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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. It was an eventful first quarter in the financial market, setting the stage for our quarterly review today of Confluence portfolio asset allocation changes. And our guest is Confluence asset allocation committee chair, Kaisa Stucke. As a reminder to our listeners, Confluence offers five asset allocation models along the risk spectrum, all centered on risk management.
Phil Adler:They are income, income with growth, growth and income, growth, and aggressive growth. These portfolios are managed by a committee that includes professionals across the firm. Now, Kaisa, before we address some of the specific changes in the allocation models this quarter. I wanna look at some of the the broader themes that you address in your current second quarter report. But I'd like to begin with a very basic question.
Phil Adler:Now I understand that increasing the allocation to fixed income is an accepted and proven way to mitigate risk in a portfolio. But I wonder if this is becoming less so and that bonds are becoming a more volatile asset class.
Kaisa Stucke:Hi, Phil. Thanks for having me. And, yes, it's true that the role of fixed income in portfolios has become more complex. Bonds still offer important diversification benefits, especially in risk off environments. But in today's world of uneven inflation and shifting policy dynamics, they can behave with more volatility.
Kaisa Stucke:We're still relying on fixed income to help manage downside risk, particularly as recession risks rise. But we're approaching it with more precision, focusing on quality and duration and sector exposure to ensure bonds remain a stabilizing force in the portfolios.
Phil Adler:Well, we'll get back to bonds later. But for now, your report anticipates currently what you call a recessionary environment occurring during your three year forecast period. And you say that signs of a slowdown were actually emerging even before the new tariffs. What were those signs?
Kaisa Stucke:Yes. You know, even though economic readings overall are strong, most of these readings are lagging indicators. But on the periphery, we were seeing signs of slowing momentum and sentiment even before the latest tariff announcement. Leading indicators like consumer expectations and new manufacturing orders had started to deteriorate. We've also seen a plateau in US manufacturing construction spending, which had surged on the back of reshoring efforts.
Kaisa Stucke:That leveling off suggests companies are becoming more cautious, especially amid policy uncertainty and cost pressures.
Phil Adler:Are the tariffs themselves now the major driver of recessionary fears, or is it the way the new tariff policies are being managed?
Kaisa Stucke:Yeah. It's really the, unpredictability of it all. The tariffs themselves add friction to trade, but the real challenge for businesses is the lack of clarity on exemptions, timing, scope, you name it. That uncertainty makes it harder for firms to commit to capital spending, which can stall growth and then ripple through hiring and investment plans.
Phil Adler:Well, the president has increased the pressure on the Fed to lower interest rates. What are you expecting in terms of rates?
Kaisa Stucke:Yeah. We do expect monetary policy to ease, but we think that path will be gradual. The Fed still has inflation concerns to weigh, especially with sticky input costs from trade friction. So while we're not returning to zero interest rates, some rate cuts are likely as the Fed has to balance this inflation risk versus a recession risk?
Phil Adler:Can you say that lower rates are key to delaying a recession or even preventing one?
Kaisa Stucke:Right. Lower rates may cushion the impact, but they're unlikely to prevent a downturn on their own. The broader issue really is demand. If consumers pull back and businesses stay in the sidelines, lower borrowing costs won't fully offset the drag from policy uncertainty and tighter financial conditions.
Phil Adler:In response to the new environment, confluence has reduced exposure to risk across all of the five portfolios. I see a dramatic reduction in mid cap stocks in four of the models, and small caps disappear in the three more aggressive portfolios where they held a place earlier. Is this because tariffs are especially hurtful to small and mid caps?
Kaisa Stucke:Yes. Smaller companies tend to be more sensitive to economic cycles and often lack the pricing power or global scale to manage through trade disruptions. And small caps also tend to be less liquid in downturns. You're correct. We've exited small caps this quarter and trimmed mid caps in several portfolios.
Kaisa Stucke:This is really to reflect the elevated recession risk.
Phil Adler:Large cap stock allocations remain steady in four of the portfolios. Only the most conservative income fund experiences a reduction. Why are large caps more likely to hold up in this environment?
Kaisa Stucke:Large caps often benefit from their stability and their stronger balance sheets and greater access to capital. They also tend to receive steady passive investment flows, which helps with liquidity during volatile periods.
Phil Adler:Within the large cap stock allocations, are there any changes in strategy we should talk about?
Kaisa Stucke:Yes, a few strategy updates to mention. Within our large and mid cap allocations, we've added a dividend focused ETF. You know, as dividends can help cushion returns when price appreciation is harder to achieve in a slower growth environment. Also, we introduced a value tilt favoring companies with strong fundamentals and consistent cash flows. And these traits usually hold up better in challenging markets.
Kaisa Stucke:Mal mentioned, we maintained our exposure to the military defense sector. This is really supported by heightened geopolitical tensions. And we added a targeted sector exposure to consumer staples, which tend to perform well during periods of economic weakness.
Phil Adler:Another dramatic change are new allocations to international developed market stocks across all the models, all five. What's the reasoning here?
Kaisa Stucke:Several factors make international developed markets attractive right now. A weakening US dollar, compelling valuations, and an improving fiscal outlook in Europe. We also expect some repatriation of capital from The US as policy and geopolitical risks grow.
Phil Adler:Will lower European interest rates help these stocks?
Kaisa Stucke:Absolutely. Easing rates in Europe can support both earnings and valuations. Combined with more accommodative fiscal policy in places like Germany, it creates a more supportive environment for equities.
Phil Adler:And, Keise, just to emphasize what is apparent from your models, now is not the time for a risk sensitive investor to invest in emerging markets.
Kaisa Stucke:Yeah. The uncertainty around US China trade tensions and the broad geopolitical backdrop, we're staying out of emerging markets for now as we see better opportunities in other asset classes.
Phil Adler:I noticed your foreign developed market exposure includes now a position in a Swiss franc currency ETF. Why?
Kaisa Stucke:You know, the Swiss franc has historically been a safe haven currency supported by strong fundamentals like low debt and independent monetary policy. In periods of global uncertainty, investors often seek assets perceived as lower risk, and the Frank typically benefits from that flight to quality.
Phil Adler:Turning to bonds, all your models show increased allocations to long term bonds, and three models reflect increased allocations to intermediate term bonds. This comes at the expense of speculative grade bonds. Why?
Kaisa Stucke:We expect the spreads on lower quality bonds to widen as the economy weakens. So we're taking a more conservative approach. Treasuries and seasoned mortgage backed securities offer better risk adjusted value, especially given the potential for rate volatility.
Phil Adler:As for commodity allocations, they are higher in the three more aggressive models. Is gold the main attraction here?
Kaisa Stucke:Yes. Gold continues to play a stabilizing role in our portfolios. It's performed exactly as we'd expect during periods of volatility. And the sustained central bank demand reinforces its long term strategic value.
Phil Adler:Well, Kaisa, I think we've covered all the major changes. There are a lot of them this quarter. One final question. What do you think are the odds of a recession during your forecast period?
Kaisa Stucke:Yeah, and we get this question quite a actually. We believe the odds have increased substantially. While timing is always difficult to pin down, we're operating under the assumption that a recession is more likely than not, and our portfolios are positioned accordingly.
Phil Adler:Thank you, Kaisa. If our listeners would like to read the detailed asset allocation outlook report and see all the changes in viewer friendly charts, that's easy to do. Just access confluenceinvestment.com. There you'll find a tab for asset allocation quarterly on the top right. Our discussion today is based upon sources and data believed to be accurate and reliable.
Phil Adler:Opinions and forward looking statements expressed are subject to change without notice, and 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.