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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's time for the quarterly review of Confluence asset allocation models. Every quarter, a committee of Confluence Professionals reviews the 5 models offered by the firm ranging from income to aggressive growth and considers revisions to reflect the state of the markets and the current economic outlook. Today, we discuss Q4 2024 changes to the model recommendations and the economic conditions which have prompted these changes.
Phil Adler:Our guest is Confluence asset allocation committee chair, Kaisa Stuckey. Kaisa, Confluence Investment Management makes it very clear that the firm's asset allocation process is centered on risk management across all the 5 models it offers. Now when I think risk management, I automatically assume, rightly or wrongly, lower returns. This relationship seems to be correct when the stock market is enjoying healthy advances as has been the case. Before we look at specific model changes, could you talk a little bit about the relationship between risk management and returns and whether there is a danger to anticipating that returns are adversely affected by risk management strategies?
Kaisa Stucke:Hi, Phil, and thanks for having me. You know, what you're describing is the underlying framework of Harry Markowitz's Nobel Prize winning theory where risk and reward are balanced against each other. You're right that a portfolio which takes on less risk should not allocate as much to higher volatility asset classes as a more risk accepting portfolio. But now, keep in mind that the same theory also brings us diversification, the proverbial free luncheon in investing. By combining asset classes with low correlations, it could be possible to smooth returns and balance risks.
Kaisa Stucke:Your question is really about looking back at time periods when stock market does well, and holding other asset classes seems to be a drag in performance. You know, academics call this opportunity cost, the cost of not taking risk. But the hook here, of course, is that we're judging the portfolios looking backwards. But portfolio management must be implemented looking forward. None of us have a crystal ball.
Kaisa Stucke:None of us can tell the future. But we can look at market fundamentals where we are today, analyze historical parallels and trends, as well as think deeply about what could happen going forward. Mark Keller, Confluence CIO, says that investing is inherently an odds making business, meaning managing diversified portfolios, we could sometimes hedge against risks that do not materialize. So to recap, risk management can sometimes lead to lower returns. It often seeks to create a more consistent return profile by aiming to avoid extreme losses.
Phil Adler:Kayser, do you think that we are right now heading toward an economic slowdown that might increase market volatility beyond where it's already been?
Kaisa Stucke:Interestingly, I'll have to give you 2 answers. A short term and a long term one. Overall, the committee does not believe we're heading towards a recession, and the US economy has shown surprising resilience this year. But we do notice some headwinds. So in the short term, let's call it a year, fiscal spending and the labor market are expected to be supportive of the economy.
Kaisa Stucke:However, in the long term, there are structural issues that present an increased likelihood of extreme outcomes.
Phil Adler:Where exactly do you see signs right now of a moderating economy?
Kaisa Stucke:The, labor market is showing signs of cooling, which could temper economic growth. The latest conference board survey indicates more workers now view jobs as hard to find and fewer seeing them as plentiful. This is a shift that's historically linked to rising unemployment. Linked to the labor market, consumer spending has been a main growth driver. But we're seeing credit card delinquencies, rising.
Kaisa Stucke:And personal savings rates are low relative to pre pandemic levels. These trends are already fostering more cautious spending as consumers move away from big ticket items, focusing instead on essentials. So while we still anticipate economic growth, we expect a general slowdown could be in the cards over the next 3 years.
Phil Adler:Okay. As we begin to look now at changes in the model recommendations, let's start with stocks. In the most risk sensitive models, you're increasing allocations to US mid cap stocks. At the same time, you're decreasing allocations to intermediate term bonds. In the more aggressive models, mid caps remain by far the favored location for equities.
Phil Adler:Could you explain the appeal of mid caps?
Kaisa Stucke:We believe small and mid cap stock valuations remain attractive, while fundamental earnings power remains healthy. Mid cap stocks, specifically offer an attractive profile. The valuation discount to large caps is historically wide and unlikely to be sustained in the long term.
Phil Adler:It looks like tariffs may play a bigger role in US policy. Does this generally favor US mid and small cap stocks?
Kaisa Stucke:Yeah. You're right. While trade policy is not the primary driver of returns, your statement is generally true. Met and small cap companies tend to be more domestic demand oriented. As I mentioned, overall, we find mid and small cap valuations attractive, and domestic economic growth should support the earnings potential.
