by the Asset Allocation Committee | PDF

• The likelihood of a recession occurring during our forecast period has declined.
• Domestic economic growth should be robust over the forecast period, although momentum has slowed.
• Elevated geopolitical tensions and ambiguity related to the U.S. elections are likely to create volatility in the markets.
• Inflation volatility is likely to remain elevated as we anticipate inflation should moderate in the near-term but will reaccelerate to higher than pre-pandemic levels due to various structural influences.
• Monetary policy is expected to ease, but we believe market expectations may be too optimistic in terms of the timing and magnitude.
• We have shortened our duration modestly as we expect normalization of the yield curve.
• In domestic equities, we maintain our Value bias as well as quality factors.
• We maintained the exposure to gold and, where risk-appropriate, added silver as a hedge in volatile times.

ECONOMIC VIEWPOINTS

Markets are currently expecting that the FOMC will shift to easing and the economy will avoid a recession. We agree that the likelihood of a recession has declined and expect economic expansion for the majority of our three-year forecast time period. The Fed dots plot indicates 75 bps of easing in 2024 and futures-based market expectations call for even more aggressive easing. Although we concur that the next step is likely to be easing, market expectations may be too optimistic regarding the timing and magnitude, and this mismatch has the potential to create market volatility. We expect the Fed to hold policy steady later this year as we head into elections to avoid the impression of political favoritism.

Economic growth should remain healthy over the forecast period; however, we believe that volatility, in general, will remain high for both economic indicators and markets. For example, we anticipate that inflation should continue to moderate in the short term due to tighter monetary policy but will reaccelerate to higher than pre-pandemic levels in the medium term. Factors contributing to tighter supply chains include supply chain rearrangement with reshoring and friend-shoring of industrial capacity, elevated geopolitical tensions, and developed world demographics. For investors, the volatility of inflation is equally as important as the level. As this first chart indicates, the volatility of inflation during the post-Cold War era has been much lower than it was pre-1990. We also expect many other economic and market metrics to return to the more volatile paradigm similar to what existed during the Cold War.

The effects of fiscal spending are a supporting factor for continued economic growth. According to the Congressional Budget Office, fiscal outlays are expected to further increase over the next three years from the current 23.7% of GDP. The Inflation Reduction Act, the CHIPS and Science Act, and the Infrastructure & Jobs Act form an accommodative fiscal backdrop, supporting corporations as well as consumers.

In the coming quarters, domestic industrial production should slowly increase as geopolitical tensions remain elevated and reshoring moves along its intended path. As this chart shows, industrial capacity construction has increased remarkably. Tight labor markets have hindered progress but growing technology/AI use should advance it. Given that capacity buildouts are extended over multiple years, there will be escalating demands on construction, labor, and materials in the short term, while increased revenue realization is likely to occur outside of our forecast period.

In addition to the U.S. elections, pivotal elections abound globally. This is especially significant amidst high geopolitical uncertainty. As the world continues to polarize into blocs, elections provide signposts along the way about the direction and speed of change. This introduces further volatility to the system, and for investors, it necessitates keeping a close eye on their portfolios. Markets tend to focus more on the uncertainty that elections introduce rather than a specific outcome. Moreover, markets discount election results rather quickly, so a quick resolution to the U.S. primaries would be beneficial.

STOCK MARKET OUTLOOK

We expect a good economic backdrop over the forecast period. While earnings growth has slowed somewhat, market consensus is calling for improving margins. The consumer is showing signs of a slowdown, with household debt service ratios rebounding to pre-pandemic highs. While saving levels have fallen, consumer confidence has remained solid and holiday shopping was strong (although we’ll quote Confluence CIO Mark Keller here: “Don’t extrapolate holiday shopping; no matter what, Santa always comes.”). On the other hand, domestic equity valuations might find support from the high levels of cash currently held on the sidelines.

