Institutional investors are currently most concerned with inflation and how it will influence monetary policy, said David Grumhaus Jr., president and chief investment officer at Duff & Phelps Investment Management.
"The bond market and the (Federal Reserve) are in a tug of war right now, the outcome of which will tell us a lot about where we will be with respect to interest rates and the economy 12 months from now," Mr. Grumhaus said.
The Fed's key short-term interest rate is now in a range of between 4.5% to 4.75%, after the central bank raised rates by 25 basis points Feb. 1. And while inflation has been steadily declining, the rate still remains far above the Fed's 2% target — with the annualized consumer price index coming in at 6.5% for December.
Below the surface, Mr. Grumhaus said institutional investors are also concerned with the "appropriateness of their asset allocation targets, determining where value is in the marketplace, and selecting strategies with limited downside."
Duff & Phelps, which specializes in real estate, energy and infrastructure investing, has about $11.4 billion in assets under management.
Last year, a historically bad one for bonds, has "stuck with investors," Mr. Grumhaus noted, and caused them to rethink how to measure risk.
"The re-evaluation of asset allocation with clients and prospects has been an exciting exercise," he added. "Going through this process allows us to learn more about clients and provide customized investment solutions. We think this highlights the importance of allocating to less-correlated assets with liquidity across the portfolio."
Mr. Grumhaus thinks a recession is in the cards this year, but it will probably be a mild one.
"A recession has been looming for the better part of a year, but there is still a wide divergence in opinions about whether it will actually occur this year," he said. "When we look at the inverted yield curve, the lag effect of rapid rate increases, and the Fed's desire to not repeat the policy mistakes of the 1970s, our best guess is that a recession is likely to happen."
By "policy mistakes," Mr Grumhaus explained that in the 1970s "we allowed inflation to run out of control by growing the money supply at an unreasonable rate."
Now he expects any recession will be moderate or could even potentially be pushed back to 2024.
"If you look at the historically strong labor market, investor money on the sidelines, and solid consumer fundamentals — savings, wage increases, modest leverage — of today, it's hard to forecast any scenario close to a global financial crisis or the deep, long recessions that we have seen in more recent downturns," he added.
Noting that the U.S. labor market is "extremely strong," he said job growth has been "accelerating across most industries, the unemployment rate and claims keep moving lower, and we are seeing the best post-COVID-19 labor participation rate."
This might lead one to conclude that the Fed will not stop raising rates anytime soon, he added.
However, the "bright spot" has been the moderation in wage inflation and the deceleration of goods inflation from January's CPI report. "Therefore, it is plausible that we will see the Fed pause after another rate hike or two if wage inflation continues to moderate," he noted. "We would also expect to see the job market start to weaken in the second and third quarters, given the rapid increase in interest rates and some recent layoff announcements following weak (corporate) earnings."
Nevertheless, he observed that the market is "definitely pricing in rate cuts later in the year," and he thinks we will have to see "significant economic deterioration" before the Fed actually cuts rates.
Within sectors, Mr. Grumhaus said public real estate markets are likely to outperform in 2023 — they began the year at significant discounts to net asset value, and have shown attractive price-to-earnings metrics and strong cash flow growth prospects.
"Moreover, REITs tend to outperform in periods when inflation moderates, which is our expectation," he added. "Additionally, infrastructure offers a wide breadth of sectors that help increase diversification and increase risk-adjusted returns. This universe is helped by stable pricing, moderated costs, and regulation tailwinds, such as government credits and funding offered via the Inflation Reduction Act."
One current trend Mr. Grumhaus thinks is not getting enough attention is the lack of liquidity in the private markets and the importance of diversification between private and public asset classes.
"Both private and public investments fit in a portfolio," he added. "However, the illiquidity we've witnessed in private markets can and has forced investors to liquidate other assets in their portfolio at the worst possible time. We think last year has shed light on this issue and will lead to increased allocations in the publicly traded arena."
