Stock market: ‘A barbell approach has a lot of merit,’ strategist says

Invesco Investment Solutions Senior Portfolio Manager Alessio de Longis joins Yahoo Finance's Brian Sozzi and Julie Hyman to provide an outlook on the stock market and discuss a defensive investing strategy.

Video Transcript

BRIAN SOZZI: Economic growth is in a slowdown regime, says our next guest. And because of that, it may be time to get a little more defensive in how you approach the markets. Alessio De Longis is a Senior Portfolio Manager at Invesco Investment Solutions. Alessio, happy New Year. I think I can still say that. So you're looking for a slowdown in economic growth. What is the biggest driver of that? And then, do you expect that to get worse later this year as we get into this land of higher interest rates?

ALESSIO DE LONGIS: Good morning, good to be with you guys. Yes, we expect after the outsized growth performance of the last two years-- and it's normal. It's absolutely normal to expect growth to decelerate. And that is, by and large, a consensus view. So the question is, with the increased hawkish twist by the Federal Reserve, which you guys have discussed at length earlier, that creates quite of a challenge, right?

Potentially a challenge for-- for asset prices, because now you are in a regime where growth is slowing. Inflation is expected to peak. And yet, the Fed needs to tighten financial conditions, and rightly so. We think that a barbell approach to your portfolio, which I'll explain in a second, a barbell approach has a lot of merit. In an environment where growth is still solidly above trend but expected to decelerate, equities can still perform well, historically they do.

But there is more of a sector rotation, or style rotation, that happens within equities that can bring a little bit more of a defensive aspect to your portfolio. A rotation from growth, from value into quality, and from small and mid-caps into large caps, that's where that defensive nature in the portfolio comes in. What does that mean?

Selling some of the-- or reducing exposure in some of the top performers of the past two years, such as financials, industrials, materials, and rotating into more defensive sectors such as technology, communication services, health care, consumer staples. Now, the rate environment, as long as the long end of the curve remains relatively well-anchored and the yield curve flattens, that sector rotation can still perform well in a rising rate environment.

JULIE HYMAN: What's so interesting to me about what you just said, Alessio, is what you view as defensive, right, because we're not talking about necessarily-- I mean, consumer staples are a classical defensive, right? But so are utilities, for example.

In other words, usually I don't think of tech and communications services as, sort of, classic defensive sectors. So it's very fascinating to me that going into this cycle, that area is now viewed as more defensive. Why do you-- those two areas in particular, why do you think they will be defensive?

ALESSIO DE LONGIS: Julie, that is an excellent question, and actually an area of research that we've focused very specifically on for the last year. The way we think about sectors and qualifying them as cyclical or defensive really comes down to analyzing their underlying bottom-up fundamentals. Historically the two sectors that you mentioned-- exactly, communication services and technology, are the ones where the fundamental characteristics have changed dramatically.

Take tech for example. Back in the late '90s, early 2000, tech was characterized by high price multiples, but low profit margins and low return on assets. As we know, now, today, we still talk about many tech companies that were just a PO box with no earnings behind it. But when you look today, where does that defensive nature comes from? Comes from those quality characteristics.

Defensiveness comes from large profit margins, very large return on assets, and very low operating leverage. When you look at tech and communication services, these businesses are more insulated from external funding. They rely on internal funding, which means, bearing the interest rate environment, they are more shielded from a deceleration in global growth, compared to more levered companies such as value companies or small and mid-caps.

BRIAN SOZZI: So let's see. I hear what you're saying. So you're looking for a growth slowdown. We're headed towards potentially four rate hikes this year. Can you make a case that cash is a defensive investment right now?

ALESSIO DE LONGIS: Um, I would go-- so the barbell approach that we mentioned earlier, I would argue that more defensiveness can be achieved paradoxically by extending duration and maintaining a long equity exposure, avoiding credit markets or reducing exposure to credit markets, and short duration assets. What do we mean by that? We expect the yield curve to continue to flatten. You guys had a very good discussion earlier on this.

The Fed hiking cycle that we are expecting is one that is very front-loaded and potentially aggressive at the beginning. And what is the objective of that? The objective of that is to give back purchasing power to consumers, especially low income households, is to lower inflation. But with the slope of the yield curve being where it is and likely to flatten more, because we're not seeing credit growth.

We're not seeing velocity of money. That slowdown may provide, actually, good returns on long-term duration assets. So to answer your question, cash is always a defensive strategy. But is it the best defensive strategy right now? Probably not.

BRIAN SOZZI: All right, so don't start hoarding cash. Words to live by. Alessio de Longis, Senior Portfolio Manager at Invesco Investment Solutions. Always good to see you.