Phil Adler:Turning to large caps, Kaisa. Led by technology, large caps have delivered the the highest returns over the past 3 years, and large caps are still represented in all 5 of the Confluence portfolios ranging from 7% to 20% of the totals. This does seem consistent with your outlook for balanced economic growth ahead, but at a slower pace than we've recently experienced. Which sectors within large caps is Confluence valuing the most?
Kaisa Stucke:Within large caps, we maintain an industry overweight to aerospace and defense, as well as cybersecurity companies. The military industrial complex will remain important as the world deglobalizes, and we've already seen geopolitical tensions rise. Additionally, we we also maintain an energy sector overweight within large caps and a uranium miner's overweight within mid caps. The green energy transition has created opportunities for both. The uranium industry has a steep supply demand imbalance after years of disinterest in the sector.
Kaisa Stucke:But what we're seeing with currently available technologies, nuclear energy is the most likely baseload energy supply option. Oh, and I'll also mention, we're even weight value growth bias.
Phil Adler:Before we leave stocks, I I want to ask to what extent do you think cash on the sidelines might sustain the market's recent advance?
Kaisa Stucke:The amount of cash on the sidelines is at all time highs at around 6 and a half $1,000,000,000,000. As the Fed eases, these funds have to reinvest into lower rates and thus are more likely to seek yields elsewhere. When equity markets pull back, we've seen cash moving to risk markets, of course, suggesting that that investors are generally okay with equity risk premiums but are concerned about overvaluation.
Phil Adler:Kaiser, the most dramatic change in the Confluence model recommendations this time around this quarter appear to be new positions in long duration zero coupon treasuries in 4 of the models. Confluence has avoided long term bonds in the recent past. Why the change?
Kaisa Stucke:You're correct. Absolutely. But it's important to keep the whole portfolio risk profile in mind here. So we're taking on equity risk because our overall economic growth expectation is not terrible. At the same time, we worry about events that could create volatility for the markets, geopolitical events, domestic elections, policy shifts.
Kaisa Stucke:In this environment, we believe it's reasonable to implement the hedge against volatility in the form of long bonds, especially in this current easing monetary policy environment.
Phil Adler:And why the particular appeal of 0 coupon treasuries?
Kaisa Stucke:Let's, let's take a quick step back and describe the mechanics of 0 coupon bonds. These bonds do not pay periodic interest, and as such, are sold at steep discount to face value. And very importantly, the duration matches their long maturity. Since they lack regular interest payments, they're more sensitive to changes in the interest rates than coupon paying bonds. Monetary policy is likely to be easing in the short run, with inflation levels not low but still contained.
Kaisa Stucke:A long duration bond could provide a hedge against sudden volatility.
Phil Adler:We already mentioned the decrease in 2 models of intermediate term bonds. What's the reasoning here?
Kaisa Stucke:Yeah. The bulk of our fixed income exposure comes from short and intermediate duration bonds. We still like the yields there and think the reinvestment risk is manageable.
Phil Adler:And speculative grade bonds do remain well represented between 13 20% in the 3 most risk averse models. Why?
Kaisa Stucke:SPECT bonds offer an attractive yield, and given our expectation for economic growth in the short term, we expect defaults and therefore spreads to remain contained. I'll point out that we're invested in the highest quality sleeve of spec bonds.
Phil Adler:Finally, Kaisa, allocations to commodities ranging from 3 to 15% are maintained in all 5 portfolios as a hedge against volatility. Within this category, does gold continue to dominate even with the current prices some might call lofty?
Kaisa Stucke:Yeah. That's a really good question. Historically, investors have sought the stability of gold in times of geopolitical uncertainty as well as times of inflation. Recently, what we've also seen is international central banks buying gold for their reserves in order to diversify away from US dollar holdings. As the world deglobalizes, we believe this trend is likely to continue.
Phil Adler:Thank you, Kaisa, for your summary of the Confluence asset allocation recommendations. I think we've hit many of the most important points, but if our listeners would like to read the detailed asset allocation outlook report, that's easy to do. Just access confluenceinvestment.com. That's confluence investment, one word. You'll find a tab for the asset allocation quarterly on the top right.
Phil Adler: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, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll. I'm Phil Adler.