AIQ Asset Management Current Outlook and Strategy Positioning – August 2024
AIQ Asset Management recently completed the quarterly rebalance of both AIQ and ARC AIQ managed strategies. The primary goal of the rebalance is to routinely bring portfolios back into balance with current models to ensure client accounts are in line with their stated risk profiles and to raise funds for scheduled outflows. We also often use it as an opportunity to make allocation changes to the Asset Allocation models, Hedged Equity Strategy, the Unified Managed Accounts (UMA), and the Innovative Solutions (IS) models as well as security changes within the individual strategies which also impact the UMAs and IS
models.
The purpose of this note is to provide an overview of our current economic and market outlook as well as to provide a broad overview of how the portfolios are positioned to take advantage of our current outlook.
Executive Summary
Market Overview
- Equity Market Record Highs: Major U.S. and global equity indices, including the S&P 500, Russell 2000, MSCI World, and emerging markets, are back to multi-year or all-time highs.
- Strong Fixed Income: U.S. fixed income markets, including investment-grade and high-yield corporate bonds, have also experienced significant gains.
Recent Volatility
- Earnings and Economic Data: Overall earnings reports for the second quarter came in above expectations and stocks responded well providing a positive backdrop through July, but the market sell-off in early August was primarily attributed to weaker economic data, a few disappointing earnings reports, and aggressive investor positioning.
- Macro Trading Dynamics: The unwinding of macro trading positions due to the strengthening Japanese Yen and lower summer trading volumes also contributed to the volatility.
Market Outlook
- Economic Slowdown:
The economy is expected to slow in the second half of the year, but a recession is not the base case.
- Corporate Earnings: Corporate earnings are projected to trend better than GDP, but margin expansion expectations may be overly optimistic.
- Interest Rates: The Federal Reserve is expected to cut interest rates starting next month, but the pace and magnitude of cuts remain uncertain.
- Messaging: If the Fed were to follow the markets’ more aggressive forecast for the pace of rate cuts, we believe it would signal increasing concern for the health of the economy and could lead to declines in risk assets.
- Bond Market Inconsistencies: There are inconsistencies in the trading of different components of the bond market with Treasury rates suggesting slower growth than either corporate bonds (credit spreads or at the low end of their historical range) or the equities are pricing in leading to potential downside risks.
Portfolio Positioning
- Growth Equities: The portfolio favors larger cap and growth equities.
- Defensive Tilt: A slightly more defensive posture (including reasonably priced growth stocks) has been adopted due to potential economic risks.
- Fixed Income: The portfolio is positioned for a curve steepening, with short-term rates falling faster than long-term rates, and is highly focused on credit analysis given expectations for a slowing economy.
Overall Outlook
- Cautious Optimism: While the market is expected to avoid significant drawdowns, there are risks associated with the economic outlook and geopolitical factors.
- Focus on Opportunities: The firm remains focused on identifying longer-term opportunities for outsized returns.
Market and Economic Outlook
The market cap weighted S&P 500 is near its all-time high, the equal-weighted S&P 500 index is at its all-time high, and the small cap Russell 2000 Index is at its highest level since early 2022. U.S. Fixed income markets are also showing strength with the broad-based Bloomberg U.S. Aggregate Index and the investment grade corporate bond index at their highest levels since early 2022 while the high yield corporate bond index continues to power to new all-time highs almost daily. This strength is not just reserved for the U.S. as the MSCI World Index (ex U.S.) also recently hit a new all-time high while the emerging markets index continues its steady march higher and is also at levels not seen since early 2022.
Readers hopefully took August off. For those of us unfortunate enough to be glued to our screens, however, it has been an interesting couple of weeks. First, earnings season came in better than expected and stocks (across market caps) generally performed well in the immediate aftermath. Solid earnings reports with positive reactions are generally a good backdrop for equity returns. So, what happened in the first week of August to drive the S&P 500 down 7% in just a few days? Well, as usual, it is complicated but at a high level, we believe the sell-off can primarily be attributed to a combination of weaker economic data, disappointing earnings reports, aggressive investor positioning (i.e., more investors expected positive movements than negative creating the potential for disappointment), macro trading dynamics being unwound due to the strength in the
Japanese Yen, all occurring at a time when the market is more vulnerable due to the lower summer time trading volumes, causing outsized declines.
