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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence of Ideas from Confluence Investment Management. I'm Phil Adler. Today, we review quarterly revisions to Confluence asset allocation models. The firm offers five models based on sensitivity to market risk ranging from income to aggressive growth, and our guest is Confluence asset allocation committee chair, Kaisa Stucke. Kaisa, you're always fighting the battle between risk and return as your committee undertakes these quarterly reviews.
Phil Adler:But as you considered these models for the first quarter of twenty twenty five, was there a sense that you're dealing with a heightened degree of uncertainty that needs to be reflected in risk parameters?
Kaisa Stucke:Hi Phil. Thanks for having me. As we looked at the market conditions this quarter, two key sources of market volatility stood out. First, geopolitical and policy uncertainty remains elevated as The US transitions away from its global hegemon role and a new administration takes shape. Second, despite broad market risks, US equities, particularly large caps, are increasingly seen as a safe haven due to their stability, strong corporate earnings, and also deep liquidity. This perception perception has driven significant capital inflows into domestic stocks, which reinforces their strength relative to other assets.
Kaisa Stucke:In the near term, we expect these flows, along with passive index investments and record high cash reserves, to provide continued support for US equities.
Phil Adler:The committee is expecting resilient US economic growth in the short term. And one reason, I guess, the key reason is the tight labor market, which creates conditions for healthy consumer spending. Why do you expect the labor market to remain tight?
Kaisa Stucke:You're exactly right. There are two primary factors persistently tight labor market, aging demographics and uncertainty around immigration policy. Aging demographic trends are a slow moving but predictable force, reducing the size of the working age labor pool. At the same time, immigration policy remains uncertain, adding an unpredictable variable to labor supply. So, structurally, The US simply does not have enough working age individuals to meet labor demand, which we believe will continue to support a tight job market in the near term.
Phil Adler:Well, are you worried that an increase in inflation might cause consumers to rein in their spending and and that could impact corporate profits and and lead to layoffs?
Kaisa Stucke:Yeah. It's interesting. We've observed some moderation in consumer spending, but overall consumer confidence has remained resilient. We don't anticipate a recession within the three year period, but we do expect a gradual economic slowdown during that period. First, consumer spending, which has been a key driver of recent economic strength, could weaken due to inflation fatigue, which reduces overall demand.
Kaisa Stucke:And second, inflation could distort business investment and spending patterns in general. What you see is when wage growth consistently outpaces productivity gains, profit margins compress, making businesses less profitable and potentially leading to cost cutting measures, including layoffs. We're monitoring these risks, but the current environment suggests that consumer strength and corporate adaptability will continue to support economic resilience in the near term.
Phil Adler:Kaisa, do you think 3% is the Fed's new unspoken benchmark for inflation?
Kaisa Stucke:It's ultimately a question of trade offs. After two decades of inflation running below target, we believe the Fed is willing to tolerate a period of modestly above target inflation rather than risk stifling economic growth. Former Saint Louis Fed president Jim Bullard often framed inflation as a range or a long term average rather than a fixed 2% at all times, suggesting that there's some flexibility built into their approach. Additionally, the Fed must balance its dual mandate, price stability and maximum employment. If inflation stabilizes around 3% without significantly disrupting economic growth or the labor market, the Fed may view it as an acceptable outcome rather than aggressively tighten policy to force inflation back to 2%.
Kaisa Stucke:However However, there's always a however. If inflation expectations become unanchored or wage pressures fuel sustained price increases, we could see a more proactive response from policy makers.
Phil Adler:The markets are paying a lot of attention to the bond market and the chance that the yield on the ten year treasury note might drift above 5%. Do you consider this a dangerous level?
Kaisa Stucke:You know, I would not call it dangerous, but our macro team considers this a level at which the Fed would intervene.
Phil Adler:Kaisa, let's move on to, model changes you're recommending at confluence for the first quarter. And what stands out is the increase in the allocation to long term bonds in three of the models with an 11% increase in the most conservative income model. Why are long term bonds so clearly favored over shorter durations?
