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Treading on Thinner Ice: Portfolio Risk Management

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March 25, 2022 — An important discipline in our investment work is portfolio risk management. This can mean adjusting position sizes of securities, adding portfolio hedges, or recognizing that the market is not appropriately pricing risks to the upside or downside. There is no question that economic risks have risen significantly in recent weeks, yet the S&P 500 is less than 6% below its all-time high. While we are not projecting a recession over the next 9–12 months, the downside risks have sufficiently escalated to no longer warrant an overweight to U.S. equities. As a result, the Investment Committee has exercised risk management by reducing U.S. large-cap and small-cap equity exposure to neutral versus our strategic benchmark and adding the proceeds to investment-grade fixed income and cash. We retain a small overweight to equities via emerging markets.

Risks rising

Three important, interrelated risks have escalated of late—all of which the market seems to be shrugging off—and will be further explored in our April Capital Perspectives:

  1. Commodity price spike—We are one month into the war in Ukraine with no certain end in sight. Sanctions and infrastructure destruction will result in reduced supply or bottlenecks in the delivery of energy, metal, and agriculture commodities. This 30% year-to-date spike in commodity prices is exacerbating inflationary pressures that are already the worst in four decades. Gasoline prices are at an all-time high. Some may take solace in the fact that, after adjusting for inflation or fuel efficiency, this price may not be as painful to consumers. However, we find it unlikely that a 30% increase in gasoline prices will not result in demand destruction across other areas of the economy. Put simply, stagflationary risks have risen.
  2. Deteriorating sentiment—Angst is evident in sentiment surveys for consumers, businesses, and investors. While every fluctuation in consumer sentiment does not offer predictive value over future stock prices, it can be telling at extremes, and the University of Michigan Consumer Sentiment Index has only been lower four other times in the last 50 years (Figure 1). Small business sentiment and capital expenditure plans are hinting they might roll over, posing downside risk for capital investment’s contribution to the economy.
  3. Hawkish Fed—The Federal Reserve has been busy on the communication trail since December to talk up expectations for monetary policy tightening and just last week undertook the first step. That has accelerated with the latest release of the FOMC statement and projections (known colloquially as the “dot plot”) which showed the median expectation for a total of seven hikes of 25 basis points (0.25%) each in 2022, including last week’s action. The dot plot skews hawkish, though, with one member penciling in the equivalent of a 50-basis point hike at almost every remaining meeting this year. Chair Powell, St. Louis Fed President James Bullard, and other voting members have also vocalized the possibility of one or more 50 basis point rate hikes this year. From today’s low starting point on the fed funds rate and, considering the anticipated rate of change, we could experience the most aggressive pace of Fed tightening ever.  

Figure 1: Consumer sentiment declining in the face of inflation

Figure 1.png

Data as of March 16, 2022. Sources: University of Michigan Consumer Sentiment Survey, WTIA.

Core narrative

Prudent investing is not about predicting the future and placing all eggs in that basket. Instead, it’s about recognizing risks, estimating what is priced into the market, and positioning accordingly. We assess that risks have risen dramatically without a symmetric price response in the market, thereby giving us an opportunity to reduce portfolio risk into relative strength. The good news is that the economy is entering this year on very solid footing, with significant cushioning to withstand these risks. A recession is not our base case, but we expect a slowing of growth from our original 2022 U.S. GDP forecast of 3%, and this will impact corporate earnings.

We still retain a modest overweight to equities via emerging markets, where prices have been beaten down, sentiment is very negative, and currencies are arguably undervalued relative to long-term equilibrium. A pivot from China toward more supportive fiscal and monetary policy, along with a more favorable outlook for commodity exporters, is expected to support returns for the asset class relative to developed markets equities. While we retain an underweight to investment-grade fixed income, Treasuries and aggregate bonds have experienced one of the largest drawdowns in history, making this an attractive time to begin adding back to the asset class. This action modestly reduces the degree of our underweight versus our strategic benchmark. We also hold an overweight to cash, which has proven its worth in a highly volatile market and is also expected to benefit from the sharp move higher in short-term interest rates.

Please stay tuned for more details on our outlook and the global investment landscape, which will be discussed in our next issue of Capital Perspectives, due to be released the first week of April.

Disclosures

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Reference to the company names mentioned in this blog is merely for explaining the market view and should not be construed as investment advice or investment recommendations of those companies. Third party trademarks and brands are the property of their respective owners.

Basis points refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.

S&P 500 index measures the performance of approximately 500 widely held common stocks listed on U.S. exchanges.  Most of the stocks in the index are large-capitalization U.S. issues.  The index accounts for roughly 75% of the total market capitalization of all U.S. equities.

 



Meghan Shue

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