The good news is that the selloff subsided fairly quickly, and markets have steadily rebounded throughout the month with economic data stabilizing, inflation continuing to fall, the Federal Reserve indicating that rate cuts are likely to begin while also adding assurances that it stands ready to protect the labor market (and thus economy) if needed. This has investors once again focused on a soft-landing scenario and chasing risk assets.
We have repeatedly written in these commentaries that we expect the economy to slow in the second half of the year as consumers finally deal with the inevitable hangover that followed the post-COVID revenge spending spree and that market volatility was likely to increase given what we believe was overly optimistic investor positioning. While it is hard to predict the “when” and the “how” these corrections will occur, being prepared helps create opportunities. In this case, we took advantage of some changes that we saw in the options market in late July to increase our hedges for UMA/IS-type accounts that can use them. The good news is that these additional hedges worked well in the volatility spike and while they have since declined in
price as the market has recovered, they are still in place should we need them again. We also took advantage of the brief spike in volatility to add a couple of highly attractive structured notes to the investment strategies that can use them (more detail in the individual strategy section below). While we hedge risks in many ways, this example shows how it varies depending on market conditions as we bought volatility when it was low with the puts and then sold it when it was high with the structured notes.
So, where does this leave us as the August dust settles? Not too far from where we were as of our last commentary following the second quarter, but with a couple of areas where we differ from the consensus market expectations. We continue to believe the economy is slowing, but that the U.S. will likely avoid a recession. Economists agree as GDP estimates show slowing growth in the second half of the year and then sub-2% growth in 2025. We do believe that the odds of a recession have increased, and economists have also flagged this risk with the Bloomberg survey suggesting odds of about 30% (seems right to us).
We expect corporate earnings to trend better than GDP (as explained in previous commentary, public corporations – especially the S&P 500 – are not very good barometers of the broader economy and thus can be expected to generally perform better). In this case, the consensus estimate is for S&P 500 earnings growth to decelerate (but still grow) in the third quarter then to quickly rebound in the fourth quarter and to accelerate meaningfully in 2025. Revenue growth, which is more directly tied to GDP, is expected to be steadier, with a growth rate in the mid-single digit range but to also accelerate in 2025. Earnings estimates is one area where we have expressed skepticism in the past and continue to do so today. We are particularly concerned that expectations for continued, and significant, margin expansion are too aggressive. While we fully understand
corporations’ ability to cut costs and drive efficiencies, we would argue that the pricing power companies achieved during the inflationary period over the last couple of years is fading which will make those margins more difficult to achieve. Companies have also already largely benefited from the significant decline in freight costs, supply chain normalization, and the discounts from bloated supplier inventories across many areas of the economy. While labor cost increases are slowing, we have yet to see mass layoffs (which would create a different set of issues) or any significant decline in labor costs so there is still underlying
pressure on company costs.
Current consensus estimates call for operating margins to increase from 13.6% in 2023 to 15.7% in 2024 as companies have caught up from the rapid increase in inflation and to 17.0% in 2025. To put that in perspective, the highest margin achieved in the 2000s prior to COVID was 14.7% in 2018. We do believe that companies have achieved a new level of profitability overall and we are also cognizant that the changes in the makeup of the S&P 500 over the years are margin accretive (e.g., Nvidia’s operating margin over the last year is above 50%), but we wonder how much more companies can squeeze out of their cost base in a slower economic environment (and can Nvidia, et al. really maintain those massive margins over time).
To be clear, we are not suggesting that we see material downside to estimates or the stock market, but with multiples also running well above average, we do wonder how much upside exists without significantly exceeding current forecasts and how much volatility we might see should investors begin to doubt these rosy forecasts (as they did a few weeks ago).
This brings us to the bond market and our big internal conundrum. We believe there are some inconsistencies in the way different components of the bond markets are trading both versus each other and versus the stock market. We are going to try to keep this high level to avoid getting too technical, but please let us know if you want to get into the details. First, we will state once again that we believe the Federal Reserve should have cut rates in July even though we did not expect them to. We do not, however, expect that the delay to have a material impact on the economy as we (and nearly everyone else) expect the Fed to cut rates at its September meeting. Our forecast is for a 25 basis point cut while Fed Fund futures currently suggest an approximate 35% chance of a 50 basis point cut. Why only 25 basis points, when we thought they should have cut in July? Perception. We simply do not expect economic data to deteriorate fast enough before the September 18th decision date for the Committee to do more than one cut because it would suggest that its confidence in a soft landing is not as high as it projects. If economic data does deteriorate, we (and everyone else) will need to reassess our economic forecast with negative repercussions likely.
