Navigating the Two P's - Putin and Powell

So far this year, worldwide investment markets have reacted to wartime inflation pressure and our Federal Reserve's ramped-up interest rate normalization process, triggering the largest bond market decline in 4 decades, and more..

Because of the unusual amount of repositioning that is necessary to navigate the risks and opportunities that are currently present, I wanted to put a short summary document together for our clients that provides some understanding of the specific actions we are taking in our managed strategies. As you read this, keep in mind that our more conservative investors have an overarching goal to reduce risk and create returns without large drawdowns, while at the same time, our growth investors remain focused on accumulating shares for the future and often look at price declines as an opportunity to buy more assets for the long run. Some of the strategies described below are applicable to one group or the other, or both.

Chaos in the Bond Market

As the war in Europe and the new lockdowns in China have added more inflation pressure, the bond market has accelerated its selling of high quality (HQ) investment grade bonds. As a result, High Quality, investment grade bond positions are down nearly double digits, and there may be more selling ahead of us so long as the world believes that the Fed will continue to let rates float higher to fight inflation.

Going back to our actions in Q3/Q4 last year, we anticipated the Fed was serious about its conviction to pursue "interest rate normalization" – allow rates to float back up toward longer-term normal levels which are considerably higher than present day rates. In the second half of 2021, we moved some HQ bonds to treasuries with CPI swaps (LA inflation focused) in the fall and that strategy is slightly positive in 2022. We also moved some HQ bonds to Real Estate Investment Trusts in Q4 and have continued to move even more in 2022. Both of these have performed well and actually have small positive returns this year.

However, those exchanges are only a portion of the HQ bonds we own in more conservative portfolios. Our intention to reduce HQ bond exposure is to be somewhat in synch with the Fed’s intentions to use its tools to normalize rates with a slow and systematic approach. The concept being to own less and less HQ fixed income as the Fed gets more and more focused on rate increases. But, keep in mind that HQ bonds are the asset category of choice to own if/when there is a recession or major stock market sell-off. (Often that is called the "flight to safety trade”). So, for more conservative investors, we would never have the intention to get rid of 100% of the HQ bonds, because that asset category can protect against large portfolio losses when there is trouble in the stock market.

We sold another portion of fixed income this week that we feel was susceptible for higher highs or lower lows, all dependent on the next unpredictable move with interest rates. Given the current environment of bond market volatility, we decided to increase dry powder (cash) until volatility subsides. In our more conservative strategies, we currently are holding more cash than any time in the past 20 years. With so much interest rate uncertainty, and more Fed action likely to fight inflation, we feel holding more cash (instead of traditional HQ bonds) is prudent for now. This is especially important for clients taking income from their accounts.

Stocks down so far this year

On the stock side of things, various segments are down year-to-date anywhere from -6% to -40% depending on sectors, size, and style. The broader market average losses (7-9%) are in line with our stock exposure in our portfolios. It's noteworthy that aggressive growth holdings (like FANGS and tech in general) are down considerably more than most of our stocks YTD. Our more aggressive investors have a couple of growth oriented positions that are down significantly this year. Because these are long-term holdings and we have conviction in the talent of the managers working in these categories to provide long-term returns that are worth the short-term risks, we anticipate hanging on for the ride until growth is in favor again.

For our conservative portfolios, there is almost no exposure to growth stocks at this time. The international stock markets are down YTD due to continued supply chain issues, labor force shrinkage due to COVID, mass shutdowns in China, and the War in Ukraine. We started exiting international on 1/24/22 and sold our last tactical international holdings on 3/3/22 as the implications of Russia's invasion of Ukraine became more clear. Since then, international markets overall have continued lower. We are nearly 10% away from a re-entry trigger, so we could be in cash for a while. One last noticeable adjustment we made in Q1 on the heels of the Fed’s statements last month regarding their short term "inflation control" strategy, we exchanged about half of our trend stock positions (previously called “defined risk” holdings) to hedged equity strategies. Because the Federal Reserve's strategy seems to be intentional to keep the market suppressed by selling incrementally more of its balance sheet assets AND raising rate targets at each moment that stocks have a reason to rally (earnings surprises, improved labor data, etc.), we think this could be a bad environment to use a trend strategy. (Trend strategies tend to trade in/out more frequently when the direction of the market is fundamentally sideways. This can cause selling at slightly lower points and buying at slightly higher points over and over again while in that sideways market cycle.) With hedge equity strategies, we get a reasonable percentage of upside stock price movement (about half historically), while at the same time, options constrain the downside to -1 to -5% in any one quarter. We plan to resume our defined risk strategy once the Fed’s “interest rate normalization” cycle is complete. BOTTOM LINE: This is a lot of activity for us in a single quarter. It is clear that we are in a bit of uncharted territory with interest rates rising so fast, bond market losses greater than stock losses, and drivers for inflation rising at an alarming rate. For more conservative investors with shorter-term time horizons, we have a greater need to hedge stock risks, and to be content with a larger amount of cash on the sidelines until the Fed gets closer to the end of its rate tightening cycle. If we are patient, it’s very possible we will re-enter at lower prices and/or get better yields, hopefully experiencing much less volatility than the broad bond market. We may systematically invest a little each month back into the bond market in the coming 6-12 months as it becomes clearer that we are getting closer to the end of the Fed tightening cycle. For our longer term investors in moderate growth or more aggressive, there is not much trading activity to report, but this is an unnerving moment in time as it would seem the Fed is trying to navigate us into a recession to control inflation. We have high conviction that US demographics are very good in the next 10-20 years, so let’s be patient and disciplined, add to accounts as we can, and try to buy assets on price dips. We hope you find this information useful as you contemplate your personal financial situation. Feel free to call us anytime with questions, thoughts, etc. We appreciate the continued confidence in our work and the opportunity to serve you and your family!