Contributors: Andrew Walker, Bruce Ensrud, Matt Stockman
PORTFOLIO MANAGEMENT UPDATES
Our Q2 2022 Market Commentary explored the contributing factors to this year’s volatile markets. In essence, The Federal Reserve (the “Fed”) began raising interest rates to combat the inflationary forces that originated from COVID-era excessive stimulus and supply chain issues. Because higher interest rates result in lower equity valuations, the Fed’s increasingly hawkish stance against inflation caused the market to steadily reprice downwards throughout the first half of the year.
Going forward, it appears as though central banks in the US and abroad are determined to bring down inflation, even if that means economic growth taking a hit. The uncertainty that this scenario presents, along with concerns related to overly optimistic market expectations for corporate earnings, has moved us to shore up risk in portfolios. These changes are summarized below:
Rebalance to Strategic Targets
In times of heightened uncertainty like we are seeing today, it is prudent to make fewer active decisions in portfolios. Therefore, we rebalanced portfolios back to long-term strategic weightings between stocks and bonds.
Increase US Large Cap; Decrease US Small Cap
In times of rising uncertainty and volatility, where inflation and access to debt capital threaten corporate profits, bigger companies have shown themselves to be more resilient given the economies of scale that their size provides.
Enhance Downside Protection / Reduce Portfolio Volatility
The liquidity that the Fed has artificially distorted markets with since the 2008/2009 Great Financial Crisis had an effect of suppressing market volatility. With the Fed attempting to reverse its easy-money policy, we expect markets to be more volatile going forward. To reflect this, introduced a trend following fund to portfolios. The fund uses quantitative signals to determine when (not how) to be invested in the market such that, over time, we anticipate this allocation will lower overall portfolio volatility – especially in down markets.
International Diversification
Valuations internationally remain very attractive versus those in the US. The economic slowdown unfolding in Europe – caused in part by its dependence on Russia for energy – warrants caution. Considering this, we have reduced our portfolio exposure to Europe. In addition, we believe that COVID accelerated the beginning of many different deglobalization trends, which is supportive of the continuation of the new inflationary regime that we find ourselves in today. With this in mind, we have added to our international value exposure in portfolios, as this area of the market should be more resilient in this inflationary environment.
Reduce Credit Risk in Bonds
Thanks to fiscal and monetary stimulus, markets and the economy have been very strong for the past few years. One area that has held up surprisingly well is corporate debt. Despite the harsh lockdowns experienced over the last few years, very few issuers defaulted on their loans. This, of course, is thanks to enormous stimulus supporting them and the economy. With this stimulus on the way out, the number of defaults is likely to rise. While we are already strongly biased towards high quality bonds in our portfolios, we have found it prudent to continue to increase our allocation towards high quality bonds.
Beyond the above changes, we also took advantage of a few opportunities to increase our use of low-cost passive index funds within US Equity allocations, to drive down overall portfolio costs.
Thank you for allowing us to partner with you as we navigate the ever-changing market. We appreciate your continued trust.
If you have questions or would like to dive deeper into this quarter’s outlook, please reach out to our investment team. We’d be happy to set up a virtual coffee to talk more.
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