Author: Amanda Ahne

Asset Allocation Quarterly (Second Quarter 2024)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

  • Our forecast does not include a recession during the three-year period.
  • The US economy is expected to be relatively strong throughout the forecast period.
  • We expect heightened geopolitical tensions to persist as the deglobalization trend continues.
  • Inflation is likely to remain higher due to structural forces such as tight labor market conditions and shortened supply chains caused by deglobalization.
  • Monetary policy is expected to remain tighter for longer given elevated inflation and low unemployment rates. While hikes are unlikely, monetary easing may be pushed out further and the terminal rate will likely be higher than observed in previous easing cycles.
  • Our fixed income focus is on the intermediate segment in expectation of a positively sloped yield curve, albeit one that is relatively flat compared to recent cycles.
  • Our sector and industry outlook favor a Value bias as well as quality factors.
  • International developed equities present an attractive risk/return opportunity.
  • Gold and silver exposures were maintained.

ECONOMIC VIEWPOINTS

The US presidential election season is starting to take over the airwaves and usually brings concern over the general direction of politics and the economy. Given that this important part of the democratic process involves intense emotions among voters, one might expect the election’s outcome to significantly influence market sentiment and performance. Yet, historical data contradicts this statement. Instead, markets have typically shown a tendency to remain flat in the first half of the election year and rally in the months just before the election. Importantly, markets are good at discounting expected outcomes, but they do not handle uncertainty and rapid change well. Congress is expected to remain divided with slim margins, thus major changes in overall legislative action is unlikely.

We will focus more on the election in the coming quarters, but for now, we continue to closely watch inflation, labor markets, and fundamental valuations of each asset class. Inflation remains front of mind as the Federal Reserve’s communication moves from “transitory” to “speed bump” inflation. As we’ve written before, we see structural forces positioned to keep inflation higher than pre-pandemic levels. Factors contributing to higher inflation include supply chain rearrangement with reshoring and friend-shoring of industrial capacity, elevated geopolitical tensions, and developed world aging demographics.

Labor markets have remained surprisingly strong with the unemployment rate currently at 3.8%. While wage growth rate has slowed, the most recent median wage level grew 4.7% year-over-year. Technological advancements, most notably AI, could change labor’s significance, but we believe there will be minimal impact during our forecast period. On the other hand, the aging workforce and uncertainty of immigration numbers will have more impact on whether the labor markets remain tight.

Inflation, labor markets, and economic growth are important indicators in their own right, but their combined effect is amplified by the monetary policy response. As higher-than-expected inflation and the strong labor market continues, our expectation is for the fed funds rate to stay higher for longer. While our forecast does not include policy tightening, we believe that the easing timeline and magnitude have been delayed. We don’t expect the FOMC to lower rates to the levels seen in recent easing cycles. We also expect the Fed to hold policy steady through the election cycle.

STOCK MARKET OUTLOOK

We anticipate a compelling economic backdrop over the forecast period. In turn, this will be supportive for risk assets. Our expectation is for the domestic market rally to broaden across market capitalizations. The large cap rally is already widening beyond the Magnificent 7, whose stocks are off their recent highs. We are not forecasting a breakdown in the largest stocks, but rather a measured and sustainable broadening of valuations that more accurately reflect business fundamentals. This glide-path should be supported by the high levels of cash currently held on the sidelines.

We continue to favor a Value style bias across all market capitalizations. Value equities still offer appealing fundamental valuations compared to historical averages, stable earnings growth, and less exposure to sectors we consider overvalued. Independent of whether an ETF is categorized as Value or Growth, our analysis focuses on the ETF’s underlying holdings to determine which ETF we anticipate will perform in line with our forecast. Within large caps, we maintain an overweight position in Energy due to geopolitical tensions in the Middle East and sustainable energy transition policies, thereby creating an opportunity within the sector. Additionally, we maintain our factor exposure to the military-industrial complex through two positions in military hardware and cyber defense. The deglobalization seismic shift continues to fuel additional conflicts that had been controlled through soft power over the past few decades of global economic growth and collaboration.

We still view valuations of small and mid-cap stocks as attractive, coupled with respectable earnings power. However, the recent mid-cap price appreciation has led us to dampen our prior overweight to the asset class. Separately, with our expectation for monetary policy to remain tighter for longer, small cap equities might face steeper financing conditions, introducing further volatility in the asset class that we do not view as appropriate for the more conservatively oriented portfolios. For the more risk-accepting portfolios, to mitigate this risk, we maintain our quality factor exposures within the mid-cap and small cap allocations, which screen for indicators such as profitability, leverage, and cash flow.