We remain overweight Value across all market capitalizations. In our view, equities categorized as Value have more sustainable earnings growth, their fundamental valuation multiples are historically attractive, and they have a lower exposure to sectors that we view as overpriced. Although Growth has recently outperformed, we anticipate we are in the early stages of a value outperformance cycle. Within large caps, we maintain an overweight position in Energy and exited the Metals & Mining and Industrials sectors. In addition to military hardware exposure via the Aerospace & Defense factor, we also added a position in Cybersecurity as we believe global conflicts will be increasingly cyber-related. The military has a long history of working with private enterprises to innovate in the tech-heavy segments of national security. Our perspective holds that the valuations of small and mid-cap stocks continue to present an attractive proposition, coupled with robust fundamental earnings power. Historically, mid-cap stocks maintain considerable valuation discounts compared to their large cap counterparts. To mitigate potential risks amid economic volatility, we uphold our commitment to the quality factor within our mid-cap and small cap exposures, which involves screening for indicators such as profitability, leverage, and cash flows.

The Uranium Miners ETF that we introduced last quarter was constructive for our portfolios as our thesis of increased nuclear energy use started to materialize. Although the underlying uranium spot price increased significantly, we believe the uranium miners will benefit further. The evolving landscape of baseload energy production, influenced by dynamic policies, has opened a window of opportunity for nuclear energy. 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. Given the constrained supply of uranium over the past decade, we perceive the supply/demand imbalance as a robust opportunity for exposure in this sector.

Low valuations in international developed equities are attractive for the more risk-accepting portfolios. The combination of deglobalization and increased geopolitical risks has widened the volatility range of the asset class. 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 a multiple expansion.

BOND MARKET OUTLOOK

Although the steeply inverted yield curve has attracted outsized interest on the short end, as indicated by the $8.8 trillion in money market funds and CDs as of year-end, it will likely prove fleeting as the Fed begins its pattern of easing. Similarly, our expectations of heightened inflation volatility for the foreseeable future combined with the rally in long-dated Treasuries over the past quarter dampen our return expectations for the long end of the curve. Contrasted with our positive view of long Treasuries last quarter, the rally occurred in a much tighter time frame than we anticipated which encouraged us to unwind this position. The belly of the curve, particularly around five years of maturity, holds the greatest allure in terms of rate stability and limitation of both market risk and opportunity cost. Within this segment, we find mortgage-backed securities (MBS) to hold merit within our thesis of an intermediate-term bond focus. With the bulk of conventional mortgages carrying rates well below refi rates, extension risk is currently dampened. Spreads on MBS remain attractive despite their narrowing since October. Conversely, corporate spreads have narrowed to historically tight levels of roughly +100 bps, encouraging a relative underweight to corporates versus the market benchmark.

Speculative grade bonds are also trading at low spreads to Treasuries; however, the concerns we have are confined to the lower-rated segments below BB. The acceptance by investors to rate adjustments on leveraged loans underscores our concern that the risk appetite has become tilted toward lower rated bonds. While this has positive implications for the refinancing wave that is poised to affect companies rated B and below over the next two years, the increased risk tolerance on the part of investors gives us pause. Consequently, the speculative grade bond exposures remain exclusively in the BB-rated segment.

OTHER MARKETS

Among commodities, elevated risks in the Middle East have implications for the price of oil, but the potential economic slowdown is dampening demand; thus, we have exited oil and its derivatives near-term. In contrast, we retain the position in gold as a hedge against elevated geopolitical risks and as international central banks are buying reserves of the metal. Gold is augmented by exposure to silver in the more risk-tolerant strategies given its low price relative to gold by historical measures. Real estate remains absent in all strategies as demand remains in flux and REITs still face a difficult financing environment.

