Inflation and interest rates are the two topics on every institutional investor's mind right now, said Matthew Stadelman, chief investment officer at multistrategy investment firm Diamond Hill Capital Management.
"Low interest rates and low inflation shaped the winners of the last decade," he said in an email.
But as the market moves to a world of higher interest rates and higher inflation, he noted, institutional clients are asking themselves, "Do the allocations I've had for the past 5-10 years make sense for the next 5-10 years?"
"They recognize there's been a paradigm shift and now they're wondering if they have enough exposure to areas like small-cap stocks or international stocks or value stocks — all areas that lagged over the last decade" Mr. Stadelman added.
Institutional investors are also revisiting their fixed-income allocations because that's "an area where the risk/reward framework has shifted dramatically," he said.
In the short term, he noted, higher interest rates pose a headwind for all fixed-income investments.
"But longer term, these Fed actions have created an attractive backdrop for long-term fixed income investors," Mr. Stadelman noted. "This has led to one of the most attractive entry points we've seen in recent years for patient investors."
The dislocation in both equity and fixed-income markets last year created a "rich environment" for selective investors with "domain expertise and patience," he said.
Within fixed income, many investors tried to get ahead of the Federal Reserve last year and reduced their bond holdings. "However, by selling they only added additional downward pressure on prices," he said. "This created an abundance of opportunities. Spreads on less liquid areas of the market spiked to levels we hadn't seen since the financial crisis of 2007-2008 and early days of COVID-19."
Looking ahead, agency mortgage-backed securities stand out to Mr. Stadelman as being particularly attractive right now. "There are no credit concerns and somewhat paradoxically, any credit-related issues that develop would actually be a positive for agency MBS holders in this environment," he added. "Yields are also much more attractive now that the Fed has stepped away as part of its transition from quantitative easing to quantitative tightening."
In addition, he said agency MBS currently have "positive convexity" — meaning duration rises as yield declines — which is "highly unusual and offers a compelling return profile."
Within equities, Mr. Stadelman thinks small-cap and midcap stocks look "especially attractive" right now.
"These stocks lagged during the bull market, and now investors are concerned about their ability to withstand a recession," he said. "This combination has led to some low prices and has given us the opportunity to buy some wonderful businesses at a meaningful discount to what we think they're worth."
The biggest discounts he sees right now are in "well-run industrial businesses that are positioned to benefit from secular tailwinds — things like re-shoring, electrification, and automation."
These attractive opportunities are being overlooked by most investors because they are preoccupied with how these companies "will fare in a recession rather than recognizing their ability to thrive over the long term," he added.
If interest rates keep rising, Mr. Stadelman said institutional investors should be wary of high-flying growth stocks. "In our experience, the stocks that led the last bull market rarely lead the next bull market," he said. "These high-flying growth stocks enjoyed a nice relief rally in January, but we are skeptical this group can sustain the momentum and we expect a change in market leadership."
High-priced defensive stocks are another area where he advises caution. "Many investors have tried to sidestep the potential economic slowdown by piling into areas like consumer staples and utilities without regard for the prices they are paying," he said. "In our view, they have merely substituted cyclicality risk for valuation risk."
Diamond Hill Capital has $26.4 billion in assets under management.