Futures expect a total of four cuts over the final three meetings this year (including September) meaning that the Fed would need to cut 50 basis points at one of those meetings. Prior to the last few weeks, we expected 50 to 75 basis points of cuts with a lean toward the Fed skipping the November meeting. Based on Chairman Powell’s, and other FOMC members’, comments at the annual Jackson Hole Economic Symposium last week, however, we now expect one 25 basis point cut at each of the three meetings for a total of 75 basis points. While the difference between 75 and 100 basis points is honestly not likely to be material to either economic activity or inflation expectations, it is the message that it sends that will be important. As with our comments about September above, we believe a 50 basis point cut at any of these next meetings would suggest that the Fed is more worried about economic growth than it has been, and we believe that could cause increased investor angst.
Looking beyond the next couple of months, futures project another five to six cuts in 2025 bringing the total to 225 to 250 basis points of cumulative cuts in the cycle which would translate into a Fed Funds rate of approximately 3.0% versus the current 5.25% to 5.50% range. This would bring the rate in line with the level that many economists believe might be the so called “neutral rate” or the rate at which monetary policy is neither restrictive nor simulative to the economy. This is a highly theoretical exercise and history suggests very little chance of rates actually normalizing in such a steady, predictable manner; but given none of us know the future, we are comfortable with this as a baseline forecast based on the assumption that the economy returns to its pre-COVID slower growth profile - albeit with a higher level of inflation given de-globalization trends - a
generally tighter labor market, a tighter housing market, and recent fiscal trends.
Under this scenario, the two-year Treasury bond is highly likely to also trend toward 3.0% from 3.9% currently. Given historical trends, the time value of money, fiscal concerns, and the general uncertainty that comes with predicting the future, we would expect rates for longer dated Treasuries to be higher than they are for near-term maturities which would translate into a “normal” upward sloping yield curve. It is the magnitude of this upward slope that will have a big impact on longer-term rates
and near-term bond returns.
Looking at the rate cut cycles over the last 40 years (i.e., post the hyperinflation of the 1970s), one will find that the spread between two and 10-year Treasury rates has often gone from negative (as it is now) to 250 to 300 basis points though it only went to 150 basis points in the most recent 2019-2020 cycle (which included the Covid lock-downs). While it is difficult to know how much the pandemic impacted the yield curve, we acknowledge that the Federal Reserve has more aggressively managed longer-term interest rates since the Great Financial Crisis than it had in the past and that that could justify a lower risk premium in longer-term rates going forward. We would also point out, however, that there are still things the Fed cannot control. Thus, even if we discount 2019’s slope, the 10-year rate would already be too low at 3.8%. Rates have been volatile over the last couple of years, but we have generally suggested that the 10-year bond should yield somewhere in the 4.0% to 4.5% range with higher spikes possible (it was 4.71% in April for instance) as long as the economy holds up ok (i.e., a soft landing). A stronger economy would suggest even higher rates. We remain comfortable with that range provided the U.S. avoids a recession.
Herein lies our conundrum. Rate investors are predicting a fairly aggressive rate cut cycle and a still muted yield curve (i.e., lower long-term rates) which is indicative of elevated economic concerns. We do not, however, see the same concerns reflected in current corporate bond credit spreads which are near their historic lows (suggesting there is little economic risk), corporate earnings estimates, or stock market valuations. We do not believe these inconsistencies can exist for long and while we see risk to risk assets as outlined previously, we would also suggest that rates have come down too far, too fast, and would caution investors from chasing bonds just because the Fed is about to cut rates.
Portfolio Positioning
With this as a backdrop, we continue to favor larger cap, growth equities as they are likely to be best positioned to meet and exceed current estimates in a slowing growth environment. We are, however, cognizant of valuation in our security selection as the stock market once again tests its all-time highs. To that end, we continued to diversify the portfolio during this rebalance adding a bit more of a defensive tilt (with the reminder that we view reasonably valued, steady-growth companies as defensive). We cut back on our exposure to consumer discretionary-oriented companies as we have finally seen significant evidence that consumer spending is slowing. Also, as a reminder, prior to the rebalance (at the end of July), we took advantage of a lull in the volatility to increase our put exposure to help hedge our UMA/IS strategies even more against increased volatility or a significant drop in the S&P 500.