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Asset Allocation Fact Sheet

by the Asset Allocation Committee | PDF

• Our three-year forecast includes a relatively mild recession followed by a recovery and the prospect for an economic expansion.
• Geopolitical tensions are elevated with heightened potential for increased turmoil in the Middle East.
• Inflation should moderate in the near-term but may reaccelerate within the forecast period due to structural influences such as deglobalization and labor market tightness.
• The Fed’s monetary policy is likely to ease as economic conditions slow, and we expect a measured and careful approach by the FOMC as the presidential elections draw near.
• We have extended duration by stepping into long-term Treasury bonds for their safety element.
• In domestic equities, we maintain our value bias as well as cyclical sectors and quality factors.
• Exposure to international developed markets was reduced due to continued monetary policy tightening from most developed market central banks.

ECONOMIC VIEWPOINTS

We are still anticipating a mild recession followed by a recovery within our three-year forecast period. While GDP growth has been positive, real-time indicators, such as the Chicago Fed Activity Index and the LEI, are exhibiting slowing growth. The long wait for an impending recession is a self-destructing prophecy to a degree—the more time that market participants have to prepare for a recession, the more opportunity they have to right-size their balance sheets and the less severe the recession is likely to be. Additionally, the Fed is close to, if not at, peak fed funds rates according to many indicators. No further hikes would support the economy and possibly avert a recession but would also allow inflation to run higher than the Fed’s 2% target rate.

Inflation has fallen recently, likely in response to the short-term smoothing of supply-chain problems and tighter monetary policy. Our expectation is that the volatility of inflation will be elevated within the forecast period due to underlying structural issues, such as deglobalization and labor market tightness. The U.S. labor market is expected to remain tight due to demographic shifts following the pandemic-prompted constriction of the 55+ age group labor pool and changing immigration policies. While the workforce is constrained, demand for workers has remained strong due to labor-hoarding and re-shoring. This has caused wage growth to persist at higher levels as compared to pre-pandemic periods. More importantly, wage growth has exceeded inflation over the past few months.

A significant longer-term mega-trend supporting domestic economic activity is the re-shoring of manufacturing capacity, including domestic reindustrialization and shortening supply-chains. Geopolitical tensions are likely to remain elevated, further encouraging international polarization into geopolitical blocs. Corporate fixed-asset investment, a proxy for manufacturing capacity expenditures, has been strong following the passage of the CHIPS and Inflation Reduction Acts. Capacity buildouts are multi-year endeavors, which will place increasing demands on construction, labor, and materials initially and skilled labor to operate in the long-term. We believe these pressures, combined with general supply-chain complexities, will further expose inflationary bottlenecks within the economy that will magnify inflation volatility.

The consequences of deglobalization are unfolding, such as the ongoing war in Ukraine and a geopolitical tragedy in the Middle East, which bear the potential to escalate unexpectedly and swiftly. Moreover, while the 2024 U.S. presidential election is rapidly approaching, the market is typically less concerned with the specific election outcome but it does have an aversion to uncertainty. From a market volatility perspective, a quick resolution to the primaries would be beneficial.

STOCK MARKET OUTLOOK

Given the long anticipation of a recession, corporations have likely had opportunity to optimize their inventories and liabilities, hence a deep recession is less likely. Additionally, domestic equity valuations could be supported by U.S. investors repatriating capital due to global geopolitical tensions and the historically high level of cash on the sidelines. Currently, the Technology sector accounts for approximately 28% of the S&P 500, and while optimism around AI and machine learning is strong, earnings within the sector have not kept up with the optimism. It will likely take years for AI to translate to productive uses, similarly to other transformational innovation such as the internet, electricity, and automobiles. In addition to our style tilt toward value over growth, we retain our Aerospace & Defense position and cyclical sector overweights in Energy, Metals & Mining, and Industrials. Remilitarization is accelerating as we see increased conflicts globally. The Mining and Energy sectors are likely to benefit from electrification/green energy policies as electrification is metals heavy.

We remain committed to our value bias across all market capitalizations. We view the sustainability of earnings growth as more attractive in equities categorized as value, with their valuation multiples remaining modest compared to historical data. In addition, the value style has a lower exposure to sectors that we view as overpriced. Although growth has vastly outperformed value year-to-date, we anticipate that we are in the early stages of a value outperformance cycle.

