Our Q3 2022 Asset Allocation Committee Meeting was held on Wednesday, November 17, 2022. TPFG Portfolio Manager Dan Helmick moderated a series of informative Strategist presentations on the performance of our suite of Strategy PLUS model portfolios.
Here's a recap:
- Most investors believe that Fed policy will not pivot until halfway through 2023.
- Some strategists expect a recession, while some have not seen these signals yet; however, if there is a recession, all strategists expect it to be a longer, but shallower recession.
- Most strategist remain risk-off, investing in defensive sectors such as utilities, consumer staples, healthcare, etc.
Joe Bell, CFA, CMT, CFP®, Co-Chief Investment Officer
Meeder helps manage the Meeder Tactical Strategy which is comprised of both Tactical equity and fixed income. This strategy is driven by a quantitative model that measures the overall reward of the market relative to the risk, with the idea of investing during more low-risk environments and being more defensive during high-risk environments. Throughout the third quarter, Meeder had about 41% allocated to equity, with the other 59% positioned defensively, which was almost entirely held in cash. Further, Meeder entered the year with a 33% cash position.
Overall, the third quarter was a tail of two halves, beginning with a strong rally in the first six weeks, followed by a strong selloff for the last six weeks. October has seen a slight recovery from the lows on the back of a better-than-expected CPI print, with the hopes that the Fed would turn to less aggressive policy. It seems that most people are expecting the Fed to pause their policy towards the middle of 2Q23. Further, looking back on every rate tightening cycle since the 70s, every time the Fed has stopped raising rates, the Fed Funds Rate has been above the CPI year-over-year reading. Currently, the gap between those two remains significant, so Meeder believes that the Fed has not completed their rate hiking cycle.
Currently, even with a strong labor market and seemingly settling inflation, the Fed remains true to their rate hiking schedule. The equity markets seem to be on the lookout for news on the Fed reversing course. Lastly, in terms of stock selections, Meeder has added value during the year, mostly within industrials, financials, and energy. They remain cautious on and underweight Technology and Consumer Discretionary. Overall, their longer-term model remains defensive driven by elevated valuations on an inflation-adjusted basis as well as factoring in a rising interest rate environment.
Brandon Knott, ETF Strategist - Product Management & Development, Capital Markets
The single most comprehensive clean energy bill was passed last quarter in the form of the Inflation Reduction Act. This bill included about $370 billion in clean energy spending, primarily through tax credits, a combination being both old legacy tax credits and new. The act improves the already competitive economics of clean energy. These tax credits make for a very competitive marketplace, making the decision to switch to clean energy methods a lot more convincing. Solar and water are probably going to be the leading technologies to take advantage of these tax credits, and are the heaviest products used in the TPFG models.
Within the solar industry, it is expected that there will be a 40% increase in solar installs over the next five years. The Inflation Reduction Act’s funding tax credits are also shedding light on and making more popular, some of the “technologies” that did not get a lot of attraction beforehand. These technologies include: battery systems, wind, and electric vehicles. Conversely, some challenges within the space are the same we see within growth, including an aggressive Federal Reserve which is suppressing growth. A lift for the space is expected in the second half of 2023, and growth in general. Invesco expects that small and mid-caps will benefit greatly for this “lift” next year. Lastly, while markets have seen some improvements, volatility is going to remain very pervasive through the first half of next year.
Ian Johnson, Vice President
The Fidelity Sector Strategy is coming off a strong 3rd quarter, outperforming its benchmark. Equity markets have struggled year-to-date, although the strategy was able to minimize some of these losses. Over the quarter, Fidelity has had fairly good stock selection in healthcare and added value in defensive sectors like energy, utilities, and communication services. At the end of September, Fidelity reallocated to be even more defensive, maintaining an overweight to inflation-sensitive sectors like energy and materials, along with defensive sectors like utilities and healthcare. The strategy was underweight Communication Services, Consumer Discretionary, and Financials.
Going forward, the business cycle should continue to mature. Fidelity feels that we are firmly in a late-cycle environment and they continue to watch for signals of higher recession risk. Elevated inflation pressures, slowing growth momentum and tightening financial conditions are some of the factors being closely monitored. The labor market remains relatively strong, even with the recent headlines of job cuts, as there is still a strong demand for workers. Inflation should remain higher on a secular basis, and we should expect some volatility for the inflation-sensitive assets. Lastly, within the next twelve months, Fidelity expects we will see a recession.