Kaisa Stucke:That's a great question. The yield curve normalized over the last quarter, meaning long term bonds are now offering a real return above inflation. The shift makes them much more attractive than they were a year ago. And investors are now able to lock in higher yields while also positioning their potential price appreciation if interest rates decline. So compared to shorter duration bonds, which tend to offer lower yields and less sensitivity to rate changes, long term bonds provide a compelling opportunity in this environment.
Phil Adler:Well, you've emphasized, Kaisa, that Confluence does see the risk of recession as low over the next three years. Now is this why you continue to recommend speculative grade bonds in the three most conservative models?
Kaisa Stucke:That's correct. Given our expectation for resilient economic growth, the risks associated with spec grade bonds remain relatively contained. As you know, spreads have tightened, but default risk remains low, and these bonds continue to offer attractive yields. As long as economic conditions remain stable, we see them as a reasonable source of income in more conservative portfolios.
Phil Adler:Moving on, all five models show increases in the allocation to US large cap stocks. And and you did mention earlier that US equities are being perceived as a safe haven asset, and you pointed out conditions creating strong support for US large cap stocks. So do you view large caps as a safe haven?
Kaisa Stucke:Absolutely. That's correct in this environment. The US economy remains attractive on a global scale, especially as foreign growth slows and geopolitical uncertainty rises. Additionally, large caps are benefiting from strong passive index flows and record levels of cash waiting to be deployed, as well as, you know, these Trump administration policies are likely to remain friendly to big businesses.
Phil Adler:How about large cap sectors? Does technology have significant more room to run?
Kaisa Stucke:Yeah. We've seen strong momentum continue in the tech sector, but at the same time, we continue to be concerned about concentration risk and elevated valuations, particularly among the top weighted names. In the short term, passive investment flows like we talked about, they'll continue to support these stocks, lifting market cap weighted indices even further. However, over the long run, we don't see these valuations as sustainable. It's hard to predict what ultimately triggers a shift, whether it's overvaluation concerns, an external shock, or simply, change in investor sentiment.
Kaisa Stucke:You know, we saw the tech sector suffer in January when a Chinese AI competitor revealed its capabilities. It serves as a reminder that sentiment can turn quickly.
Phil Adler:Foreign markets are another, area where there have been some changes in your model recommendations. Foreign market valuations do remain low, but you're not seeing much of an opportunity, and you're eliminating any allocation in any of the models to international developed market stocks. Why?
Kaisa Stucke:That's right. We exited international developed equities this quarter, and I'll add that we haven't held emerging market equities for the past three years. This decision reflects several concerns. First, slowing global economic growth. Second, the continued strength of the US dollar.
Kaisa Stucke:And last, escalating trade tensions. Given these independent but strong factors, we see better opportunities domestically and prefer to allocate capital where we have stronger conviction.
Phil Adler:Commodities have been stellar performers in the past three years. Allocations to commodities do remain in your new report, but they are reduced in four models. Which commodities do you continue to favor the most?
Kaisa Stucke:I'll first take a step back and say that commodities are this unique uncorrelated asset class that can serve as a hedge against volatility, inflation concerns, and geopolitical risks. Gold remains in our portfolios across the board to hedge against these risks. But, additionally, we are seeing demand for gold from central bank reserve buying in this environment that The US is stepping back from its global role.
Phil Adler:Keisa, before we go, I wanna bring up one more investment option that has certainly been widely noted in in the popular media, and that is the emergence of crypto ETFs, which has prompted some investment funds to introduce crypto in their allocation models. Now is Confluence any closer to doing that?
Kaisa Stucke:It's a question we get asked at an increasing frequency. At this point, we don't consider crypto as standalone asset class. There is limited historical data on its performance across different market cycles, and the investment vehicles available are still in their early stages. Some analysts are correlating crypto with gold, but we simply don't have enough data to be able to develop an an investment framework and, therefore, evaluation model for crypto. We continue to monitor developments in the space, but don't see it fitting into our models at this time.
Phil Adler:Thank you, Kaisa, for your summary of the Confluence asset allocation recommendations for this quarter, the first quarter of twenty twenty five. If our listeners would like to read the detailed asset allocation outlook report, that's easy to do. Just access confluenceinvestment.com, and you'll find a tab for the asset allocation quarterly on the top right. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice.
Phil Adler:Also, this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole. I'm Phil Adler.