SUMMARY
In an environment where parts of risk assets rallied strongly (AI-related companies, credit), and other areas lagged where valuations remain more attractive (mid/small caps, international), I continue to prefer to remain diversified and not really do anything outside of rebalancing. This means reducing some of the bigger winners, reducing leverage and reallocating to the other areas that lagged. It’s something I’ve been doing selectively this year as risk assets have rallied strongly the last six months.
Rebalancing is a simple strategy in this environment. I’m not drastically changing my investments or trying to tactically time when to buy/sell high quality companies. Remember, I’m a long-term investor. I try to have a heavy overweight to quality companies’ stocks through diversified ETFs and active managers. I don’t try to get in/out for short-term moves (that most people get wrong anyway) – it isn’t worth it to me.
My exposure to higher income-generating risk assets (high yield bonds, emerging markets debt, closed end funds, option income strategies) could provide some cushion if the broader markets experience a short-term selloff or a longer period of stagnation. I’m comfortable with that. I continue to have exposure to closed end funds, but discounts to NAV are relatively tight, so they are generally less attractive to me at these levels. I have no need to get overly aggressive here, just remaining neutral.
If the equity markets experience a significant decline of 15%+ for whatever reason, I have plenty of “drier powder” in my allocation to higher income-generating assets. If the opportunity emerges, I can then utilize this allocation to start to get more aggressive for the longer-term capital appreciation potential of higher quality growing companies.
Commodities could continue to catch a bid if China’s economy reopens, but I don’t have any reason to dedicate exposure to commodities (gold, oil or otherwise). I’d rather allocate to high quality growing companies diversified across sectors, including those tied to commodities / natural resources.
Bond yields remain very attractive for shorter-term investors or for those that have lower risk tolerances. If the Fed cuts interest rates and the yield curve shifts lower, bonds could experience price appreciation. Just remember that if rates start trending lower, and you don’t really need the bond income, you’ll be reinvesting at lower yields. Reinvesting at lower yields can be a problem for longer-term investors. Keep in mind, that if inflation remains sticky or moves higher with a global economic reacceleration, interest rate-sensitive bond prices could decline.
I’d rather take on some additional volatility for higher potential long-term returns that comes with investment grade credit over government bonds, as defaults should be minimal on IG bonds. I don’t want to just stay focused on corporate bonds, but leverage active bond managers that are diversified across bond sectors, credit quality, and the yield curve.
Quickly on the Fed and potential rate cuts. Markets are pricing in multiple rate cuts before the end of the year. If the economy continues at its current pace, maybe there are less rate cuts than needed in 2024 and maybe they are pushed until next year. Fine. If the Fed does cut rates multiple times this year, which everyone appears to be focused on, what are the magnitudes of the cuts? There are no rules that state it needs to be a 25 basis points (bps) cut each. Maybe it’s 10 bps or 15 bps instead.
At least right now, I’m not worried about the number of cuts, but anticipate either no cuts or up to three cuts, maybe for a total of 50 bps before the end of the year. Maybe it’s three cuts at 15 bps each for a total of 45 bps cuts by the end of the year. Maybe the Fed wants to get at least one cut before the Presidential election.
While many investment strategists thought the U.S. economy would be hit hard with a quick jump in interest rates, it didn’t. The U.S. economy has been fine in a higher and sustained interest rate environment. So again, at least right now, I’m not all that worried about the number of Fed rate cuts this year.
Equity and bond market volatility could pick up from here, but with opportunities across quality mid/small caps, international equities and bonds that pay attractive yields, I don’t have much of a desire for market hedges at this time. I’d rather stay diversified and rebalance whenever any part of my portfolio becomes out of tolerance relative to my targets.
I’m just keeping it simple until there are bigger dislocations in the market, and we are no where near those levels yet. Well, maybe a little stretched in the large cap, AI-related companies, but that’s just over the short term. My “drier powder” remains in higher income generating assets and being relatively neutral on leverage. I can use that drier powder if/when the financial markets get a lot more attractive than they are now.
I prefer to let the markets come to me, not try to be precise in my guessing on what the markets will do.
RISK ASSETS
Risk assets rallied in Q1 as investors sought opportunities across global equities and credit-sensitive bonds. Broad U.S. large cap indices (S&P 500, NASDAQ) valuations appear stretched over the short-term, which calls for some caution over the short-term. Prefer to remain diversified outside of the passive, market-weighted indices and allocate to high quality companies across sector, market cap and geography.
Foreign developed and emerging market valuations appear attractive, but higher geopolitical risk, currency volatility and potentially less exposure to higher quality growth companies is an issue. Nothing is pound the table cheap by any means, but I’m fairly neutral to slightly bullish overall.
Credit spreads remain tight, but overall total return potential remains attractive when paired with equities. Although there is no inherent growth potential in fixed rate bonds, higher absolute yields may be able to provide some cushion in a risk off market environment.
Following the strong rally in risk assets over the last 6 months, investors should anticipate a sell off. No one knows the depth of a potential selloff, but a 8-10% decline in equity markets is normal in any given year. If markets decline anything deeper than that, I would consider increasing exposure to risk assets.