We expect continued volatility in the fixed income markets as investors grapple with economic concerns, the imminent beginning of the Fed’s rate normalization cycle, currency fluctuations, and the still dynamic inflation backdrop. In the outlook piece following the May rebalance we suggested that the 10-year bond could be anchored around 4.5% and that we had added some duration given the big increase in rates since the March rebalance. Well, buying duration was a good move, but we should have done much more as the 10-year was far from anchored to 4.5% as it is now 3.8%. As explained above, we believe that is too low and have removed that extra duration from the portfolio and positioned it for curve steepening with short-term rates falling faster than long-term rates. While we see the risk that long-term rates could rise leading to losses on those longer- term bonds, we have not made a big bet on that as of now. While credit spreads briefly spiked in early August, they have returned to historically low levels supported by investor confidence in the soft-landing thesis, strong refinancing activity, and the benefit that should come with lower rates. While we understand the drivers, we fear that there is a lot of good news already priced into spreads at these prices which keeps us selective in our security selection with an intense focus on preserving and growing client capital.
We remain cautiously optimistic that markets (both equity and fixed income) can avoid any material drawdowns but are cognizant that a lot is riding on the Fed and the soft-landing scenario. There is little room for error given current expectations/valuations and, as we approach a seasonally difficult time for markets and a highly uncertain election, we felt a mildly more defensive posture to be prudent. We continue to diligently monitor the many risks that could lead to a change in the economic and/or market environment including the ever-present (and unfortunately elevated) geopolitical risk, rising interest rates, potential continued supply chain disruptions, commercial real estate defaults, and rising oil/gasoline prices while the same time focusing on the longer-term opportunities for outsized returns.
Recent Commentary
AIQ Asset Management Current Outlook and Strategy Positioning – August 2024
AIQ Asset Management recently completed the quarterly rebalance of both AIQ and ARC AIQ managed strategies. The primary goal of the rebalance is to routinely bring portfolios back into balance with current models to ensure client accounts are in line with their stated risk profiles and to raise funds for scheduled outflows. We also often use it as an opportunity to make allocation changes to the Asset Allocation models, Hedged Equity Strategy, the Unified Managed Accounts (UMA), and the Innovative Solutions (IS) models as well as security changes within the individual strategies which also impact the UMAs and IS
models.
The purpose of this note is to provide an overview of our current economic and market outlook as well as to provide a broad overview of how the portfolios are positioned to take advantage of our current outlook.
Executive Summary
Market Overview
Recent Volatility
Market Outlook
Portfolio Positioning
Overall Outlook
Market and Economic Outlook
The market cap weighted S&P 500 is near its all-time high, the equal-weighted S&P 500 index is at its all-time high, and the small cap Russell 2000 Index is at its highest level since early 2022. U.S. Fixed income markets are also showing strength with the broad-based Bloomberg U.S. Aggregate Index and the investment grade corporate bond index at their highest levels since early 2022 while the high yield corporate bond index continues to power to new all-time highs almost daily. This strength is not just reserved for the U.S. as the MSCI World Index (ex U.S.) also recently hit a new all-time high while the emerging markets index continues its steady march higher and is also at levels not seen since early 2022.
Readers hopefully took August off. For those of us unfortunate enough to be glued to our screens, however, it has been an interesting couple of weeks. First, earnings season came in better than expected and stocks (across market caps) generally performed well in the immediate aftermath. Solid earnings reports with positive reactions are generally a good backdrop for equity returns. So, what happened in the first week of August to drive the S&P 500 down 7% in just a few days? Well, as usual, it is complicated but at a high level, we believe the sell-off can primarily be attributed to a combination of weaker economic data, disappointing earnings reports, aggressive investor positioning (i.e., more investors expected positive movements than negative creating the potential for disappointment), macro trading dynamics being unwound due to the strength in the
Japanese Yen, all occurring at a time when the market is more vulnerable due to the lower summer time trading volumes, causing outsized declines.
The good news is that the selloff subsided fairly quickly, and markets have steadily rebounded throughout the month with economic data stabilizing, inflation continuing to fall, the Federal Reserve indicating that rate cuts are likely to begin while also adding assurances that it stands ready to protect the labor market (and thus economy) if needed. This has investors once again focused on a soft-landing scenario and chasing risk assets.
