best play was to have less interest rate risk than whatever your home base was, your benchmark, or essentially stay as close to cash as possible. I believe that actually has pivoted.

Late last year, even early this year, we felt like the market was still pricing in rate cuts too soon, but over the second quarter, when front-end rates rose by about 80 basis points, what you saw was those rate cuts for the most part being priced out of the market.

We think, if anything, actually it may have flipped to the other side where the market is expecting maybe a little too much of the soft landing or even a no-landing scenario. We still think there’s a reasonable chance that that reduction in inflation that we expect to continue to see will occur in the face of a weakening economic environment and that will bring the Federal Reserve into cutting mode sometime next year. So, with that, we are seeing it as being more appropriate to lean into or consider adding some interest rate risk.

Castleton: I think that’s a great point. One of the biggest concerns that I get with clients about leaning into duration or adding something is, especially over the last couple weeks, seeing the longer end reprice higher. They’re still nervous given the Fed hasn’t committed to pausing yet. So do you have a message to them on, there’s no perfect time to add duration, but you’re obviously finding opportunities now.

Wilensky: There’s always risk in anything having to do with investing and certainly in trying to call interest rate movements. It’s something that we do every day, but we actually, just like Jeremiah was talking about security selection being crucially important on the equity side, on the fixed income side we will take interest rate views, but we much prefer to use our research and all of our experience to pick individual investments. But people always want to talk about the duration call, so we’re absolutely willing to do that.

I think at this point, while taking on a little more duration, given the inverted shape of the yield curve, you’re giving up a little carry to do that. Last year we didn’t think it made sense because we thought, again, the market was pricing in aggressive cuts going out into the future that we didn’t think would actually be realized. Now that yield give-up is much smaller and we think we’re getting much closer to that point in time where policy rates will start to either stop moving up and eventually start to move down.

Having some of that duration in your portfolio means two things. One, you avoid the eventual, you don’t care so much about the return over three months. You care about your returns over, let’s call it, two to three years and we think that duration will outperform over that kind of time period. Certainly, as we think about 60-40-type strategies, having a little bit of that duration in the portfolio or having more duration in the portfolio, I think, is going to help you position for if there is an economic downturn that would cause earnings estimates to fall and cause weakness on the equity side. You’re going to want to have that duration to provide that ballast.

Castleton: Wonderful. Thank you. So that’s a great recap on where we’re seeing opportunities, where we’ve been. It’s very difficult to predict this macro environment and I do think it’s great that we’re working at a fundamental shop where we’re leaning on expertise and our knowledge to pick the right companies, the right bonds that we can put in our portfolio. So, Jeremiah, just what are you most focused on in the equity markets over the year ahead from sector, whatever perspective you might see?

Buckley: Yes. Sure. I think while we’re not dismissing the possibility of a recession, I think it’s important for us to continue to monitor the lagged impact that rising interest rates have. I think we’ve got to be careful not to declare victory that, hey, rates are higher now, the Fed is close to being done, and there’s been no impact on the economy. There is a long lag and I think in particular in this case where a lot of companies issued debt during the pandemic at very low rates, there is likely an explanation for a longer lag. We need to be very careful about that.

While the economy in the US continues to be resilient, there is weakness outside the U.S. in other countries. We need to be careful about that as well because, being in the U.S. large cap space, we focus on multinational companies and so we’re very concerned about what’s going on in China and what’s going on in Europe. So those are the two concerns that I have.

I think on a more positive note, I think what has helped this year is again that supply chain normalization, the labor market normalization with participation improving, immigration again helping in that framework as well, but also supply chain constraints easing and lead times coming down. We’re getting to a more efficient manufacturing system as inventories have come down and so that should continue to help.

We’ve also seen raw materials come down. We’ve seen transportation costs come down. Those haven’t worked their way yet through a lot of companies’ cost of goods sold yet. We’re still optimistic that we’ll see margin expansion going forward. As long as companies are improving margins, we think that the labor force is generally safe and that we could continue to have pretty good employment, which continues to drive the bus.

Lastly, I talked a lot about artificial intelligence, but it’s really an important technology that we need to keep close eyes on, both on how it impacts different companies who are supplying that growth and that investment but also who are again benefiting from that and how it changes their business and how they become more productive because that productivity growth will continue to drive their ability to invest and grow their earnings over time. So those are the areas that we’re focused on. We think there’s concerns that we have to be aware of from a macro standpoint, but we think there are internal initiatives and internal themes within the market and the economy that can continue to drive earnings growth going forward.

Castleton: Thank you. Greg, you touched on this a little bit. It sounds like you think fixed income can once again be the ballast in a 60-40 portfolio again. Is there anything else you want to add in terms of what you’re really excited for about fixed income in the year ahead?