We maintain our allocation to Uranium Miners, bolstered by ongoing global initiatives to develop and utilize nuclear energy. The evolving landscape of baseload energy production, coupled with policy shifts, have highlighted nuclear energy as a key player in the energy transition. Ambitious green energy policies are driving substantial goals for reducing fossil fuel usage, yet the current green energy technologies face challenges in generating energy at the required scale and consistency. Furthermore, a persistent supply constraint of uranium over the last decade underscores a compelling supply/demand imbalance. This scenario presents a significant opportunity for strategic exposure to the uranium sector, aligning with our long-term investment outlook.

International developed equities remain constructive given relative valuations. Most equities in the developed world ETF are large global market leaders that possess competitive advantages, yet these companies are trading at valuation discounts to domestic large cap companies. Given the attractive valuations and high dividend yields, we have added international developed in the lower-risk portfolios. We maintain a country-specific exposure to Japan as shareholder-friendly reforms continue to take effect and as capital flows continue moving into Japan, which could potentially lead to multiple expansion.

BOND MARKET OUTLOOK

We anticipate that the path to a positively sloped, though relatively flat, Treasury curve by the end of the forecast period may be uneven given our expectations of heightened inflation volatility. In the near term, with inflation above the Fed’s preferred 2% level, tight labor markets, a data-dependent Fed, upcoming domestic elections, and the US Treasury’s need for heavy issuance of debt, we concur with the market’s assessment that the Fed will be content to leave its fed funds rate higher for longer. These influences alone portend a volatile period for bonds, especially among longer maturities.

As with last quarter, an  inverted yield curve leads us to emphasize the intermediate segment of the curve due to its modest rate stability and resultant limited market risk and opportunity costs.

(Source: Federal Reserve Economic Data)

Among  sectors, we find advantages in mortgage-backed securities (MBS), particularly highly seasoned pools with lower coupons, relative to Treasurys. Extension risk is more limited in these pools and recent spreads are attractive from a historical perspective. By contrast, investment-grade corporates are currently trading at historically tight spreads  of less than 100 bps to Treasurys, approaching the record from 1998. Accordingly, we employ corporate bonds more liberally in the short-term segment and maintain our overweight to MBS in the intermediate-term bond sleeve of the strategies.

Looking at speculative-grade bonds, while spreads have tightened post-COVID, they remain above historically tight levels and still offer attractive yields. Although caution is appropriate in the broader speculative bond segment, we find continued advantage in the higher-rated BB segment given that credit fundamentals remain relatively healthy and the vast majority of bonds in this segment are trading at discounts to par.

OTHER MARKETS

Among commodities, we retain the position in gold as both a hedge against elevated geopolitical risks and an opportunity given increased price-insensitive purchasing by international central banks. In the current deglobalization environment, international central banks are seeking to buy gold as a reserve asset in fear of the weaponization of the dollar. Silver is maintained in the more risk-tolerant portfolios for its low price relative to gold. Real estate remains absent in all strategies as demand is still in flux and REITs continue to face a difficult financing environment.

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Asset Allocation Fact Sheet

Business Cycle Report (April 25, 2024)

Posted on by Amanda Ahne

by Thomas Wash | PDF

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

The Confluence Diffusion Index receded from the previous month, in a sign that the economy is still fragile. The March report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index slipped from -0.0909 to -0.1515,  slightly below the recovery signal of -0.1000.

  • Investors’ dimming hopes for a June rate cut have caused a mild tightening of financial conditions.
  • Sinking housing starts signal a potential slowdown in construction activity.
  • Payroll data appears positive, but pockets of weakness remain in the job market.

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.

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Magnificent…Small Caps? Why Now and Why Confluence (April 2024)

Posted on by Amanda Ahne

A Report from the Value Equities Investment Committee | PDF

Why Small Caps?

Small capitalization stocks have spent the better part of 10 years in the shadows of their larger cap brethren but now currently provide an attractive opportunity, in our estimation. The divergence has been driven primarily by the narrow focus on a select few mega-cap technology-oriented businesses. This has led the Russell 2000 Index to trade at two standard deviations below its average relative to the Russell 1000 Index (see Figure 1), which was last reached during the Savings and Loan (S&L) Crisis of the late 1980s/early 1990s.

