TPFG Portfolio Management Team
The Pacific Financial Group hosted a virtual Asset Allocation Committee meeting on Thursday, October 21st, featuring a group of our partners and strategists. Each shared their viewpoints and outlook on the market and their strategies.
• Volatility returned to equity markets. This is to be expected from equity investing. Supportive government policy has kept a lid on volatility, and policy is expected to normalize gradually.
• Inflation was a common discussion point for most strategists. Opinions on transitory vs persistent inflation were mixed, with most expecting it to be transitory. Housing prices look more persistent than other components of CPI.
• Risks from China and Evergrande are likely to remain localized. U.S. exposure is minimal among our strategists. Chinese homeowners generally have more equity than the U.S., and Chinese home loans are less securitized, reducing the probability of contagion.
Janus Henderson Investors
Nick Watson, CFA - Portfolio Manager, Multi-Asset
Compared to the first half of 2021, capital markets in the third quarter changed behavior. While the reopening theme (Financials and Value equities) continued early in July, performance retrenched back to Technology and Growth stocks by the end of the quarter. Foreign equities, both developed and emerging markets, experienced some negative returns as the market tried to price in changes in macroeconomic indicators and central bank policy. Inflation picked up globally, caused by labor shortages but also electricity shortages in China and petrol shortages in the U.K., and has proved more persistent. Central banks are beginning to mention sizeable steps to ending easy monetary support. Bond yields rose in the second half of Q3, but remained flat over the whole quarter. Quantitative easing has depressed volatility, which should be expected to return. Janus Henderson currently favors European and Japanese stocks. U.S. domestic equities look a little rich, potentially vulnerable to rising rates. The COVID environment is receding, and the easy part of the recovery has now been achieved. Janus Henderson still favors equities over fixed income, with an emphasis on active management due to tight spreads. Investment grade valuations look stretched. They are not yet bullish on Emerging Markets, despite the recent drawdown, but feel bad news is not yet fully priced in. Within the Balanced fund, the current allocation is overweight equity and underweight bonds, buy roughly 3-4%. Fixed income is positioned at the higher end of risk, utilizing some high yield. During the quarter, some equity positions were trimmed, and moved back to a low-risk fixed income ETF. A Growth ETF position was reduced, and moved to Janus Henderson Contrarian.
Justin Blesy, CFA - Senior Vice President, Asset Allocation Strategist
PIMCO continues to monitor a transition in policy support, which the market has digested well so far. They are focused on a few key risks. First is the Federal Reserve tapering plan and execution. PIMCO’s base view is to expect an announcement in November, implementation starting in January, and winding down through 2022. A rate hike may be possible in the second half of 2023. There is still a long road to policy normalization, and risks include the potential for communication errors. Second is risks from China, Evergrande, and Taiwan. Currently, PIMCO feels this situation is idiosyncratic, and likely to be contained locally. They will continue to watch for signs of contagion, but it is not expected at this time. Third is energy prices and inflation. There has been a strong spike around the globe, especially in Europe. These are mostly supply chain issues. PIMCO sees it as transitory. The final key risk is persistent COVID and Delta variant disruptions. S&P valuations look high historically. Yields rose at the end of Q3, but still remain lower than Q1 and lower than pre-COVID. Even though headline inflation is over 5%, it should come back down in the next 12 months, more in-line with historical levels. Core CPI has been very stable, and most of the overshoot was in autos and travel. Autos in particular rose over 100% between Q2 and Q3, annualized. This is not expected to persist. Energy similarly contributed to headline inflation, and is expected to be transitory. Granted, there are wider tail risks to inflation, but not enough to adjust PIMCO’s base case. In credit, spreads remain tight as yields are generally low and economic growth is supportive. PIMCO is cautious on duration, more so than 6 months ago. Their portfolios target a duration of 4.5 years, compared to 6 for the aggregate bond index. Emerging Market fixed income is selectively attractive, same as some mortgage backed securities. They are bearish on investment grade corporate as it tends to be higher duration.