Wilensky: Yes. You definitely noted that from an overall asset allocation setup, it’s a much better position and I think we’re much more excited about how 60-40 portfolios can behave in a variety of economic environments. As far as what we’re doing on the fixed income side and what we’re most excited about from a portfolio construction perspective, I think Jeremiah said it so well when talking about, there are definitely economic risks and we want to make sure we’re building a resilient portfolio, and as we look across the various sectors of the bond market right now, in our view, we can see some sectors that I think are doing a better job of pricing in the range of outcomes that can occur.

Some of those can be very positive economic outcomes, but also we’ve got to be on guard for economic downturns. As we do that, I think, broadly speaking, we’re finding that we can add very high-quality securitized assets, whether we’re talking about securitized credit assets, let’s say asset-backed securities or mortgage-backed securities, the spreads that are being offered there tend to be above their long-term averages, in some cases closer to their wides than their long-term averages, where, when we look at corporate credit, that’s tending to have spreads that are below their long-term averages.

So if we look at that and say, whatever economic environment we end up in, we might as well take more exposure in those securities that are offering higher spreads than normal. Overall, even if we get an economic downturn, I think for reasons like the one that Jeremiah pointed out, most companies and individual households are coming into this recession, a recession if it happens, the one that everyone’s been forecasting, in a better starting point than they would have been in most other situations. It’s households having refinanced their mortgages, having still some excess savings. They’ve locked in low rates. Same thing with corporations that have locked in low rates. Even though, in that situation, we can have some pain for sure, we think it won’t be as bad as a normal downturn.

Castleton: I’ve heard that the explanation for no recession, by the way, is Taylor Swift, Beyonce, and Barbenheimer. However, I do think that those actually make a little bit more of a realistic answer in terms of why we haven’t gotten there yet. So thank you both. I think the last thing I want to wrap up with is just summarizing. The insights you provided were great. For implications for investors, I got three takeaways.

It’s extremely difficult to, again, predict this macro environment. In equities I think it’s good to, from what I’m hearing, be picky in terms of what you’re owning from a valuation perspective with an emphasis really on earnings. You actually came out with a piece recently on our blog that’s talking about that focus on earnings. In fixed income, we still like the short end of the curve. It’s still attractive given the inversion, but it’s time to start leaning into duration a little bit more. Then, from my perspective, a lot of clients do have a lot of cash sitting on the sidelines. You offered some really great opportunities in terms of deploying some of that, getting a little bit more comfortable adding into risk.

The last thing I want to wrap up with is obviously, these are great insights for the core of a client’s equity-fixed income allocations, but you manage a multi-asset strategy. Is there value for clients also owning a strategy that is multi-asset in addition to that core? Jeremiah?

Buckley: Obviously we’re biased and have an opinion on this, but we do think, from an overall strategy standpoint, having a balanced strategy makes sense. We hope that having less volatility, maybe not capturing all of the upside in equity markets but not capturing all the downside as well, by having that ballast of the fixed income portfolio, can keep investors confident enough to stay invested instead of being parked in cash and having that on the sidelines. They have that ability to participate in capital appreciation when markets are favorable, but they also have some protection when markets are more volatile.

What we’ve been focused on over time is trying to add value through asset allocation, adjusting between equity and fixed income over time, to be able to add value relative to a static mix of equities and fixed income, and then the security selection. That added security selection alpha creation makes us believe that having a balanced strategy as a core part of your portfolio continues to make sense.

Castleton: Greg, anything to add there?

Wilensky: I think Jeremiah did a great job, but if I were to add one thing, it’s the fact that it’s not just about bringing together or slapping together an equity portfolio and a fixed income portfolio. Any investor could do that. They could pair an equity mandate and a fixed income mandate and try to make asset allocation decisions. I think one of the things that’s different for us is, we are talking about how the fixed income allocation and the equity allocation are going to interact with each other and think about the risks and scenarios that might be good or bad for each allocation and try to essentially manage the risk at an overall aggregate level rather than just thinking about this as two bolt-on portfolios. That’s something that can’t be replicated if all you’re doing is try to marry an individual fixed income and equity portfolio together.

Castleton: Makes a ton of sense and it’s exactly what we see in our consultations with clients that do have multi-asset portfolios. It can get the opportunity for them to get a pivot in their portfolio of overweighting equities or fixed, depending on the strategy, but still staying invested in that core. It does tend to have the ability to provide some smoothing effects on volatility. Thank you for your insights. You guys work very closely together. You’re in constant contact with one another. Thank you so much for sharing your insights here today and thank you for tuning in to this episode. For more insights from Janus Henderson, feel free to download the other episodes of Global Perspectives anywhere you get your podcasts or you can go to our website at janushenderson.com. I am Lara Castleton. See you next time.