(Source: Kailash Capital)

Additionally, the divergence has placed the relative valuation of the Russell 2000 at levels last witnessed toward the end of the dot-com boom of the late 1990s/early 2000s. This has some investors questioning the vitality of small caps. However, we view the relative underperformance as cyclical, driven by the prolonged accommodative monetary policy that followed the Great Financial Crisis of 2008-2009, which seems to have encouraged a more aggressive allocation of capital toward tech and unprofitable small caps.

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Bi-Weekly Geopolitical Report – The Changing Face of War (April 22, 2024)

Posted on by Amanda Ahne

by Daniel Ortwerth, CFA | PDF

If the United States were at war with another great power, would we know it?  How would we know it?  These questions might seem absurd but consider that the US has not fought a war against a major world power since 1945.  Meanwhile, when the US has engaged in conflicts against weaker and regional powers since World War II, the beginnings and endings of the conflicts have tended to be blurred.  Technology has advanced in ways unimaginable to the 1945 mind.  This has changed the nature of life, and it has also changed the face of war.  In this report, we consider how the contours of that face have changed over time, what it takes to recognize war in the 21st century, and whether the US and its allies might already be at war with China and its allies.

By addressing key elements of technological advancement and geopolitical evolution, we explore how 80 years have changed the face of war.  We consider aspects of war that have not and never will change as well as what has changed, and we drive to the bottom line for investors.  In our view, that bottom line has remained constant through time as war is expensive, citizens pay the price, and that price largely manifests itself in the form of higher inflation and long-term interest rates.  Will the US ever go to war again with another major power in a way that we can recognize?  Will we know it when we are there?  These questions are harder to answer than ever before, but investors can still prepare.

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Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify 

Keller Quarterly (April 2024)

Posted on by Amanda Ahne

Letter to Investors | PDF

“What could go wrong?” When that question is uttered with confidence, wise folks immediately brace themselves for calamity. It is an oddity of the stock market that the more quickly a stock ascends in price, the less often people seem to worry about what could go wrong. Rising stock prices have a way of anesthetizing investors against concern that “something could go wrong.”

There’s nothing wrong with the question, but it matters whether it’s voiced with hubris or humility. In our view, an investor needs to critically inquire as to what can go wrong before ever committing capital to an investment. This is where risk management starts. Most investors, however, tend to begin their work with the question, “How much money can I make?” But we have found that worrying about risk is even more important. That’s because while the price of every security has an expected return built into the price (an earnings yield and rate of growth for a stock and a yield to maturity for a bond), the actual return depends on the probability that return is actually realized.

That probability is the answer to the question, “What can go wrong?” Good investors obsess over that question, whether the subject is an individual stock or the construction of an entire portfolio. We know that if we correctly understand the risks, we will better understand the probability that our return expectations will be realized. We can’t predict the future (no one can), so it’s a matter of doing our best to put the probabilities in our favor. That’s where correct analysis of risk comes in.

Our analysts, strategists, and portfolio management teams spend more time on risk management than on any other pursuit. This activity doesn’t guarantee against downside risk, of course. This is a “batting average” business, and the goal is not to eliminate risk, which is impossible, but to not knowingly accept unreasonable risk relative to the returns we expect. I have always thought that if we manage the downside appropriately, the upside will take care of itself.

Last quarter I referred to a book that over 40 years ago profoundly affected how I thought about investing: Benjamin Graham’s The Intelligent Investor. In 2003, Jason Zweig issued an excellent revision and commentary on that classic which, if possible, made the original even better. In that edition is this insightful observation:

The longer a bull market lasts, the more severely investors will be afflicted with amnesia; after five years or so, many people no longer believe that bear markets are even possible. All those who forget are doomed to be reminded; and, in the stock market, recovered memories are always unpleasant.

Even though the stock market has seen some sharp selloffs in the last five years, it seems to me we are living in such a time as Mr. Zweig describes. While the Fed has the overnight rate at over 5% today, memories of extraordinary monetary support (0% interest rates for most of the last 16 years plus Quantitative Easing or bond-buying) have convinced investors that they won’t be abandoned by the authorities. Then add a new productivity enhancer like Artificial Intelligence (AI) and the market had all it needed to take valuations to new highs. But there’s no such thing as a risk-free market.