We have repeatedly written in these commentaries that we expect the economy to slow in the second half of the year as consumers finally deal with the inevitable hangover that followed the post-COVID revenge spending spree and that market volatility was likely to increase given what we believe was overly optimistic investor positioning. While it is hard to predict the “when” and the “how” these corrections will occur, being prepared helps create opportunities. In this case, we took advantage of some changes that we saw in the options market in late July to increase our hedges for UMA/IS-type accounts that can use them. The good news is that these additional hedges worked well in the volatility spike and while they have since declined in
price as the market has recovered, they are still in place should we need them again. We also took advantage of the brief spike in volatility to add a couple of highly attractive structured notes to the investment strategies that can use them (more detail in the individual strategy section below). While we hedge risks in many ways, this example shows how it varies depending on market conditions as we bought volatility when it was low with the puts and then sold it when it was high with the structured notes.
So, where does this leave us as the August dust settles? Not too far from where we were as of our last commentary following the second quarter, but with a couple of areas where we differ from the consensus market expectations. We continue to believe the economy is slowing, but that the U.S. will likely avoid a recession. Economists agree as GDP estimates show slowing growth in the second half of the year and then sub-2% growth in 2025. We do believe that the odds of a recession have increased, and economists have also flagged this risk with the Bloomberg survey suggesting odds of about 30% (seems right to us).
We expect corporate earnings to trend better than GDP (as explained in previous commentary, public corporations – especially the S&P 500 – are not very good barometers of the broader economy and thus can be expected to generally perform better). In this case, the consensus estimate is for S&P 500 earnings growth to decelerate (but still grow) in the third quarter then to quickly rebound in the fourth quarter and to accelerate meaningfully in 2025. Revenue growth, which is more directly tied to GDP, is expected to be steadier, with a growth rate in the mid-single digit range but to also accelerate in 2025. Earnings estimates is one area where we have expressed skepticism in the past and continue to do so today. We are particularly concerned that expectations for continued, and significant, margin expansion are too aggressive. While we fully understand
corporations’ ability to cut costs and drive efficiencies, we would argue that the pricing power companies achieved during the inflationary period over the last couple of years is fading which will make those margins more difficult to achieve. Companies have also already largely benefited from the significant decline in freight costs, supply chain normalization, and the discounts from bloated supplier inventories across many areas of the economy. While labor cost increases are slowing, we have yet to see mass layoffs (which would create a different set of issues) or any significant decline in labor costs so there is still underlying
pressure on company costs.
Current consensus estimates call for operating margins to increase from 13.6% in 2023 to 15.7% in 2024 as companies have caught up from the rapid increase in inflation and to 17.0% in 2025. To put that in perspective, the highest margin achieved in the 2000s prior to COVID was 14.7% in 2018. We do believe that companies have achieved a new level of profitability overall and we are also cognizant that the changes in the makeup of the S&P 500 over the years are margin accretive (e.g., Nvidia’s operating margin over the last year is above 50%), but we wonder how much more companies can squeeze out of their cost base in a slower economic environment (and can Nvidia, et al. really maintain those massive margins over time).
To be clear, we are not suggesting that we see material downside to estimates or the stock market, but with multiples also running well above average, we do wonder how much upside exists without significantly exceeding current forecasts and how much volatility we might see should investors begin to doubt these rosy forecasts (as they did a few weeks ago).
This brings us to the bond market and our big internal conundrum. We believe there are some inconsistencies in the way different components of the bond markets are trading both versus each other and versus the stock market. We are going to try to keep this high level to avoid getting too technical, but please let us know if you want to get into the details. First, we will state once again that we believe the Federal Reserve should have cut rates in July even though we did not expect them to. We do not, however, expect that the delay to have a material impact on the economy as we (and nearly everyone else) expect the Fed to cut rates at its September meeting. Our forecast is for a 25 basis point cut while Fed Fund futures currently suggest an approximate 35% chance of a 50 basis point cut. Why only 25 basis points, when we thought they should have cut in July? Perception. We simply do not expect economic data to deteriorate fast enough before the September 18th decision date for the Committee to do more than one cut because it would suggest that its confidence in a soft landing is not as high as it projects. If economic data does deteriorate, we (and everyone else) will need to reassess our economic forecast with negative repercussions likely.
