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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. Every quarter, a committee of professionals reviews the 5 asset allocation models offered by the firm and considers revisions to the models to reflect the state of the markets and the current outlook. Today, we review changes that that took place during the latest portfolio rebalance heading into this year's Q3, about a month ago. So I'm excited to hear some updates on the committee's thinking.
Phil Adler:Our guest is Confluence Asset Allocation Committee Chair, Kaisa Stuckey. Again, to refresh our memories, the 5 asset allocation models offered by Confluence exist along the risk spectrum. They are income, income with growth, growth and income, growth, and aggressive growth. Kaisa, before we address specific changes in the allocation models, I'd like to focus on how the broader Confluence outlook outlined in your latest report holds up in the face of some market events that occurred fairly quickly following its publication. First, there was the July jobs report.
Phil Adler:Seems like a long time ago, but it was the catalyst for a brief but sharp sell off in stocks. And adding to the concern over jobs at that time was the triggering of the Saum rule, which compares recent unemployment rates and has historically been accurate in predicting a recession. The confluence 3rd quarter outlook does not include a recession during the 3 year forecast period. Do you remain confident that there will be no recession?
Kaisa Stucke:Hi, Phil. Thanks for having me. You're correct. We're constantly asking ourselves about the likelihood of a recession and follow on implications. Our process relies on the analysis of fundamental value of macroeconomic and market data.
Kaisa Stucke:So the discrepancy between the underlying fundamental value and the investor perception of that value is what keeps this industry endlessly interesting. While the markets may have sold off, we're seeing a balance of economic data and policy response that still looks encouraging for risk assets. So, no recession likely. The sum rule was really the buzzword of the summer. In essence, it's a straightforward but reliable concept that states that when the 3 month average US unemployment rate rises by 50 basis points or more from its 12 month low, a recession is underway.
Kaisa Stucke:In July, the rule was triggered when the unemployment rate increased to 4.3%. We'll be closely monitoring the August report for a confirmation of a trend in overall weakness in the labor markets. But let me let me just tell you. Sure. There's been some softening in the labor markets.
Kaisa Stucke:The details of the labor report reveal a more compelling story. The rise in unemployment was actually driven by growth in the overall labor force, not by layoffs. So layoffs are often a key factor in triggering recessions, but we aren't seeing broad weakness in economic indicators. In fact, layoffs are not prominently featured in company earnings calls. And with the recent indication that a rate cut is in the cards, the likelihood of a recession is further diminished.
Phil Adler:Kaiser Confluence forecasts that economic growth is likely to continue to support domestic equities. Do recent earnings and also credit card delinquency reports suggest any major reason for caution?
Kaisa Stucke:There's a lot wrapped in this question. First, the macroeconomic backdrop. We don't think a recession is imminent, as I mentioned before. Recent economic volatility since our portfolio rebalanced state will likely lead the Fed to deliver cuts faster than initially anticipated, but that does not mean the economy has fallen off the rails. We remain constructive on US equities due to longer term trends, such as supportive fiscal policy, a data dependent Fed, changing supply chains, and aging demographics among other factors.
Kaisa Stucke:Now, we could talk for hours about each of the factors mentioned, but I'd also like to emphasize the difference between slowing growth and indicators and declining indicators. So, you know, the first and the second derivative of the rate of change. We've seen more slowing growth rates in economic readings and less outright declining metrics. Something like the wage growth has slowed, but according to the Atlanta Fed, it still increased 4.6% year over year, something that was not seen for over 10 years before the pandemic. I'll quickly reply to the other parts of the question.
Kaisa Stucke:Rising credit card delinquencies is not a new trend. In fact, newly delinquent credit card balances have been increasing since the middle of 2021, and the rate of growth has actually declined in the most recent data. Consumers' confidence has weakened somewhat recently, but the conference board consumer expectations have strengthened over the past few months. Now, on the other hand yeah. Personal savings rates have declined as households spent down their pandemic savings.
Kaisa Stucke:It's usually at the fringes that the early indications of weakness develop. And while we keep a close eye on the conditions, we've not seen enough distress to change our constructive expectations for domestic equities. Finally, last point here. You asked about earnings. Earnings season is almost complete for q 2.
Kaisa Stucke:And, overall, it's looking healthy at about 8% year over year increase for the S and P 500. Perhaps more importantly, earnings growth is broadening, and we could expect this trend to continue.
Phil Adler:Kaisa, confluence in the latest outlook sees a likely increase in volatility. Now since the report was published, there have been 2 trusted volatility indexes suggesting higher market risk and volatility did increase sharply as the Japan carry trade unwound. And it's possible, perhaps it even seems likely, that the unwinding is not over and may spread to other currencies. My question is, is volatility rising more quickly than you expected?
Kaisa Stucke:We've been talking about structurally higher volatility for a while. Part of it is that we've been coming off a period of low volatility in macroeconomic environment over the past decade and a half, and a relatively calm geopolitical landscape over the past few decades. We're seeing the effect of geopolitical volatility as the US continues slowly withdrawing from from its global hegemon rule. In addition to 2 hot conflicts, there are numerous developing situations that have the potential to escalate. But on the other hand, macroeconomically, since 19 eighties, globalization has kept inflation low by focusing on the efficient supply chain.
Kaisa Stucke:So currently, we're seeing the return of shorter supply chains, as well as a move from just in time to just in case inventory management. Both those trends lead to a higher structural level of inflation. So not only are we not surprised by the volatility, we've been anticipating it. Now, a short answer to your Japan carry trade question. The potential impact of financial markets has proven less disruptive than anticipated.
