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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays), and a new monthly Q&A format called the Confluence Mailbag.
Welcome to the Confluence of Ideas from Confluence Investment Management. I'm Phil Adler. Investors might be forgiven if they feel at least a little bit surprised about The US stock market's performance in the latest quarter. Market proved to be resilient even as the conflict in The Middle East continued. The key question now is, can this generally positive trend continue?
Phil Adler:The answer from Confluence Investment Allocation Committee appears to be yes. The chair of the committee, Kaisa Stucke, meets with us today to discuss investment strategy and how the firm has rebalanced its five model portfolios for the upcoming third quarter. Kaisa, what stands out to me is the way your committee's outlook for the economy and markets during recent quarters has been justified by the actual results. And you continue this quarter to look for economic expansion and a low probability of recession during the next three years in spite of what appears to be a long list of challenges, including the war in The Middle East, but also stubborn inflation, the highest mortgage rates in eleven months, rising trade barriers. I could go on.
Phil Adler:It seems to me that these may be unusual times for investors. What do you think?
Kaisa Stucke:Hi, Phil. These times are unusual in the sense that investors are dealing with several significant risks at once. You already mentioned some geopolitics, trade, inflation, interest rates, but unusual does not necessarily mean recessionary. Our base case remains for continued economic expansion, growth near the economy's long term trend. Business investment is still strong, particularly around AI, infrastructure and domestic manufacturing.
Kaisa Stucke:Consumer spending is positive, although more uneven across income groups. So we see a constructive environment, but one with a wider range of possible outcomes. That is why we remain invested for growth while also emphasizing diversification and risk management.
Phil Adler:Kaisa, what should investors demand from advisors during times like these?
Kaisa Stucke:That's a good question. We think investors should expect discipline, transparency, a clear connection between the economic outlook and portfolio positioning. Really, an adviser should be able to explain not only what is owned, but why it's owned, what role each allocation serves, and how the portfolio might behave under different market outcomes. Investors should also expect consistency with their own risk tolerance. A conservative investor should not suddenly find that the portfolio has become dependent on a narrow group of more volatile asset classes, you know, simply because those assets have recently performed well.
Kaisa Stucke:The goal should not be to react to every headline. It should be to maintain a thoughtful process that adapts under the underlying risk and return outlooks.
Phil Adler:Rating in volatility can sometimes come at the expense of returns, and we investors often do prioritize returns. Confluence appears to value durability against volatility quite highly. Could you talk a little bit about the value to investors of managing volatility?
Kaisa Stucke:Sure. You know, managing volatility is not about eliminating every decline. It is not simply about producing the smoothest possible return pattern. It's about improving the durability of the investment experience. You know, for example, large losses require disproportionately larger gains to recover.
Kaisa Stucke:So, example, a 20% decline requires a 25% return just to get back to the starting point. And volatility can also cause investors to abandon the strategy at exactly the wrong time. By keeping each portfolio within a defined risk range like we do, we try to help investors remain invested through the difficult periods. That can be especially important for retirees or other investors taking distributions because volatility combined with withdrawals can permanently impair a portfolio.
Phil Adler:Well, I think it's fair to say that there have been no wholesale changes to your asset allocations for the five portfolios in the coming quarter, but there there still been some interesting moves, I think. One is the reappearance of small allocations to mid and small cap stocks in the growth and income and growth portfolios. Are higher financing costs and the possibility of higher interest rates becoming less of a problem for this group?
Kaisa Stucke:Yeah. You know, higher financing costs remain an important consideration for smaller companies. Sure. So we're not treating the entire small and mid cap universe as equally attractive. What has improved is the balance between risk and opportunity.
Kaisa Stucke:Valuations are more attractive than they are for many mega cap companies. Earnings participation is beginning to broaden, and continued economic growth should allow higher quality, smaller businesses to perform even if the rates remain elevated. But, you know, that is why our additions are modest and very selective. We introduced small and mid cap exposures, as you mentioned, only in the portfolios where the risk budget allows, and we emphasize quality and dividend characteristics. We're positioning for a broader participation, without assuming that financing conditions will suddenly become easy.
Phil Adler:We see healthy allocations to large cap stocks remain steady in your portfolios, ranging from 10% for the, the conservative income portfolio up to 50% for growth, 42% for aggressive growth. These steady percentages do disguise, though, some under the hood sector rotations. What stands out here?
Kaisa Stucke:Yeah. You're right. You know, US large cap equities remain a core allocation, and that's really due to their earnings, their balance sheets, and investment spending that all remain supportive. But under the surface, we're trying to reduce dependence on the same small group of mega cap companies. So, we continue to emphasize value and dividend oriented companies, and we maintain targeted positions in energy, industrials, and aerospace and defense.
Kaisa Stucke:All these areas may benefit from infrastructure investment, reshoring, rising electricity demand, and increased defense spending. And I will mention that we also changed our aerospace and defense exposure to an equal weighted approach. That in itself gives us a broader participation in the industry while reducing concentration in its largest companies. So the theme is more diversified large cap exposure.
Phil Adler:Kaiser, recent stock market returns indicate that value investing has lately gained the upper hand versus the momentum strategy, which favored AI. I think it's fair to say that anyway, but I'm wondering if this is true, how long this might last? How does Confluence strategy acknowledge this apparent shift?
Kaisa Stucke:You know, it's a it's an interesting one because it's not a simple choice between value and AI related growth. The large technology companies remain important, and AI investment continues to be a powerful long term theme. But valuation among some of those companies already reflect a great deal of future optimism. And at the same time, earnings prospects are improving across a broader group of companies. That creates an opportunity for value, dividend paying companies, and more economically sensitive sectors to participate.