Futures expect a total of four cuts over the final three meetings this year (including September) meaning that the Fed would need to cut 50 basis points at one of those meetings. Prior to the last few weeks, we expected 50 to 75 basis points of cuts with a lean toward the Fed skipping the November meeting. Based on Chairman Powell’s, and other FOMC members’, comments at the annual Jackson Hole Economic Symposium last week, however, we now expect one 25 basis point cut at each of the three meetings for a total of 75 basis points. While the difference between 75 and 100 basis points is honestly not likely to be material to either economic activity or inflation expectations, it is the message that it sends that will be important. As with our comments about September above, we believe a 50 basis point cut at any of these next meetings would suggest that the Fed is more worried about economic growth than it has been, and we believe that could cause increased investor angst.
Looking beyond the next couple of months, futures project another five to six cuts in 2025 bringing the total to 225 to 250 basis points of cumulative cuts in the cycle which would translate into a Fed Funds rate of approximately 3.0% versus the current 5.25% to 5.50% range. This would bring the rate in line with the level that many economists believe might be the so called “neutral rate” or the rate at which monetary policy is neither restrictive nor simulative to the economy. This is a highly theoretical exercise and history suggests very little chance of rates actually normalizing in such a steady, predictable manner; but given none of us know the future, we are comfortable with this as a baseline forecast based on the assumption that the economy returns to its pre-COVID slower growth profile - albeit with a higher level of inflation given de-globalization trends - a
generally tighter labor market, a tighter housing market, and recent fiscal trends.
Under this scenario, the two-year Treasury bond is highly likely to also trend toward 3.0% from 3.9% currently. Given historical trends, the time value of money, fiscal concerns, and the general uncertainty that comes with predicting the future, we would expect rates for longer dated Treasuries to be higher than they are for near-term maturities which would translate into a “normal” upward sloping yield curve. It is the magnitude of this upward slope that will have a big impact on longer-term rates
and near-term bond returns.
Looking at the rate cut cycles over the last 40 years (i.e., post the hyperinflation of the 1970s), one will find that the spread between two and 10-year Treasury rates has often gone from negative (as it is now) to 250 to 300 basis points though it only went to 150 basis points in the most recent 2019-2020 cycle (which included the Covid lock-downs). While it is difficult to know how much the pandemic impacted the yield curve, we acknowledge that the Federal Reserve has more aggressively managed longer-term interest rates since the Great Financial Crisis than it had in the past and that that could justify a lower risk premium in longer-term rates going forward. We would also point out, however, that there are still things the Fed cannot control. Thus, even if we discount 2019’s slope, the 10-year rate would already be too low at 3.8%. Rates have been volatile over the last couple of years, but we have generally suggested that the 10-year bond should yield somewhere in the 4.0% to 4.5% range with higher spikes possible (it was 4.71% in April for instance) as long as the economy holds up ok (i.e., a soft landing). A stronger economy would suggest even higher rates. We remain comfortable with that range provided the U.S. avoids a recession.
Herein lies our conundrum. Rate investors are predicting a fairly aggressive rate cut cycle and a still muted yield curve (i.e., lower long-term rates) which is indicative of elevated economic concerns. We do not, however, see the same concerns reflected in current corporate bond credit spreads which are near their historic lows (suggesting there is little economic risk), corporate earnings estimates, or stock market valuations. We do not believe these inconsistencies can exist for long and while we see risk to risk assets as outlined previously, we would also suggest that rates have come down too far, too fast, and would caution investors from chasing bonds just because the Fed is about to cut rates.
Portfolio Positioning
With this as a backdrop, we continue to favor larger cap, growth equities as they are likely to be best positioned to meet and exceed current estimates in a slowing growth environment. We are, however, cognizant of valuation in our security selection as the stock market once again tests its all-time highs. To that end, we continued to diversify the portfolio during this rebalance adding a bit more of a defensive tilt (with the reminder that we view reasonably valued, steady-growth companies as defensive). We cut back on our exposure to consumer discretionary-oriented companies as we have finally seen significant evidence that consumer spending is slowing. Also, as a reminder, prior to the rebalance (at the end of July), we took advantage of a lull in the volatility to increase our put exposure to help hedge our UMA/IS strategies even more against increased volatility or a significant drop in the S&P 500.
