Market Update - Tactical Portfolio Adjustment
As promised earlier this week, we wanted to share our upcoming portfolio adjustments which we will begin to implement tomorrow. These adjustments are part of our quarterly tactical trades and in response to the continued market volatility. We had our quarterly call with our portfolio construction team (BlackRock) earlier today and our investment team agrees with the proposed tactical adjustments.
My goal is to keep this letter rather brief (not my strong suit) while sharing their key research findings and tactical portfolio adjustments. Many of the themes I will share below align with what we shared earlier this week in our Market Commentary. As a reminder, our long-term strategic models remain intact. We are not market timers and firmly believe that staying the course and investing in a diversified manner through a strategic allocation is the proven path to long-term wealth. The portfolio adjustments we will be making to our models are simply tactical short-term adjustments to take advantage of perceived inefficiencies in the current economic environment. These tactical shifts are aimed to deliver positive returns over time against the benchmark returns.
Key Research Themes
The start of this year has been historic, and not in a positive way. The chart below illustrates what an outlier 2022 has been with both global equities and global fixed income experiencing negative returns. Given the degree of this outlier, I think there is a strong argument that the pendulum has swung too far to the downside.
BlackRock’s research largely aligned with what we shared on Monday. They acknowledge that the whispers of a recession have increased but they still think a full-blown recession is unlikely. As indicated in the chart below, the labor market remains very strong with unemployment back to the pre-pandemic rate of 3.6% along with a record number of job openings. On the right side of the chart, consumer finances are still elevated relative to the historical trendline. So, while economic growth may slow, the US consumer should help cushion the blow with consumer demand remaining strong.
The biggest concern I shared earlier this week was around inflation. BlackRock shared some interesting data points where they believe that inflation could peak over the next couple of months. Commodities, a leading indicator of the direction of inflation started to roll over (chart on left) and as a result, the future expected CPI print should start to follow suit (chart on right). I won’t quote the number they provided for sake of being wrong, but our lead Chartered Financial Analyst (CFA) on the call shared a CPI number that would be less than half of our current CPI by year-end (I hope this is accurate). If this scenario plays out, I think much of the recession fears have already been priced into this correction and the landing could be much softer than what is currently being reflected at these market levels.
Proposed Tactical Shifts
The research themes noted above are driving the tactical shifts shared below. These shifts continue a trend of recent adjustments to reduce active risk and add resilience amidst the current market uncertainty. This quarter we have three equity and one fixed income adjustment.
- Trim equity overweight to 1%.
- Our models are currently overweight 2% equites. We are going to reduce this by 1% and carry an overweight of 1% to equities across all models. Our preference still favors equities, but making this adjustment reduces our active risk and moves us closer to the benchmark targets if volatility persists.
- Add infrastructure and high dividend-paying stocks, reduce technology and small cap stocks.
- As the chart below illustrates, infrastructure and dividend-paying stocks tend to perform very well at this point in the cycle (moderately tight financial conditions and a steepening front-end yield curve). This is a sector play that tends to deliver better performance in a tightening market. These positions are defensive in nature and provide a lower volatility profile.
- Reduce energy and commodity positions
- These positions have greatly aided our portfolios YTD and are largely attributable to the positive returns relative to the benchmarks. With inflation potentially peaking next month and commodities starting to roll over, we feel now is a great time to take some profits and reduce our allocations to both our energy and commodity positions.
- Increase exposure to TIPS and convertible bonds
- Fixed income continues to be a challenge. BlackRock believes that investment grade and high yield markets will remain challenged given relatively narrow spreads over Treasuries. We have not had allocations to high-yield bonds this year but are shaving our investment grade exposure in favor of TIPS (inflation-protected bonds) and convertible bonds (debt holdings that act like stocks).
We will continue to actively harvest losses and rebalance client portfolios back to target. When the market starts to recover our clients will be wellpositioned to participate in the future recovery. We understand this has been a difficult period, but we are pleased with how our portfolios have responded and continue to believe the markets are on track to find their footing. Our belief is that we should start to turn the corner over the back half of the year.
We appreciate your commitment and trust in us. If there are any questions we can answer, please don’t hesitate to reach out. Many of you with tax deferred accounts will start to see trades placed tomorrow. We will be trading many of our taxable accounts early next week and should have our proposed trades fully implemented by mid-week.
I hope you have a great weekend!
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Please reach out if you want to talk through any of the adjustments laid out above.
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