Portfolio Management Update

My view has not changed since last quarter. The U.S. economy is in a rare soft landing. The Federal Reserve should continue to ease at a slow and more measured pace as inflation is no longer a problem and the US economy is slowing down. Bond market price action, yield curve steepening and credit spreads narrowing indicate a soft landing is priced in. A balanced asset allocation strategy that addresses slower economic growth, lower inflation, and a slow easing cycle is the best strategy. Investing in Interest rate sensitive areas of the market such as bonds and cyclical equity sectors is an appropriate strategy for this type of market environment.

A balanced strategy, investing in both stocks and bonds offers current income, and potential appreciation in response to lower interest rates. Also, a balanced strategy would dampen portfolio drawdowns that are likely to come in any year. Bonds are a diversifier against equities now that bond yields have normalized. Thereby offering some protection in a market correction. What is more, current bond market yields are historically attractive enough to compete directly with stock returns so on a risk-adjusted basis it makes sense to invest in both.

Even with fewer cuts than expected, this environment could still be supportive of stocks and bonds. A growing economy should provide a tailwind for equity prices over the long term, while rates could remain at a level that presents bond investors with a real alternative to equities. High yield bond market breadth is historically strong, suggesting positive forward returns for equities.

Within equities, I am investing in Large-cap Growth stocks that benefit from AI tailwind as well as more cyclical areas of the markets like Small-cap stocks, and an allocation to intermediate duration fixed income investments. This investment allocation may provide more growth and income in a soft-landing economic scenario.

Rate-cutting cycles have tended to favor risk assets such as equities and dividend paying stocks. The first cut often sees defensive areas of the equity markets outperform economically sensitive ones. However, economically sensitive stocks regain the lead when there is no recession. Communication Services outperform after first rate cuts, so do Technology stocks. Slow easing cycle also favors financials, industrials, and energy sector. Financials are one of the most interest rate sensitive sectors. The best conditions for financials are non-recession, rate cuts, and yield steepening. The yield curve has turned positive for the first time in years, suggesting the economy could accelerate, which also favors the cyclical sectors mentioned. As the yield curve normalizes, Net Interest Margin spreads start to widen. That should benefit all the banks.

Current equity sector price performance suggests cyclicals would be the better long-term investment. Sectors showing better earnings growth are Information Technology, Health Care, and Communication Services. Lastly, the Information Technology and Communication Services sectors are expected to see the largest price increases. On the other hand, the Utilities, a defensive sector, is expected to see one of the smallest price increases according to FACTSET.

AI stocks underperformed last quarter after leading year-to-date. Many investors are rotating out of AI and tech stocks and into value stocks. I have held my AI stocks as an analyst expect strong demand and monetization of AI functionality as supporting earnings growth for these stocks in years ahead. Many Tech and AI stocks are now trading at more reasonable valuations.

I remain overweight in the Technology sector. Currently, Technology sector is in a consolidation phase that creates a long-term buying opportunity in certain stocks. The Technology sector is almost 30% of the S&P 500 Index. Its importance in the global economy continues to expand. It is early days for AI, there are only rough estimates on how large the potential market will be. PricewaterhouseCoopers estimates it could be $15.7 trillion by 2030. The AI market could be larger than those of previous technological advances such as the internet and smart phone. Technology stock valuations have shrunk but still are trading at a premium because their sales growth, earnings growth and profit margins are superior to other sectors and stocks. Elevated expectations combined with premium valuations could leave the most richly priced Tech stocks vulnerable if earnings miss expectations.

The most attractive area of the US stock market is Small-cap 600 stocks trading at a more reasonable valuation and higher estimated earnings growth. Small-Caps are near the lowest valuation to overall market valuation in fourteen years according to Morningstar. The current P/E valuation is still attractive at a forward Price-to Earnings ratio of 15.7 based on 2025 earnings estimates. CFRA projects S&P SmallCap 600’s 2025 earnings growth of 20.8% versus 14.2% for the S&P 500 Index.

A friendlier interest rate environment could eventually boost Small-cap earnings. Historically, highly economically sensitive Small-cap stocks lead in a recovery cycle. Small-cap stocks should benefit more from lower rates than Large-cap stocks because Small-caps are far greater issuers of floating-rate debt than Large-cap stocks and have more earnings sensitivity to lower rates than large caps. When credit spreads narrow, as is the case now, and rates are cut, and the economy expands, small caps could do well. What is more Small- caps benefit more from any proposed tariffs and from a stronger US dollar.

