The Pacific Financial Group hosted a virtual Asset Allocation Committee meeting on Monday, April 19th, featuring a group of our partners and strategists. Each shared their viewpoints and outlook on the market and their strategies. Below is a summary of each strategist’s comments.
Value outperformed during the quarter by the widest margin since 2001. The reopening trade that began late last year continues, focusing on energy, financials, and industrials. Sentiment is optimistic due to fiscal stimulus and vaccine distribution.
The American Funds Growth model had positive security selection in the Communication Services and Healthcare sectors. Detractors included equities in social media, entertainment, and biotech. Looking forward, large and regional banks are both expected to do well as net margin creeps up. Industrials and machinery also represent an opportunity. Caterpillar in particular may see longer term growth from autonomous vehicle demand, an electrical vehicle boom, and general demand for raw materials. The model took some profit in internet stocks during the quarter.
The Conservative Income portfolio performed in-line with its benchmark. Fixed income security selection was positive despite interest rate headwinds. Corporate bond exposure was additive as duration was relatively short in the model.
Strategic changes were made in the previous quarter, so further sector changes are not expected. There is no heavy overweight, and the models are instead looking for pockets of opportunity.
The BlackRock models have had strong quarter and 1-year performance, outperforming their benchmarks. Previous tilts towards small caps have done well and the model leaned into this theme further at the most recent trade, increasing iShares ESG Aware MSCI USA Small Cap (ESML) from 4.5% to 9.5%. This position should continue to benefit from the economic reopening.
Positioning in the rest of the portfolio is very diversified, with no other particular tilt. The portfolio remains at a 70% Domestic, 30% Foreign equity target. While there is technically a 1% reduction in Emerging Markets, U.S. small cap should be a more efficient play towards for the reopening economy.
The goal of the portfolio is to act as a risk-ballast against both inflation and deflation. The asset class selection contrasts overall growth metrics vs inflation, and results in Core Bond plus Satellite positioning. Year-to-date, the portfolio has done well against the U.S. Aggregate Bond index. Inflation expectations have been rising, and the portfolio has tilted away from Core Bond and towards inflation-sensitive assets, such as floating rate, real estate, commodities, and real return.
Inflation continues to be a significant risk for the next several quarters, resulting from demand/supply mismatches and wage pressures this fall. Capital expenditures could also fuel demand. Inflation is likely here to stay, along with a depreciating dollar.
The equity sector model is highly quantitative, based on business cycle research. It was back-tested to the 1960s, looking at economic trends in production, employment, earnings, interest rates, etc. The beginning of 2021 evaluated to an early economic recovery. While there have been some signs that the recovery is maturing, the model has not switched phases yet. For context, the model showed August 2020 still in a recessionary phase.
The portfolio is not changed unless the business cycle turns. There were already significant changes last year as cycle probabilities evolved. Note that cycle definitions have different time frames, with a full cycle lasting 7-8 years. The early cycle is relatively short at 6-8 month. Mid cycle is the longest at 2-7 years. Late cycle is roughly 2 years, and recessions are very short.
At the moment, the model is firmly in the early recovery phase and has not rolled over to a mid growth phase yet. Consumer balance sheets and cash positions are strong. Consumer demand is strong, and spending is underway. The portfolio has pro-beta positioning, with overweights to Industrials, IT, and Healthcare. Staples and Communication Services are underweight. Technology is tilted towards semi-conductors. Security selection in industrials detracted for the quarter, mainly from conglomerate stocks.
JP Morgan’s Quarterly Strategy Summit was held in March. Positioning was optimistic, resulting from policy support and vaccine distribution. A prolonged period of above-trend growth is expected, led by the United States. Headline inflation should be volatile as near term reflation vies with longer term secular disinflation. Returns will be driven by earnings growth going forward, not multiple expansion. It is unlikely the same sectors do well going forward.
The portfolios are currently pro-risk, with equity over fixed. Emerging Markets exposure was reduced; while Emerging Markets was previously expected to outperform, the current cycle rotation and sinking dollar have become a headwind. Value exposure was increased, while Growth and Quality were reduced. Year-to-date performance was very strong, with positive alpha. An overweight to small caps and U.S. value contributed to performance, while an underweight to duration was also additive.
Long term, a sustainable rise in interest rates would be necessary for Value to continue its outperformance. Inflation should rise slowly and not be a concern. Note that Growth positioning is more neutral than underweight.
Portfolio positioning is currently 100% equities, since mid-November 2020. Momentum trends are very strong, including wide market breadth in the rally. Small and cyclical stocks have done well, and the rotation to value should continue. Interest rates are rising, but are still on a multi-decade downtrend. Previous rate increases were matched with narrowing spreads, so the effect is muted and should be positive for equities. There is some concern that investor sentiment is too bullish. In fixed income, they are underweight Treasuries and have reduced Emerging Market and Investment Grade exposure. High yield exposure was increased, and duration was shortened to below 4.
The secular bull market is still in its 8th inning, and could extend further. Elevated real returns in the S&P 500 are typical in a late bull market. Risks include cyclical spending running out, equity ownership being the highest since the late 90s, and potentially higher interest rates.
At the beginning of the year, allocations in the model had the smallest amount in total return, TIPs, and international fixed income in the model history. PIMCO held their Forum in March to generate a 12-month outlook. GDP growth is expected to be 7%+ annually, the strongest in 40 years. Note that this only gets GDP back to pre-COVID trends. Risks include early movements by the Federal Reserve, but this isn’t likely. Rates will likely be range-bound through 2023.
The model had a strong 2020, up 8%, but is down 1.8% in 1Q-2021. The duration profile of the model remains modest. Long term, inflation pressures should be minor. The economy has been previously under 2%, so exceeding that for some time is fine.
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