We expect continued volatility in the fixed income markets as investors grapple with economic concerns, the imminent beginning of the Fed’s rate normalization cycle, currency fluctuations, and the still dynamic inflation backdrop. In the outlook piece following the May rebalance we suggested that the 10-year bond could be anchored around 4.5% and that we had added some duration given the big increase in rates since the March rebalance. Well, buying duration was a good move, but we should have done much more as the 10-year was far from anchored to 4.5% as it is now 3.8%. As explained above, we believe that is too low and have removed that extra duration from the portfolio and positioned it for curve steepening with short-term rates falling faster than long-term rates. While we see the risk that long-term rates could rise leading to losses on those longer- term bonds, we have not made a big bet on that as of now. While credit spreads briefly spiked in early August, they have returned to historically low levels supported by investor confidence in the soft-landing thesis, strong refinancing activity, and the benefit that should come with lower rates. While we understand the drivers, we fear that there is a lot of good news already priced into spreads at these prices which keeps us selective in our security selection with an intense focus on preserving and growing client capital.
We remain cautiously optimistic that markets (both equity and fixed income) can avoid any material drawdowns but are cognizant that a lot is riding on the Fed and the soft-landing scenario. There is little room for error given current expectations/valuations and, as we approach a seasonally difficult time for markets and a highly uncertain election, we felt a mildly more defensive posture to be prudent. We continue to diligently monitor the many risks that could lead to a change in the economic and/or market environment including the ever-present (and unfortunately elevated) geopolitical risk, rising interest rates, potential continued supply chain disruptions, commercial real estate defaults, and rising oil/gasoline prices while the same time focusing on the longer-term opportunities for outsized returns.
Q2 2024 Commentary
Executive Summary
Market Review:
Key Observations:
Investment Strategy:
Fixed Income:
Conclusion:
The investment team is generally pleased with the risk-adjusted performance of its various strategies thus far this year and are comfortable with current positioning. We do, however, acknowledge that it is a challenging environment with a concentrated market, high valuations, and ongoing economic concerns. It is vital that we remain vigilant in our research process and that we continue to focus on mitigating risk while seeking long-term returns for clients.
TOPICS
IMPORTANT DISCLOSURES:
Our portfolio characteristics and holdings are subject to change at any time and are based on a representative portfolio. Holdings and portfolio characteristics of individual client portfolios may differ, sometimes significantly, from those shown. The investments presented are examples of the securities held, bought and/or sold in our strategies during the last 12 months. These investments may not be representative of the current or future investments of those strategies. You should not assume that investments in the securities identified in this presentation were or will be profitable. Diversification and asset allocation do not ensure a profit or guarantee against loss. We will furnish, upon your request, a list of all securities purchased, sold or held in the strategies during the 12 months preceding the date of this presentation. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities identified in this presentation. One or more of our officers or employees may have a position in the securities presented and may purchase or sell such securities from time to time. The benchmark shown for each model is a different weighted blend of various indexes or securities. Indexes are unmanaged, statistical composites, and their returns do not reflect payment of fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index.
Investment advice offered through Advisor Resource Council, a registered investment advisor. Additional information, including management fees and expenses, is provided on our Form ADV Part 2, available at the SEC’s Investment Advisor Public Disclosure website. As with any investment strategy, there is potential for profit as well as the possibility of loss. We do not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.
The Standard & Poor’s 500 b. (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. You cannot directly invest in an index.
The Russell 1000 Index measures the performance of the large-cap segment of the US equity universe. It includes the approximately 1,000 largest US stocks, representing approximately 93% of the value of the US equities market. It is not possible to invest directly in an index.
The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. It is not possible to invest directly in an index.
MSCI EAFE: The MSCI EAFE Index (Europe, Australasia, Far East) is designed to measure the equity market performance of developed markets outside of the U.S. and Canada. You cannot directly invest in this index.
MSCI Emerging Markets Index captures large and mid-cap representation across 24 Emerging Markets (EM) countries*. With 1,330 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Bloomberg US Aggregate Index is a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. You cannot directly invest in an index.
Bloomberg Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. The index excludes emerging market debt. It is not possible to invest directly in an index."
FTSE (3M) Treasury Bill Index is intended to track the daily performance of 3-month US Treasury bills. The indices are designed to operate as a reference rate for a series of funds.