Capital Group | American Funds
Stanley Moy, CFA, CAIA - Multi-Asset Investment Product Manager
Their models had performed well during Q3, until the last week of September. Still, the Growth model managed to lose less than the S&P 500. The Growth model is focused on Growth exposure, but does have a position in Fundamental Investors. This growth and income focused fund is intended to dampen volatility, which it did during Q3. Non-U.S. equities dragged, as domestic stocks were positive. The materials sector was challenging, weighted down by steel prices and a slowing Chinese economy. American Funds still believes in this position long term, so it was held throughout the quarter. The Conservative Income model performed in-line with the benchmark for Q3. Fixed income did the heavy lifting, as equity performance was negative. American Funds Strategic Bond was a recent addition from April, and weathered volatility well. The model had very strong gains from credit and inflation-linked bonds. Looking ahead, the focus is on opportunities in consumer discretionary, industrial, and financial equities. Stocks for hotels and restaurants were added; the lack of international travel is being made up for in domestic travel. Auto companies and online market places also represent an opportunity. Both residential and commercial construction look to continue strong demand, flowing through to building and electrical products. American Funds is selecting domestic companies without ties to international supply chain bottlenecks. Financials have been experiencing a steady stream of trading in capital markets. During the quarter, the models took some profit in energy equities. The position was incepted in Q3 2020, and has paid off well in 2021. Lastly, none of the American Funds models have any exposure to Evergrande, nor in any of the underlying funds. PIMCO is monitoring for potential of contagion to other Chinese real estate developers and banks, but is not expecting it to spread. A much smaller percentage of Chinese mortgages are securitized, compared to the U.S., and Chinese homes have a lot more equity.
Eric Mueller - Director, Model Portfolio Strategist
Their models were traded on 10/21/21, with some modest changes. BlackRock continues to be optimistic by overweighting equities and leaning into cyclical and small cap stocks. They have been gradually shifting from EM to Developed, and are continuing the trend. They are overweight U.S. domestic vs foreign, overweight developed vs EM. For the quarter, performance was roughly flat. Their All Equity ESG model only fell 3% at the end of September, vs 4% for the S&P 500, showing some downside protection. They offer two flavors of ESG: ESG Aware is sector constrained, with very tight tracking errors. Compared to regular indexes, ESG scores only slightly tilt the exposure. ESG Advanced has a much looser tracking error restriction. Some sectors can be removed completely, and the focus is on industry leaders in sustainability measures. This has done well in 2021 and Q3, and the models usually see a balance between the two. More generally, continuing jobless claims have dropped 90% from their pandemic peak, and there is upside potential in equities as workers re-enter the workforce. Payroll numbers have room to improve through the end of the year. BlackRock continues to see inflation as transitory. Supply issues seem to be short term. Housing prices do seem to be more persistent, and could be a medium term driver. They are considering bringing in more inflation resilient investments.
Stephen Kolano, CFA - Chief Investment Officer
The portfolio is focused on two significant tail risks: inflation and deflation. The model seeks to hedge against both of those, and act as a complement to bonds. Currently, the model is balanced 60% against inflation and 40% against deflation. Q3 performance was down 92bps, underperform the U.S. aggregate index. There was a pause in inflationary pressures early in the quarter. Real rates increased, and the 10-year Treasury moved back to the 1.75% range. During the quarter, the model tilted towards inflation as a threat, removing exposure in global natural resources and taking profits. There are some signs of energy supply increases from OPEC and U.S. domestic drilling. Equity overall should expect some cost pressures. The model rotated towards Real Estate, and re-added floating rate exposure. The labor markets are seeing structural changes, and supply chain bottlenecks will likely be transitory. Wage pressures in consumer services could prove more secular. They expect inflation to remain higher than the historical rate. Profit margins appear to have reached their peak, and BNY does not feel the market has priced in cost increases yet.