James Macey, CFA, CAIA - Senior Investment Strategist
The 3rd quarter was a story of two parts. The first half started with a rally, followed by a selloff in the second half. The first nine months of this year was the third worst for equities ever and the worst ever for small caps and fixed income, leading us to have the first calendar year where both stocks and bonds finished negative in history. In recent weeks, equities have done well, with some areas almost being in a bull market. The recent CPI and PPI prints came in lower-than-expected, although inflation still remains high. The extensive geopolitical tensions will also make an impact on markets, so there is still much volatility to be expected. The pricing in of a recession has now increased, emphasized by the Fed’s rate hiking schedule. The inverted yield curve further signals a coming recession, with the inversion only seeming to widen further. In response to such signals, BNY is underweight in Liquid Real Assets (9% allocation – 1% underweight) and fixed income (54% allocation – 6% underweight), and slightly overweight in Real Return (37% allocation – 7% overweight).
Lastly, the Fed is very clear on what it needs to do and continues to vocalize this. The Fed remains a key theme that drives strategy decisions. Further, the Fed needs to continue efforts to lower inflation. BNY believes that the Fed may begin to pivot soon, as their hikes have clearly begun to make an impact, especially seen with the mortgage rates that have doubled in ten months. BNY does not expect a hard landing for the economy, however, even as the Fed continues to bring the overall economic growth down.
Bradley Noss, CFA, CAIA - Client Solutions Associate
Although 2022 has been one of the most difficult fixed income environments to be seen, bonds now have significantly higher yields which will improve their forward-looking return potential. We have seen significant changes since the start of the year. We thought monetary policy would tighten gradually and inflation would moderate quickly, although this was not the case. There has been a slowing growth picture and some of the largest tightening seen in decades. Inflation continues to persist above central bank targets, recently breaking out into some of the lagging sectors such as services and rent that can make it a little more pervasive.
From here, PIMCO believes that inflation will remain sticky, but will begin to moderate as we head into 2023. The softer CPI print was a positive sign, although PIMCO does not believe this will continue into a trend. They expect that core inflation will end next year closer to 3.5% - 4%, and the Fed reaching its terminal rate of 4.5% - 5% early next year. Further, they see the Fed Funds Rate staying at or near the terminal rate until there’s a meaningful decline in inflation. PIMCO expects that the Fed will continue to fight rising inflation without a regard for economic growth, and that we will enter a recession early next year, followed by overall increases in unemployment. They also expect that the recession will be longer, but shallower. Longer because the lack of monetary and fiscal support is even less than seen in prior recessions, although it will be shallower because of healthier household and corporate Balance Sheets.
PIMCO has positioned themselves to be fairly cautious. They are staying positioned in high quality, resilient assets, and are neutral on duration as they wait for the benefits from higher rates and higher yields. Credit spreads have widened, and they do not believe we have seen the bottom in growth yet. In the meantime, they have tried to remain in higher quality that would be resilient in another downturn, such as Investment Grade Corporates and both non-agency and agency mortgages. In real assets, PIMCO has favored commodities and TIPS that can provide a hedge against persistent inflation. They are also underweight equity overall, remaining defensive in their existing equity exposure. Lastly, with the rise in rates, municipals seem to be extremely strong, especially on an after-tax basis. In an event of a recessionary environment, municipals have a lower default rate than their equivalent corporate bond counterparts.
The Enhanced Core Fixed Income Model has positioned itself to align with these outlooks by increasing their allocation to the real return fund and the mortgage opportunities and bond funds, while reducing exposure to the Emerging Markets Bond Fund, Total Return Fund and Investment Grade Credit Fund.
Matt Peron, Director of Research & Portfolio Manager
Janus Henderson characterizes our current market environment into two segments, the first being rate adjustments which has pressured multiples. Looking at equity multiples versus interest rates, it has been an almost one-for-one adjustment, as in whenever rates have risen so have the multiple adjustments. Janus has a fairly benign view on the rate hikes from here, as rates could, and probably should, go higher, although Janus hopes the Fed stays under the 5% mark. The pressure from these rate hikes has yet to manifest itself, and they are just starting to see this in downward earnings revisions which are starting to pick up. Janus expects a shallow, but prolonged mid-cycle slowdown/recession. They also expect choppy quarterly GDP and earnings reports.