If the economy can manage a moderate slowdown, inflation at least remains stable or better yet continues to decelerate over time, and the U.S. Federal Reserve embarks on an interest rate cutting cycle, diversified exposure to higher quality risk assets may continue to be supported by investors.
U.S. EQUITIES
U.S. equities continued to find support in Q1, initially led by investor optimism around “artificial intelligence”. This pushed a number of higher quality growth companies’ valuations to levels that appear to be a bit elevated and is a cause for short-term caution. Other areas of the U.S. market started to pick up a bit, particularly across higher quality mid- and small caps and where valuations did not appear as overly stretched. Companies with weaker fundamentals, higher leverage, weaker growth generally lagged the higher quality companies.
I prefer to remain allocated to higher quality companies, with diversification across sectors and market cap in the U.S. where valuations outside of the “Magnificent 7” or “Fab 4” or whatever the catchy name for the group of companies are, still remain relatively attractive.
Public Service Announcement: Don’t fall into the trap of focusing on fancy names of a group of companies: FANG, FAANG, Magnificent 7, Fab 4. It’s just the media grasping for something catchy. Six months ago it was the Magnificent 7, then Tesla, Apple. and Alphabet (Google) lagged. Now it’s the media focused just on the Fab 4: Microsoft, NVIDIA, Meta and Amazon that have rallied. It’s stupid. I’m ignoring it and staying diversified.
If interest rates can remain relatively stable, even if they gravitate a bit higher with stickier inflation, higher quality growing companies with stocks trading at moderate valuations could remain a solid place to be.
It’s difficult for me to want to own lower quality stocks, even if there might be positioning for a cyclical upturn if interest rates start to decline. If there is another leg to the broader market rally, don’t be surprised if quality as a factor starts to underperform and broader indices with exposure to lower quality companies, particularly in small cap, start to outperform.
FOREIGN EQUITIES
Developed market equities also performed well in Q1, while emerging markets equities lagged a bit. I continue to favor higher quality growing companies outside of the U.S., where secular trends in technology, energy and the consumer can remain solid over time. Remember, companies outside of the U.S. generally have a focus on making money over time. I’m not a fan of the added volatility from foreign currency exposure, but I am a fan of diversification.
There are plenty of companies in the U.S. as well, and maybe foreign equity exposure isn’t really needed, but I’m sticking with diversification into quality non-U.S. companies for now. With U.S. mid/small caps fairly attractive from a valuation perspective, my need to diversify outside of the U.S. is probably lower than it has been in the past.
China
China is a potential opportunity to keep an eye on. Sentiment has been horrible the last couple of years, China’s self-inflicted government interference in its economy and quality technology companies hasn’t helped. Geopolitical risk remains high and a U.S. Presidential election this year doesn’t help. Exposure to lower quality capital markets in general is a risk. So lots of negatives.
The opportunity though, is that valuations appear pretty attractive, market technicals (the squiggly lines) could be indicating a long-term market bottom, and there is some initial evidence that the economy may be stabilizing with the potential for an upswing.
I thought China’s economy could pick up coming out of COVID like the rest of the world, but it really didn’t and markets pushed Chinese equities lower because of it. If China, the second largest economy in the world, does start to see signs of better economic growth, investors may be able to take advantage. This doesn’t mean just piling into Chinese risk assets, positive secondary effects could be found in broader Asia, companies that export to China (many in Europe), commodities, etc.
As a long-term diversified investor, I tend to prefer some exposure to higher quality growing companies in foreign developed and emerging markets. With valuations at a discount to the U.S. and the potential for China’s economy to pick up a bit from current levels, this structural diversification may provide some benefits going forward.
HIGH INCOME
High yield bonds are attractive in this environment. With rates at potentially close to cycle highs, the absolute total return potential of high yield bonds could be 6-8%+, which is an attractive complement to equities. If equity markets chop around for awhile, or we get a selloff due to some of the higher growth companies correcting, high yield credit could provide a downside buffer. High yield would probably decline, but often holds up better relative to higher growth companies during a risk asset market decline.
High yield corporate bond spreads are tight relative to Treasuries, so I wouldn’t overweight high yield in a conservative asset allocation, but when defined within the risk assets allocation, a decent allocation to high yield bonds makes sense to me. If the Fed starts to cut rates and we remain in a fairly moderate economic environment, the duration (interest rate sensitivity) of high yield bonds could also add some price appreciation as interest rates decline.
Emerging markets debt can also be an interesting spot to add higher income-generating bonds to the portfolio. If China’s economy can pick up a bit, there could be some added currency appreciation in emerging countries positively tied to a better Chinese economy. This could put at least a floor on Asian and commodity-related countries’ bonds and currencies, with the potential for upside price appreciation.
Closed end funds generally trade at a discount and discounts right now are somewhat neutral to a bit tight. I don’t feel the need to be overly aggressive here and will maintain my positions at this time. With short-term rates still high and the yield curve inverted (short-term rates higher than longer-term rates), borrowing costs are elevated and the spread to borrow at lower rates and invest at higher rates isn’t that great either. With that said, the higher rate environment makes closed end funds still somewhat attractive as a complement to a diversified equity allocation, in my opinion.