Phil Adler:Well, you touched on this in our last quarterly discussion. But could you remind our listeners about steps Confluence is taking to deal with volatility and and mitigate risk in its portfolios?
Kaisa Stucke:Right. Right. You know, time in the market, diversification, and valuation management are cornerstones of our risk management. So first, time in the market, not timing the market, has been shown to be instrumental in wealth accumulation. Investors are better off staying invested throughout the cycle.
Kaisa Stucke:To aid this goal, Confluence offers the 5 portfolios you mentioned along the risk spectrum for investors to find the level of volatility appropriate for their financial goals and time horizons. 2nd, diversification, the proverbial last free lunch in this industry. Confluence creates portfolios by including low correlation asset classes. For example, we include gold as a geopolitical hedge, but we have also seen increased central bank reserve buying of the metal. Both those factors move gold independently of risk assets.
Kaisa Stucke:And 3rd, allocating 2 asset classes with lower valuations is also a risk management tool. So we like mid and small caps, both of which are trading at a significant valuation discount to large caps.
Phil Adler:One other recent event in the equity markets was a rather dramatic, although it was quite a short term event, but it was a rotation out of technology stocks. Again, it didn't seem to last for very long, but what do confluence models anticipate in the way of stock market rotation?
Kaisa Stucke:Yeah. This is a good follow on question here. Our analysis looks at both the potential growth rates for sectors during the anticipated market regime and the valuations of these sectors today. Since the pandemic, we've seen a narrow domestic equity market rally with a handful of stocks trading at valuations that are quite elevated. History suggests that this valuation discrepancy is unlikely to continue.
Kaisa Stucke:No tree can grow to the sky, as the saying goes. Over the forecast period, we anticipate a broadening of the equity rally, but we also include unique subsectors in our portfolios that represent uncorrelated risk reward opportunities. Currently, we have an aerospace and defense as well as uranium subsector overweight. Within mid and small caps, we include a high quality screening ETF.
Phil Adler:Just a few more questions. A couple of more questions, Kaisa. Following the July jobs report, we were bombarded with with various forecasts for a 50 basis point Fed rate cut at the September meeting with more to come. Money markets, if I'm correct, anticipate about 100 basis points of cuts by the end of the year. What is Confluence looking for from the Fed?
Kaisa Stucke:Right. So we wrote at the time of the rebalance, the Fed remains data dependent. We still very much believe it. Jay Powell gave a clear signal in Jackson Hole that monetary policy will turn dovish. Recent employment data have shown signs of weakness, leading to concerns by the Fed.
Kaisa Stucke:In contrast, the Fed noted an optimistic outlook regarding the downward trajectory of inflation. While the baseline expectation is for 2 to 4 rate cuts this year, it's important to remember that Powell's Fed is data dependent and will react accordingly.
Phil Adler:Turning to bonds, looking at the confluence stance on bonds, longer dated maturities are are clearly out of favor. Why?
Kaisa Stucke:Good question. Now the yield curve remains steeply inverted with short maturity yields higher than longer maturities. The Fed would need to implement 6 25 basis point cuts in order for the Fed funds rate to yield less than the 10 year treasury, all else being equal. As a consequence, absent a sizable move higher in long rates or a drastic cut to the Fed funds, yield curve normalization is likely to occur well beyond this year. At the same time, we believe higher inflation will pressure long term bonds higher, meaning part of the yield curve normalization occurrence from the price declines among long maturity bonds.
Phil Adler:Now as we look at model changes implemented by Confluence in the Q3, we see a decrease in the allocation to short term bonds in the income with growth model while allocations to short term bonds are maintained in the more conservative income model and the less conservative growth in income model. Explain.
Kaisa Stucke:Our process looks at risk at the portfolio level. Meaning, we can use diversification between asset classes to balance risk. In the income and growth portfolio and the current inverted curve environment, we focus on the intermediate maturity bonds. This posture limits high levels of reinvestment risk from the shorter maturities while avoiding significant price risk from the longer maturities. At the same time, in the same portfolio, we added to our speculative grade bond allocation as the economy and risk markets are expected to do well over the forecast period.
Phil Adler:And the other major model recommendation change occurred in the 3 least conservative models, beginning with growth and income. In each case, small cap allocations were reduced in favor of mid caps. What's relatively attractive about mid caps?
Kaisa Stucke:Well, let me first reiterate that we have an optimistic view of domestic equities across all capitalization. But the current valuation deviations between market caps are remarkable by historical standards and also are unlikely to continue in the longer term. We expect the amplified effect of earnings growth and valuation normalization to offer a particularly attractive profile in the mid cap equities. However, higher current interest rates impact capitalizations differently. Small cap equities, which hold a larger proportion of floating rate debt, are therefore disproportionately affected by higher rates.
Kaisa Stucke:This could negatively affect earnings growth in small caps.
Phil Adler:Finally, Kaisa, I'm struck by the fact that normally, your your quarterly reviews do not result in wholesale changes to your recommendations, and this was also the case this quarter. Do you consider this a validation of your process?
Kaisa Stucke:Absolutely. We formulate our capital market assumptions over a 3 year time frame. We'll have to see some tremendous moves or unanticipated trends to move our 3 year average expectations. We tend to move stepwise with the market cycle and not make sudden changes.
Phil Adler:Thank you, Kaisa. If our listeners would like to read the detailed asset allocation outlook report, that's easy to do. Just access confluenceinvestment.com, that's confluenceinvestment, one word, 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, and this information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stoll. I'm Phil Adler.