Kaisa Stucke:So, our more conservative portfolios have a stronger value orientation, while the more aggressive portfolios are more balanced between growth and value. We're not trying to predict the exact length of the rotation. We're positioning for a market that is less concentrated than it has been.
Phil Adler:Looking at, some of the smaller changes in your allocations, I do see international developed market stocks still claim healthy allocations, but also I see emerging market stocks are now making an appearance in your asset allocation universe showing up to the tune of 5% in the aggressive growth portfolio, and I was curious why.
Kaisa Stucke:Yeah. Emerging markets offer a combination of attractive relative valuations as well as improving long term opportunity, but they also carry meaningful geopolitical policy and currency risks. That's why we introduced them only in the aggressive growth strategy, as you mentioned, where the portfolio can tolerate greater volatility. So, let's talk about the potential catalysts. They include improving global manufacturing activity, or favorable demographics in selected countries, or even possibly a weaker US Dollar.
Kaisa Stucke:A softer dollar can support returns for US investors and ease financial conditions in parts of the emerging world. I will mention that the allocation is relatively small. It's intended to enhance geographic diversification and participate in broader global market leadership without changing the overall risk characteristic of the strategy.
Phil Adler:Turning to commodities, you reduced their positions in all five portfolios. Why?
Kaisa Stucke:Yeah. This reduction reflects both what happened in the commodity markets and where we currently see the most attractive risk adjusted opportunities. Commodities had a very strong first quarter, followed by a weaker second quarter. Oil declined as some of the geopolitical risk premium faded. Gold pulled back following its earlier advance.
Kaisa Stucke:So, we concluded that portions of the capital allocated to commodities could be more productively deployed in equities as market participation broadens. We therefore reduced commodity allocations across the portfolios, but we did not eliminate the category. Gold remains an important strategic diversifier because it can provide protection against geopolitical uncertainty and currency risk.
Phil Adler:Does oil occupy any part of the, commodities allocation, or are we talking mainly gold here?
Kaisa Stucke:At this point, the strategic allocation is focused on gold rather than direct oil exposure. Oil can be an important source of inflation sensitivity, but is also highly cyclical and can be driven by short term geopolitical developments, or production decisions, or changes in global demand. We currently have energy exposure through our equity allocations in the domestic large cap, where we own oil, E and P companies. Gold serves a different role. We view it as a store of value and a diversifier against geopolitical risk, inflation, and dollar weakness.
Kaisa Stucke:We've reduced the size of the gold allocation this quarter, and we eliminated platinum, but gold remains present across most of the strategies.
Phil Adler:Turning to bonds. They continue to be an important element in your more conservative portfolios. Intermediate term bonds seem to get the most attention. What's the strategy?
Kaisa Stucke:We believe intermediate term bonds currently offer an attractive balance between income and interest rate risk. Starting yields are at attractive levels, so investors don't need to rely entirely on falling rates and price appreciation to generate a reasonable return. A larger share can come from coupon income. And, I will mention that our changes were selective. We increased intermediate term exposure in some portfolios, reduced longer duration exposure in another, and across the board, we maintained an emphasis on high quality treasuries and agency mortgage backed securities.
Kaisa Stucke:We still remain cautious toward corporate bonds because credit spreads are tight and do not provide much compensation for additional risk. The objective is income diversification and measured duration exposure, not a large directional bet on falling interest rates.
Phil Adler:Well, as US inflation settles in what appears to be a two and a half percent to three and a half percent range, do you see a time coming when the appeal of bond coupons begins to grab significant attention at the expense of stocks?
Kaisa Stucke:That's certainly possible, but at the margin. When investors can earn meaningful income from high quality bonds, the hurdle rate for owning equity rises. Stocks must offer sufficient earnings growth and return potential just to justify their additional volatility. However, we don't see bonds and stocks as mutually exclusive. In our base case, continued economic growth should remain supportive for equities, while higher starting bond yields make fixed income more useful as both income source and a diversifier.
Kaisa Stucke:The relative balance depends on the investors' risk tolerance. Conservative portfolios can make a greater use of current bond yields, while growth oriented portfolios still need equities to generate long term capital appreciation.
Phil Adler:Kaisa, I'd like to close with another stock market question as I look for signs the market might retreat. I guess I'm just a worrier. But this has been a pretty big year for IPOs. I'm wondering if that has brought us closer to an oversupply of equities that could drag down valuations.
Kaisa Stucke:Yeah. It's interesting. New issuance can matter because every IPO creates additional supply that investors must absorb. If issuance becomes excessive or is accompanied by weak underwriting standards and unrealistic valuations, it can be a sign of speculative behavior. But, IPO activity by itself is not enough to conclude that the broader market is oversupplied.
Kaisa Stucke:What matters is the scale of issuance relative to overall market liquidity, relative to quality of the companies coming public, and whether investor demand remains disciplined. At present, our larger concern is not aggregate equity supply, but valuation concentration within parts of the existing market. That's one of the reasons why we're broadening exposure across company sizes, styles, sectors, and regions, rather than relying only on the most highly valued market leaders.
Phil Adler:Thank you, Kaiser. If our listeners would like to read the detailed third quarter twenty twenty six asset allocation outlook report and see all the changes in viewer friendly charts, that's very easy to do. Just access confluenceinvestment.com. There 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.
Phil Adler:Opinions and forward looking statements expressed are subject to change without notice. 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.