Option income strategies will probably always be an attractive source of income for me. Volatility has been relatively low, so income has trended lower a bit, but with elevated valuations in U.S. large cap grow companies, some income generation and potential downside protection from the options works for me at this time.
COMMODITIES
For me, commodity prices are often just driven by short-term traders and market technicals. I never try to figure out where I think the fundamental price of gold or oil should be. I’ve covered many investment managers that have high conviction in their views of higher or lower commodities, and they can be very wrong. If the “experts” can’t get it right, who is to say that I would. I do not have dedicated exposure to any commodities.
In my post on November 28, 2023 titled “Quick Look: Gold”, I indicated there could be both fundamental and technical reasons for gold to go higher. Here we are with gold up a decent amount from those levels. Since gold broke out of its long-term trading range, there is no real upside technical resistance so until there is a fundamental reason for gold to decline (higher rates, stronger U.S. dollar, lower inflation), gold could continue higher from here.
For me, I’m not touching gold as a commodity in my portfolio because I have no idea what that fundamental value should be. I don’t know if it’s cheap or expensive and for that reason, gold is not an asset class for me to dedicate any position to. In a diversified equity and bond portfolio, I already have exposure to areas that can benefit from higher gold prices, including mining companies so I’m good with that.
Oil prices have caught a bid as well, potentially on the belief that the Chinese economy may be reopening. This could be bullish for oil prices as Chinese demand could increase. The Russian/Ukrainian war continues and anything can happen there. Europe’s economy has been challenged a bit, and if European growth can accelerate, that could put additional support for oil prices going higher. Artificial intelligence infrastructure will have a huge demand for energy, and demand for oil to provide energy isn’t going away any time soon.
Again, I’m not allocating a dedicated position to oil, but exposure to oil-sensitive assets in a diversified portfolio could gain some benefit. Oil could just remain a long-term volatile asset, trading between $65 and $100, and short-term traders may try to benefit from that trading range. I just prefer diversified exposure to high quality growing companies across sectors, and that can include energy companies so that takes care of my oil exposure for me.
CONSERVATIVE ASSETS
Bond investors should be loving the current interest rate environment. You can get over 5% on money markets and CDs, and you can get higher potential returns by adding in some additional credit risk. For short-term investors or investors who are risk adverse, this is a great environment for conservative assets. For longer-term investors that can withstand higher levels of volatility, conservative assets may still be less attractive than risk assets as current fixed bond yields may not be sustainable.
Just remember, if interest rates start coming down, and you aren’t actually utilizing that income generated from your conservative bond allocation, you will be reinvesting that income at lower interest rates. We’re not there yet, but if the Federal Reserve starts to cut the fed funds rate, you may not want to get stuck chasing equities (that may have already potentially rallied) when bond yields are lower.
U.S. GOVERNMENT BONDS
U.S. government bonds can provide ballast in a conservative asset allocation. With interest rates across the yield curve above 4.25%, having exposure to duration could be beneficial. This is particularly the case with the belief that the Fed will be cutting the fed funds rate at some point. Longer-term, with U.S. debt at increasingly concerning levels each year, longer-term rates could creep higher if something isn’t done with the debt. In this environment, I’d prefer to have moderate exposure to duration, with exposure across the intermediate part of the yield curve (within 10 years) and not get overly extended.
U.S. INVESTMENT GRADE CREDIT
Investors don’t often realize how large the U.S. bond market is. Sectors include Treasuries, agency MBS, non-agency MBS, asset backed securities, other securitized debt, single issuer debt, floating rate debt, CLOs, municipal bonds, etc. Structurally, I will almost always prefer diversified exposure across sectors within the investment grade credit universe. I will also almost always allocate to an active bond manager that can effectively diversify my bond allocation across sectors, credit quality, yield curve, issuers, etc.
In this market environment, with the potential for lower interest rates and a moderately decelerating economy, I prefer to be overweight non-Treasury bond sectors for additional yield and total return potential. While volatility from credit may be higher than Treasuries, as long as bond defaults are kept to a minimum by the active managers I allocate to, I’ll take on that added volatility for modestly higher total returns.
OTHER
I use this section to talk about other potential strategies, generally whether or not hedges are needed on asset classes. Across equities, I do like higher income generating assets as a potential lower volatility cushion to traditional equities. Higher generating asset can potentially generate returns in a flat equity market, which we may get to following the recent rally. Structural hedged equity could also be beneficial to hedge larger cap growth stocks where valuations appear stretched over the short-term, but I’d rather allocate to quality companies that have lagged across mid/small caps and internationally instead of trying to accurately time hedges in this environment.
Across fixed income, while credit spreads are generally tight, the high absolute yields across fixed income are enough for me to withstand volatility from spreads widening or if interest rates move higher in a sticky inflation scenario. I don’t feel the need to have dedicated hedges on my bonds at this time and prefer to allocate to active bond managers instead.