To align with these outlooks, Janus Henderson continues to be underweight equities and overweight high yield. They are waiting for some stress with a concern of elevated defaults that would open an opportunity to add further exposure in high yield. Lastly, they continue to maintain their modest, risk-off position, stating that most of the equity market turbulence is behind us and do not see much more downside, although they are expecting more volatility to come throughout the next few quarters.
Michael Krause, CFA - Partner
The Tactical Income Fund focuses on tactical management of high yield, in both corporate and municipals on the fixed income side as well as multi-factor equity. Counterpoint’s Tactical Income fund received a sell signal to be risk-off in early January. The entire year, Counterpoint had exposure to treasuries, but kept duration low. In August, they received contradicting signals for high yield, ultimately ending back in cash. At the end of October, another buy signal was received, signaling that the market is trying to find some value. The story this year has been changes in Treasury rates, and not so much high yield spreads. Currently, Counterpoint is about 50% high yield and 50% bank loan and floating rate to moderate the higher interest rate risk we are experiencing.
High yield spreads are near the average levels for what we have seen throughout the year, peaking at about 600 bps. These spreads are slightly higher than the 350 bps that we saw at the start of the year, but largely is not pricing in much of a default cycle or a recession risk. Yield curve spreads have been flat to negative, painting a picture of a market that believes the Fed is going to hike almost too aggressively and then back off. These yield curve shapes are indicating that short term rates are not expected to last, that the Fed is capable in fighting inflation, and also that there is an excess amount of liquidity.
Most investors believe we have seen the highs of inflation already, although Counterpoint is not seeing lowered levels of inflation until 1Q24, expecting it to be coming in then at around 2.8%. Counterpoint expects continued inflation to be higher than expected, with higher short-term interest rates. In order to really stop inflation, the Fed will have to notably increase quantitative tightening, although Counterpoint expects the Fed does not want to break anything. The Fed has said they do not want to pivot quickly either, so the hikes should gradually reduce. Counterpoint also does not see a recession threat in the near term.
DISCLOSURE: The information provided herein is the opinion of The Pacific Financial Group (“TPFG”), a registered investment adviser, and may change without notice at the discretion of TPFG. Market Data is as of the time period noted and TPFG makes no warranties as to the accuracy of the information or any representations made or implied at any time given. The information should not be construed or interpreted as an offer or solicitation to purchase or sell a financial instrument or service. The information is for informational purposes only and should not be relied on or deemed the provision of tax, legal, accounting, or investment advice. Past performance is not a guarantee of future results. All investments contain risks to include the total loss of invested principal. Diversification does not protect against the risk of loss. Information from companies mentioned herein are the express option of the third party author. TPFG is not affiliated with any of the companies mentioned herein. Capital Group® | American Funds® are registered marks of The Capital Group Companies, Inc. BlackRock® is a registered mark of BlackRock, Inc. MFS is a registered mark of MFS Investment Management. JPMorgan is a proprietary mark of JPMorgan Chase & Co. Fidelity Institutional® and the Fidelity Investments logo are registered service marks of FMR LLC. PIMCO is a proprietary mark of Pacific Investment Management Company LLC. BNY Mellon is a proprietary mark of The Bank of New York Mellon Corporation. Meeder is a proprietary mark of Meeder Investment Management. Janus Henderson is a registered mark of Janus Henderson Group plc. Invesco is a registered mark of Invesco Ltd. In each instance, the mark is used with permission. No representation is made by The Capital Group Companies, Inc., BlackRock Inc., MFS Investment Management, JPMorgan Chase & Co., Fidelity Institutional Wealth Adviser LLC (“FIWA”), Pacific Investment Management Company LLC, The Bank of New York Mellon Corporation, Meeder Investment Management, Janus Henderson Investors, Counterpoint, or Invesco, or by anyone affiliated with such entities, regarding the advisability of investing in any investment product offered by Pacific Financial Group.