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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. Coming off a stellar third quarter for domestic and international equities, the Confluence Asset Allocation Committee met, as it does every quarter, to consider changes in the investment mix for the firm's five model portfolios. As a reminder to our listeners, the Confluence investment models, all with a focus on risk management, exist across the risk spectrum. They are income, income with growth, growth in income, growth, and aggressive growth.
Phil Adler:These portfolios are managed by a committee that includes professionals from across the firm. Our guest today to discuss the firm's fourth quarter asset allocation outlook is the chair of the committee, Kaisa Stucke. Kaisa, I think the question most investors are asking is, is there room for this dynamic stock market to run further to the upside? And perhaps a different version of the question might be, is it time to anticipate a sharp reversal? It wasn't that long ago that your committee anticipated a recessionary environment occurring sometime during your three year investment window, and then last quarter you changed that stance and said the likelihood of a recession during the three year time period had declined.
Phil Adler:You positioned your models accordingly, and looking at the recent performance of your models, you were certainly rewarded for that. So I wanna begin our discussion by asking, are the same dynamics that created the third quarter stock market advance still pretty much in place?
Kaisa Stucke:Hi, Phil. Thanks for having me. So let's address your last question. Are the dynamics that supported the stock rally in place? Yes, in the short to medium term.
Kaisa Stucke:The same drivers remain strong business investment, healthy corporate balance sheets, and fiscal support through both industrial policy as well as tax incentives. And in addition to supportive fiscal policy, monetary policy is also likely to remain accommodative, especially once we get a new Fed chair next year. This is a market where fundamentals and policy are intertwined more than ever. Diversification, discipline, and risk management are key, and that's the foundation of how we position our portfolios each quarter.
Phil Adler:Among the reasons you cite for the stock market's rise recently is the prevalence of passive investing. This simply wasn't much of a factor twenty or thirty years ago when money didn't automatically pour into index funds. How big is this? Is this a a major reason why investors should take heart in the recent strength of the stock market?
Kaisa Stucke:You're right. Index investing has become both prevalent and powerful. It's a steady, quiet structural force in the market. Today, passive flows continually direct capital into large cap indices, which then helps sustain momentum, even when fundamentals might otherwise suggest a pause. This dynamic naturally benefits the biggest companies and compress market dispersion.
Kaisa Stucke:It's one of the reasons, but not the only one, that our committee maintained and even slightly increased large cap exposure this quarter. With that said, it's important to remember that this flows over fundamentals environment can't last indefinitely. The valuation gap between large and smaller companies has widened considerably. And over time, these divergences tend to correct. So while passive investing is a key pillar of market strength right now, it's also something we monitor closely for when the tide eventually shifts.
Phil Adler:Kaiz, there's something else I was wondering about, and that is the tale of two economies in The United States. Higher income fueled by healthy investments fueling consumer spending and profits, while lower income families are struggling with inflation and benefit cuts. Now I'm not asking a political question here. I'm simply wondering whether this divided economy, which seems likely to continue, is bullish for stocks.
Kaisa Stucke:You're right. We're seeing a real divide. Higher income households are still spending, helped by asset gains and strong balance sheets. Meanwhile, the bottom 60% of earners are feeling pressure from inflation and shrinking savings. While overall consumption has remained generally robust, the lower income households are increasingly taking on leverage to keep running.
Kaisa Stucke:We're watching credit card balances and the proportion of consumers only making minimum payments on their cards. And both metrics have increased recently. While consumption is the largest part of the domestic GDP calculation, Business investing has been the driver of economic growth recently.
Phil Adler:So rising credit card balances and delinquencies are not necessarily a major threat to the stock market?
Kaisa Stucke:Not at this stage yet. Delinquencies are rising from historic low levels. The stress is concentrated, as we talked about, in the lower income households, but not in the broader system. We're watching it, but overall credit conditions remain healthy, and the banking system is well capitalized. The greater macro risk is a slowdown in consumer momentum, not necessarily a credit crisis.
Phil Adler:Well, European stock markets have done very well, as you anticipated last quarter. Do you expect the dollar to remain in a weakening trend, providing still more fuel for foreign markets?
Kaisa Stucke:Yes, we do. The dollar is likely to remain on a gradual weakening path as policy becomes more accommodative and trade balances adjust. That benefits US investors holding foreign assets, and Europe in particular continues to gain from fiscal spending on defense and infrastructure. So we modestly increased international developed market exposure again this quarter, both broad based and Europe focused.
Phil Adler:Well, so much depends on interest rates. Do you think The United States has won this round in the inflation battle enough for investors to expect from the Fed a steady decline in rates, particularly next year when the makeup of the Fed changes?
Kaisa Stucke:Inflation has stabilized near that 3% level, and that's where we think it will stay for a while. While it's above the Fed's target, but the new leadership expected next year is likely to emphasize employment and debt sustainability over forcing inflation back to 2%. We anticipate rate cuts and an end to quantitative tightening, both of which should steepen the yield curve modestly. So in short, policy is shifting from restrictive to supportive.
