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Portfolio Management Actions Fall 2022
The late-cycle economic phase with stagflation conditions and high recession risk calls for a balanced diversified portfolio. There-Is-No-Alternative-To-Stocks (TINA) is dead. Bonds for the first time in years are competitive to stocks. Although many stocks offer greater long term growth potential. Stay balanced by overweighting quality short term bonds, and quality dividend growing stocks both defensive and cyclical ones.
Stagflation environments favors defensive sectors over cyclical sectors. Utilities, Consumer Staples, and Health Care have led the defensive leadership during periods of stagflation. Defensive sectors have outperformed cyclical sectors over last 12 months. It is too late to overweight them in a portfolio. I would not add to Utility or Consumer Staples stocks because of valuation concerns. Although, it is safe to own Healthcare stocks even as the economy slows down. Healthcare stocks are less economically sensitive and are still attractively valued. Also, rising dividends in healthcare stocks can counter inflation.
I am looking for opportunities in what has repriced for slower growth and even a recession. Most cyclical sectors such as Consumer Discretionary, and Technology sectors fit the bill. Twelve months from now I would expect those sectors to outperform defensives. Economically sensitive sectors lead the stock market into recession but also lead the stock market out of a recession. I am holding onto Technology stocks. Technology sector has produced positive returns during a recession when yields peak. I will add to Technology position when the two-year yields peaks, and the U.S. Dollar peaks. Technology stocks valuation repricing should be soon complete as interest rates are nearing a peak. A peak in yields should cause the U.S. Dollar to fall from its highs which benefits Technology earnings as a major part of sales are foreign.
Energy has underperformed during both stagflation and recession regimes; it is the most economically sensitive sector during recession. However, this time I believe its different due to supply issues, energy prices should hold up even in a U.S. recession. Energy companies are coming off record profits and free cash flow. Their balance sheets are healthy, and energy companies are returning capital in the form of dividend growth. Moreover, Energy sector is among the cheapest sectors. I am overweight energy and adding to position.
I am underweight foreign equities. Many foreign economies are projected to experience a more severe recession next year than the U.S. Higher energy cost abroad will squeeze foreign corporate profit margins. Given a stronger dollar, foreign equities earnings growth in the US dollar term has been downgraded, at some point earnings risk will be fully discounted into price. The dollar index hit its highest level in more than 20 years last quarter. The Fed has front loaded hikes at a pace not seen in decades. Interest rate differentials between countries makes the U.S. dollar more attractive compared to other currencies. However, the U.S. dollar could be peaking as interest rate differentials narrow going forward. That suggests adding to foreign stocks in 2023.
I also want balance between equities and bonds. Bond returns after the Fed begins rate hikes in six of the past seven Federal Funds Rate hike cycles, generated positive returns 12 months after the Fed started to raise rates according to State Street Global Advisers. Furthermore, Late cycle to recession phase favors quality bonds over defensive stocks. Four to eight months before a recession, bond prices start to rise, especially long-term bond prices. What’s more long-term rates also reflect the outlook for growth and inflation. The more successful the Fed is in slowing the economy and inflation, the more likely it is that bond yields will stabilize or fall in 2023.
I also prefer quality bonds over defensive stocks because the yield curve is inverted right now which says economy is on a recession watch. Historically, in a severe economic slowdown, bonds outperform stocks. In a recession long term bond prices continue to rise providing a double digit return to investors according to FMR research.
High inflation in a maturing business cycle slipping into recession suggest buying only investment grade bonds. Downgrades in high yield security credit ratings is picking up this year according to Bloomberg. Financial conditions are tightening as High Yield credit spreads widen, downgrades increasing, and default risk rises as economy enters a recession. Most vulnerable bonds to default are non-investment grade bonds. Expect low quality bonds to underperform high quality bonds as economy slows. I have sold all non-investment grade bonds.
For now, I am overweighting short-term bonds, however, in coming months it should be time to overweight long term bonds. If CME forecast of 4.8% terminal FFR pans out, then I will begin adding more duration in portfolio by investing in long term quality bonds and cyclical stocks, instead of Treasury Bills in coming months. In the meantime, the case for putting money into short-term bonds is very compelling with 4% yields.
I sold gold position in portfolios. Gold outperforms when inflation is accelerating, and monetary policy is easy, flooding the economy with excess cheap money. Going forward the Fed is quickly removing those conditions. Additionally, Treasury Inflation Protected Breakeven yields are projected to decline over the next two years.
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