What else am I investing in and why?

The energy sector is the cheapest sector. The oil market is trading more on oversupply and weaker demand now. A broader Middle East conflict could lead to a higher geopolitical risk premium for oil. At the same time, China is talking about greater fiscal stimulus. The Fed rate cuts support higher oil prices as lower interest rates translate into a weaker dollar and stronger prices for dollar denominated commodities.

I think the Healthcare sector is trading at attractive valuations compared to the S&P 500 Index and sectors that have outperformed. Healthcare is a sector that should meet low bar earnings projections. Wall Street analyst project the sector to see price gains of 9% according to FACTSET. Furthermore, Healthcare performs well during periods of expansion and Fed easing interest rates.

I reduced exposure to utility stocks based on valuation concerns. Reinvested proceeds in intermediate corporate bonds and Healthcare stocks. I intend to increase position in “AI” Utility stocks when selling stops as the 10 Year Treasury yield reach intermediate peak. The growth of AI means data center growth which means growing demand for electricity. Wells Fargo sees 80% growth in electricity demand by 2050 because of data center demand.

Gold is making new all-time highs fueled by World Central Bank purchases. China and other Central Banks are diversifying away from US Dollar and increasing their gold holdings to become less financially reliant on the Western financial system. Also, World Central Banks as well as US Fed are in an interest rate easing cycle. Lower rates and lower inflation create a lower real interest rate environment that favors gold purchases over Treasuries. The opportunity cost of not owning Treasury-bills for income may fade, making Gold a more attractive investment. Furthermore, the US Government deficit spending and rising debt, and escalating tensions in the Middle East are reasons to own gold. There is more upside in gold because the market has not yet focused on the deficit spending or ballooning US Government.

I am underweight Developed Market Foreign Equities and Emerging Market Equities. The US economy has the best fundamentals for earnings growth. However, World Central Banks are easing, and China is stimulating its flagging economy, so I am slightly increasing exposure to emerging markets. Chinese market is cheaper than U.S. equities. Chinese growth stocks are trading at single multiple P/Es with double-digit growth rates versus US growth stocks trading at forward P/E of 23 plus. Geopolitical risks remain high which could cap a multiple expansion in Chinese growth stocks.

What are the current adjustments to the bond’s component of portfolios?

The recent jobs report shows a strong market with normal unemployment, suggesting the number of rate cuts already priced in bonds might be unnecessary. I am incrementally trimming exposure to long-term credit bonds and reinvesting in Intermediate Term Credit Bonds. Why? No recession, instead the economy is in a soft landing- do not need recession protection of Long-Term Bonds. Given the bond market has discounted too many rate cuts, then long-term bond prices are fully priced. Lastly, deficit spending and overall Government debt levels could adversely impact Treasury bond prices in 2025.

Treasury bond yields could rise in 2025. A stronger-than-expected economy could push longer-term bond yields higher and prices lower. This would exponentially increase the cost of servicing national debt – some of this debt was issued at rates of 3%. Treasury bonds could face a buyers strike by fixed-income investors next year. The US Government continues to spend and borrow beyond its means – Government debt is now a whopping $34 trillion! The Government expects to issue $9 trillion in Treasury issuance in 2024, in 2025 it expects to be $12 trillion! Bond investors may want a higher yield from Treasuries to induce them to buy, especially if Government debt levels reach a level that warrants a credit downgrade.

Yields on cash and shorter-maturity products will drop in an easing cycle. Now is the appropriate time to move from cash to intermediate term bonds to lower investor reinvestment risk. The long end of the yield curve has become the riskiest part once again. The sweet spot of the yield curve is the middle of the curve, three to seven years in maturity. The middle manages interest rate risk, reinvestment risk, and purchasing power risk better than either the short end or the long end.

I prefer intermediate Investment Grade over Non-investment grade bonds. High-quality bonds have tended to provide the important benefit of diversification from equities. In the past, investment grade Long-term bond prices have risen during periods of recession or crisis. Those bonds function as “portfolio insurance” that help offset equity risk in portfolio.

I am underweighting cash equivalents. Cash yields are losing their attractiveness compared to short term bonds. The Federal Reserve is in an easing cycle. That means cash-equivalent yields decline towards 3%. It’s time to move cash-equivalents positions into short term bonds that have lower reinvestment risk. Besides an ETF investing in Treasury Bills indexed for inflation, Cash equivalents is invested in investment grade floating rate notes with a duration of 0.02 – extremely low-interest rate risk.