Phil Adler:So you can say with inflation stabilizing near 3%, we've entered a new chapter for the bond market, one that creates new opportunities?
Kaisa Stucke:Yes. This environment does open a new chapter for bonds. With inflation stabilizing and yields returning to more normal levels, bonds can once again serve as both income generators and portfolio stabilizers. After years of low rates and distorted policy signals, fixed income is finally offering real return potential, and that restores balance to multi asset portfolios.
Phil Adler:Well, could talk much more, I think, about macroeconomics, but it's probably time to look at some of the committee's specific changes in model recommendations entering the fourth quarter. And let's begin with bonds, which you just mentioned. The allocations to intermediate term bonds are boosted in four the five confluence models, while short term and long term bond allocations are reduced. What strikes me is the scope of the changes. Am I right when I call these changes dramatic and a decisive move away from the barbell strategy you advocated last quarter?
Kaisa Stucke:You're right. We made decisive moves into intermediate term maturities across most portfolios, and it's a clear pivot away from last quarter's barbell stance. Credit remains solid, but spreads are tight. So we're underweight corporates and favor treasuries and seasoned mortgage backed securities for quality and liquidity both. The opportunity has simply moved to the intermediate part of the curve.
Phil Adler:Another noteworthy change in your models, Kaiser, I think, are the increases in large cap stock valuations, which already seem to be at pretty high levels, and these increases are occurring in all five model portfolios. Again, these seem to me to be dramatic, suggesting strong confidence. Am I on the right path?
Kaisa Stucke:Right. Yeah. In the short to medium term, the market leadership and liquidity remain in the large cap segment. Large caps continue to benefit, as we talked about, from passive inflows and resilient earnings. We tilted modestly toward growth over value, reflecting strong tech and capex trends.
Kaisa Stucke:But we kept dividend oriented positions for income and balance. I will also mention that mid caps were reduced and small caps remain absent, as they still face headwinds from tariffs, financing costs, and margin pressures.
Phil Adler:Well, following up on the mid caps and small caps, the new allocations, are they because they are pretty much out of favor, those two classes, or do you simply see greater opportunities in the big names?
Kaisa Stucke:That's a great observation. It's less about being out of favor and more about opportunity and risk balance. Large cap equities currently benefit from what we talked about, the balance sheet, stable earnings, dominance of passive flows, all of which have supported their performance. Small and mid caps, meanwhile, still face headwinds. We mentioned financing costs as well as slower growth.
Kaisa Stucke:We've not held small cap equities for a few quarters now and reduced mid cap allocations, although we still hold it in some portfolios. We continue to monitor that space closely, looking for the most attractive risk adjusted opportunity as always.
Phil Adler:Kaisa, I wanna ask a similar question about the foreign markets. I see increases in allocations to international developed market stocks in two of the five models, while emerging markets continue to be shut out. Are emerging markets a category to avoid at all costs, or is it simply that the developed markets, particularly in Europe, are much more attractive?
Kaisa Stucke:I will say at this stage, developed markets offer better visibility. Emerging markets face structural challenges, currency volatility, political risk, and weaker policy coordination, while developed economies like those in Europe are deploying large fiscal programs that support corporate earnings. So our capital is working harder in developed markets right now.
Phil Adler:Just a couple of more questions. Within the developed foreign stock markets, is this mainly a large cap play, or do the smaller caps have a strengthening role to play in allocations, unlike in The United States?
Kaisa Stucke:Both play a role, but interestingly, international small cap stocks have attractive fundamentals. They're less exposed to global trade friction and benefit more directly from local fiscal stimulus. And the ETF we hold, the small cap value equities, holds many industrial and materials companies, which are poised to gain from reshoring and infrastructure investment.
Phil Adler:We can't conclude without a couple of questions about commodities and your allocations there anchored by gold are steady as we enter the fourth quarter. The continuing 15% allocation to commodities in the aggressive growth portfolio seems like a pretty strong statement. We've seen gold prices, which were at record highs, become volatile at the time of our recording. Is this volatility a minor phenomenon in an overall bullish environment?
Kaisa Stucke:In our portfolios, gold continues to serve as a strategic asset. Central banks are steady buyers and geopolitical uncertainty remains high. Even with the price volatility, gold offers diversification and protection against both inflation and geopolitical shocks. We view short term volatility as noise within a broadly supportive environment.
Phil Adler:Are there other commodities besides gold that are becoming decisively more appealing?
Kaisa Stucke:We are watching other precious metals, silver, platinum, palladium, although central bank buying does not focus on these metals. And additionally, we're monitoring industrial metals as they could benefit from defense and infrastructure spending. But for now, gold remains our anchor commodity due to its liquidity, correlation profile, and role as a portfolio stabilizer.
Phil Adler:Thank you, Kaisa. If our listeners would like to read the detailed fourth quarter twenty twenty five asset allocation outlook report and see all the changes in viewer friendly charts, that's very easy to do. Just access confluenceinvestment.com, and 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. 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 Stole. I'm Phil Adler.