Sharika Cabrera, CIMA® - Executive Director Investment Specialist
JPMorgan is constructive on the economy, and sees continued progress on reopening and recovery. Volatility returned, but that is normal when investing in equities. Globally, they expect the global economy to continue expansion amid declining COVID cases. Household balance sheets remain strong, and there is potential in a powerful CAPEX cycle. In equities, JPMorgan continues to bias towards cyclical equities, though switching U.S. cyclicals for European cyclicals. Europe is now vaccinating more per day than the U.S., and should do well in a rising interest rate environment. The model balanced cyclical with quality in the 3rd quarter. U.S. Large Core has seen strong earnings growth, and should remain a key driver of performance. Interest rates remain at historic lows, and JPMorgan expects inflation to decline over the next 24 months. High headline inflation is mostly a combination of base effects from the lockdown, and supply constraints in used cars. It should recede, and there is room for rates to continue higher. Equity volatility is being caused by worries of the Delta variant, inflation, and a growth slow down, but none of that should be powerful enough to derail current momentum. Tactically, JPMorgan has shifted some of the cyclical tilt to quality. Emerging Markets were underweight at the beginning of the year, and the model is now back to neutral. Performance over the past year has been positive, driven by the overweight to equity vs fixed. Underweight to duration helped, as has small cap exposure.
Kyan Nafissi, CFA - Investment Director
The Equity Sector strategy is heavily quantitative. The model is firmly mid-cycle, showing strong economic activity levels, and good balance sheets. Employment prospects are good, and banks are well capitalized. There is some upward pressure on inflation, caused by low rates and deficit spending. Long term, the aging U.S. population will work less and reduce demand. The model is pro-cyclical, overweighting Beta by 10%. Sector overweights are to Industrials, Technology, Healthcare, and Materials. In Q3, the market took a breather, and defensive sectors outperformed. The industrial sector position caused underperformance in the model overall, while an underweight to Consumer Staples was constructive.
Meeder Investment Management
Joe Bell, CFA, CMT, CFP® - Co-Chief Investment Officer
The model is split 70% to tactical equity, and 30% to tactical fixed income. Year to date, the equity portion has done well, staying 100% invested until recently. In the third quarter, the model switched to 74% equity exposure. Market breadth hit an all-time high in August 2020, and the Russell 2000 was essentially flat since that time. Valuations look high on traditional metrics, but looks warranted given low inflation and rates. The Equity Risk Premium still favors equities over fixed income, which will likely continue until rates rise above 4%. Overall, Meeder feels this is a pause in the bull market, rather than a turn. An overweight to healthcare added to performance in the 3rd quarter. Earnings so far have been strong to start the 4th quarter. Nearly 90% of stocks remain above their 200-day moving average. The model has a slight overweight to international. China is being monitored, as it adds volatility to the portfolio. They are facing slowing growth, commodity shortages, and property issues.
Counterpoint Asset Management
Michael Krause, CFA - Partner
Counterpoint manages a high yield bond timing strategy within the PFG Tactical Income fund. They are a quantitative boutique manager, utilizing both high yield corporates and high yield municipal bonds. Both sectors treaded water during the quarter. Indicators were generally flat, including credit spreads and Treasury interest rates. Within their equity indicators, value, volatility, and quality did well. For inflation, they use the 30-year TIPS breakeven rate. Compared to pre-COVID, they are 40-50bps higher. This implies that the market is only pricing in a 15% to 20% bump in CPI over the next 30 years, which seems small. Counterpoint considers this a market risk to fixed income. Regarding the QE taper, they expect Fed balance sheets to continue to rise, but at a declining rate. Volatility from the anticipated taper was lower than expected. An expanding Fed balance sheet usually adds return to equities, but a taper should reduce equity returns. Contracting Fed balance sheet is also additive. For this quarter, they are starting to see some signals in the fixed income space. Municipals have a sell signal in October, same as high yield corporates, due to nominal treasury yields moving higher and getting close to breaching moving averages. They anticipate more movement in the high yield space.
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. 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 AM® 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 Investors is a proprietary mark of Janus Henderson Group PLC. Counterpoint is a proprietary mark of Counterpoint Asset Management, LLC. 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., FIAM LLC, Pacific Investment Management Company LLC, The Bank of New York Mellon Corporation, or Meeder Investment Management, or by anyone affiliated with such entities, regarding the advisability of investing in any investment product offered by Pacific Financial Group.