We believe that small and mid-capitalization stock valuations are attractive, with fundamentals continuing to be healthy. Mid-cap stocks remain at historically wide valuation discounts to large cap stocks. We maintain the quality factor, which screens for profitability, leverage, and cash flows, in our small and mid-cap exposures to limit potential risks during economic volatility. This quarter, we introduced a position in a uranium producers industry ETF within our mid-cap exposure. The changing nature of baseload energy production and the policies shaping it have created an opportunity for nuclear energy. Green energy policies have set ambitious goals for reducing fossil fuel usage, while the new green energy technologies cannot currently produce energy to the scale and consistency needed. With the supply of uranium having become crimped over the past decade, we view the supply/demand imbalance to offer a solid opportunity for the exposure.

We reduced our exposure to international developed equities in several strategies, but allocations remain in the more risk-tolerant portfolios. Although valuations remain low, risks have increased. Most developed market central banks persist on the tightening path in an attempt to control inflation. At the same time, economic growth is showing signs of slowing. This creates an environment for potential policy-driven errors. Given the increased geopolitical risks and re-shoring supply-chain activity, the U.S. dollar strength cycle has the potential to extend further than previously anticipated, resulting in additional downward pressure on international equities. Accordingly, in the Aggressive Growth strategy, we exited the emerging markets position due to increased geopolitical and economic growth risks. We believe that return/risk trade-offs are more attractively presented in domestic equities for the more risk-accepting portfolios.

BOND MARKET OUTLOOK

Although the quarter commenced with the market split in its anticipation of a Fed pause versus another increase in the fed funds rate prior to year-end, we believe that inflation will continue to moderate over the next several quarters and, accordingly, the Fed’s monetary policy will begin to ease. This chart indicates that the fed funds rate is well above its implied rate. Naturally there are potential curbs to our assessment, such as the structural forces of deglobalization that have the potential to keep inflation elevated above the Fed’s 2% target. Moreover, the aforementioned mega-trends will likely lead to greater volatility of inflation, especially relative to the docile environment that persisted during the period following the Great Financial Crisis. Nevertheless, the near-term outlook is for the inflation-fighting vehemence of the Fed to modulate, especially as the composition of its voting members turns more dovish next year. Consequently, we find the duration trade to be less fraught with the potential for turbulence that has existed since early 2022, and we expect the yield curve will flatten from its current inversion. This lends us the latitude to extend duration in the strategies from their prior concentration in the short-end and even place limited exposure to long-term U.S. Treasuries to hedge against the potential for even more increased geopolitical risks or a more severe recession.

The expectation for an economic contraction encourages a degree of caution toward investment-grade corporates. While companies carrying investment-grade ratings have sound balance sheets and have termed out their debt, thus avoiding a “debt wall” in the near-term, spreads to Treasuries remain contained relative to historical averages. In contrast, spreads on speculative grade bonds have risen to the point where we find it advantageous to selectively add to our exposure. Although the refinancing wave is poised to affect companies rated B and below over the next two years, with attendant difficulties for their cost of capital, our spec bond position is strictly held in the BB-rated segment which has little exposure to floating rate debt and can be characterized as an equity surrogate where incorporated.

OTHER MARKETS

Despite the currently low valuations of REITs, we expect the sector to continue to lag heading into an economic contraction and a continued high interest rate environment. Therefore, allocations to REITs remain absent in all strategies. In the commodity segment, we maintain a position in gold as a flight to safety asset during economic contractions and as a hedge against elevated geopolitical risks. For portfolios where the allocation to commodities is larger than 5%, we are adding a position in a broad-based commodity ETF with exposure to oil, gas, metals, and agriculture. Turmoil in the Middle East tends to support the broad commodity complex, especially oil and its derivatives.

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Asset Allocation Fact Sheet