This is an environment where a long-term investor needs to consider the probabilities of what can go wrong. Is there a cost to weighing risk carefully? Of course, there is no free lunch. It means not chasing “hopes and dreams” stocks that others are, where the prospects of big gains are paired with big risks. The market today seems to be more excited about future gains than the possibility of loss. The wisest saying in the investment business is to “be cautious when others are bold and bold when others are cautious.” We are a bit cautious these days but are prepared to be bold when the opportunities present themselves.

We appreciate your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Asset Allocation Bi-Weekly – The Incremental Uranium Demand for Weapons (April 15, 2024)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

In our Asset Allocation Bi-Weekly report from March 4, 2024, we began to explain more fully our recent decision to introduce uranium and uranium miners into our Asset Allocation strategies. Our key thesis was that current and planned investments in new nuclear reactors for electricity generation, especially in China and India, will likely lead to booming demand for uranium in the coming decades, while supplies are likely to be constrained. This theory is increasingly discussed among investors, and we think it’s a key reason for the jump in spot uranium prices since 2022, as shown in the chart below. In this report, we discuss a less-recognized source of incremental uranium demand that could drive prices even higher: China’s ongoing rapid expansion in its arsenal of nuclear weapons and the possibility of a global nuclear arms race in the future.

(Source: Tradingeconomics.com)

After decades of keeping only a “minimal” nuclear deterrent of about 200 warheads, China has recently begun a dramatic expansion of its arsenal. Western analysts believe China’s arsenal has expanded by about 42 warheads annually since 2020, reaching 500 warheads in 2024. Publicly observable and classified evidence suggests Beijing aims to match the United States’s deployed arsenal of 1,770 warheads by 2035 (not including reserves), which would imply adding an average of 115 warheads per year until then. Finally, as we have written elsewhere, we think rising geopolitical tensions around the globe and growing doubts about the US’s commitment to its allies could potentially prompt a dozen or more non-nuclear states to develop nuclear weapons in the coming decade or two. If that results in a global nuclear arms race, the world could end up producing several hundred new nuclear warheads each year.

In every scenario we’ve looked at, China would be the main driver of new nuclear weapons production in the years to come. So, in order to understand the incremental uranium demand for weapons, we will focus on China’s expected needs. Because of China’s long nuclear history and technological prowess, we assume its nukes are similar to the advanced, plutonium-based hydrogen bombs fielded by the US and Russia. According to a 1999 declassification guide from the Department of Energy, such bombs can theoretically be made with just 6 kg of plutonium, similar to the mass of fissile material for a uranium-based bomb. Another DOE report says that the US has used 3.4 metric tons of plutonium in its 1,054 nuclear tests since World War II, implying the use of about 3.25 kg per test. Actual weapons probably use more plutonium than the hypothetical minimum or test levels, so we assume current and future Chinese bombs would use at least 10 kg of plutonium each. Data on weapons-grade uranium and plutonium stocks from the International Panel on Fissile Materials suggests modern hydrogen bombs encompass an average of about 15 kg of plutonium each, which we use in our calculations below.

Of course, very little plutonium occurs naturally on Earth; it is generally made from uranium. Open-source reports indicate that producing 1 kg of plutonium takes about 4,000 kg of uranium. If these reports are accurate, each new Chinese warhead requires about 60 tons of uranium, and China’s current annual production of about 42 warheads probably represents about 2,520 tons of uranium. Unclassified sources don’t clarify what form of uranium is used in the 1:4,000 ratio, but if it is standard uranium mine output (i.e., “yellowcake,” or minimally processed ore consisting of about 85% triuranium octoxide), then China’s current annual nuclear weapons output is using the equivalent of 4.2% of the approximately 60,000 tons of uranium that was produced by mines around the world in 2023. We therefore suspect that China’s current nuclear build-up is probably helping to buoy spot uranium prices even today.

Looking forward, if China increases its bomb output to the expected 115 per year, its nuclear program would require at least 11.5% of 2023’s global mine output and would more obviously put upward pressure on uranium prices. Moreover, we believe our estimates could be quite conservative. For example, it may be that the plutonium/uranium ratio of 1:4,000 refers to pure or enriched uranium, which would imply that even greater quantities of uranium ore are needed. China might also decide to build up an inventory of reserve warheads, further boosting the need for uranium ore. Plutonium and uranium production waste may also boost uranium needs. Finally, if geopolitical tensions do result in a global nuclear arms race, we believe the total uranium demand from China, Russia, the US, all other existing nuclear states, and new nuclear states could easily overwhelm global supplies and send long-term uranium spot prices dramatically higher.

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