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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 Investment Management Bi-Weekly Asset Allocation report for January 21, 2025. I'm Phil Adler. For years, US Treasury Bonds have been viewed as a safe haven place for investors to hold cash, both to stabilize portfolios and await future opportunities. But perhaps that is no longer the case. Confluence associate market strategist Thomas Walsh joins us today to discuss whether Magnificent Seven stocks have become a legitimate safe haven.
Phil Adler:Thomas, looking at returns, it has been a very tough couple of years for US treasuries. Just how bad has it been?
Thomas Wash:Thank you for having me. Over the past two years, US treasuries have significantly lagged behind equities. While the S & P 500 has achieved its 1st back to back 20% plus gain since the dotcom bubble, bond returns have been less than stellar, and this weakness has been particularly evident in long term bonds. Investors have become increasingly hesitant to hold on to these bonds primarily due to the ongoing uncertainty surrounding both monetary and fiscal policy.
Phil Adler:Thomas, explain further what are some of the trends working against bonds.
Thomas Wash:Well, I I think the most significant trend we're seeing today is uncertainty about the direction of monetary policy. Last year, the Federal Reserve lowered interest rates by a full percentage point. Now their primary goal was to prevent a weakening in the labor market following the triggering of the Somme rule. However, recent economic data, particularly the surprisingly low number of unemployment claims, have raised serious questions about the necessity of further rate cuts. Now adding to this dilemma, there's also growing concern about the market's capacity to absorb the massive influx of treasury securities resulting from the substantial government deficit.
Phil Adler:Do you think these anti bond trends are likely to continue for the next year at least?
Thomas Wash:You know, it's it's still too early to make definitive predictions as much depends on the progress made in controlling inflation and the fiscal policy direction of the incoming presidential administration. You know, on the monetary side, the market appears to be more hawkish than the Federal Reserve. Notably, one of the Fed's more influential voices, governor Chris Waller, has expressed openness to multiple rate cuts. At the same time, futures markets suggest a 70% probability that the central bank will either cut rates just once or not at all this year. Now on the fiscal side, officials from the Trump administration have expressed optimism in controlling the deficit, believing that prospective economic growth and targeted budget cuts will more than offset the costs associated with implementing tax cuts.
Thomas Wash:That said, we do believe that if economic trends start to shift that the investment environment could become more favorable to bonds.
Phil Adler:Thomas, many investors can now very quickly identify the stocks known as the Magnificent 7. Apple, Microsoft, Amazon, Nvidia, Meta, Tesla and Alphabet. The adjective is for a reason. The returns have truly been magnificent. The question now is whether going forward these stocks are a relatively safe place to hold cash.
Phil Adler:Is the ability to generate huge earnings the the key argument that supports this point of view?
Thomas Wash:In short, yes. You know, the Magnificent Seven have largely served as a safe haven for investors fueled by optimism regarding US economic growth relative to the struggling economies of Europe and China. You know, as US bond values have declined due to rising inflation and and concerns about the growing deficit, the magnificent 7 have become increasingly attractive as an alternative investment for those seeking greater exposure to the US economy.
Phil Adler:Would you say, Thomas, that these magnificent 7 companies seem intent on increasing dividends and implementing other shareholder friendly policies?
Thomas Wash:Yeah. You you can kinda say that. You know, last year, several companies demonstrated a renewed focus on shareholder returns. Notably, Meta and Alphabet initiated their 1st ever dividends, a significant shift in their capital allocation strategies. This growing trend of companies prioritizing shareholder payout suggests a maturation of these businesses potentially contributing to their increased investor appeal.
Phil Adler:I suppose as an example that Meta's decision to get out of the fact checking business might be another shareholder friendly strategy.
Thomas Wash:I I think that's an interesting perspective and one I haven't really considered. But, I think one of Meta's key challenges in recent years has been attracting younger users as it faces declining market share from competitors like TikTok. You know, like, do you remember a few months ago when Mark Zuckerberg briefly flirted with a cage fight against Elon Musk? While that was clearly a spectacle, it highlights his desperate need to regain relevance. Now when it comes to the removal of fact checking, it might be a strategic move by Meta to increase engagement of its audience by attracting younger viewers who may be drawn to more unfiltered, even controversial content.
Thomas Wash:Regarding META's effort to become more shareholder friendly, well, the company's decision to distribute dividends 4 times a year signals a shift away from its early stage high growth mindset. This demonstrates a commitment to returning value to investors and move typically associated with more mature companies.
Phil Adler:These stocks might face some pressure if inflation rises further and the Fed pauses future rate cuts. But I guess it's logical to assume that longer term treasuries might face even more pressure in this particular scenario.
Thomas Wash:Yeah. You know, I believe that rising inflation and a potential pause in Federal Reserve interest rate cuts could dampen investor optimism in the stock market. This could lead to decreased consumer spending negatively impacting overall economic growth. Now regarding the Magnificent Seven technology companies, their future performance will likely depend heavily on their ability to consistently demonstrate strong earnings growth and improve profitability.
Phil Adler:Do you think the Magnificent 7 might be a safer place to hold cash than stocks of large companies that traditionally pay healthy dividends?
Thomas Wash:I believe that as long as these leading technology companies continue to demonstrate strong earnings growth, they will remain attractive investment opportunities. However, I don't anticipate their dominance to persist indefinitely. In fact, we could witness a broader market rally within the S and P 500 if the earnings growth of these magnificent seven companies begin to show signs of moderation. This could shift investor attention towards other sectors and companies within the broader market.
Phil Adler:Thomas, investor sentiment can seem fickle at times. Could sentiment about the Magnificent Seven turn simply because the stocks have risen so far so fast?
Thomas Wash:You know, reflecting on the past year, it's evident that an unexpected recession could shake investor confidence in these companies. For example, in July, the triggering of the sum rule, a widely recognized indicator of a potential recession, initially led to a brief decline in the stock prices of many of the companies within the magnificent seven. However, these stocks quickly rebounded within a few months as a perceived political landscape and economic conditions improved.
Phil Adler:For investors, Thomas, who are cautious about future Magnificent 7 returns, would it be wise to avoid S and P 500 index funds because index performance is so dominated by these 7 companies?
Thomas Wash:You know, the increasing dominance of the Magnificent Seven technology companies can limit portfolio diversification, especially as they are in technology companies can limit portfolio diversification, especially as their influence continues to expand. This concentration risk underscores the potential benefits in investing in small and mid cap stocks. By diversifying into these segments, investors can mitigate the risk associated with overreliance on a few large cap stocks.
Phil Adler:Well, how about gold and other commodities? Where do they fit in the safe haven conversation?
Thomas Wash:You know, gold is poised to play an increasingly significant role, particularly if confidence in the US dollar wanes. We are witnessing a growing trend of countries seeking greater economic independence from the US amid rising geopolitical tensions. One prominent strategy employed by these nations is the accumulation of gold reserves. Now in the long term, gold is likely to become the preferred asset for those seeking safe haven investments while also reducing their exposure to US dollar denominated assets.
Phil Adler:Well, to sum up, what is the confluence advice for investors who are looking for a safe haven and are attracted to these magnificent seven stocks?
Thomas Wash:Well, in in short, we believe that given the expectation of robust US economic growth coupled with increasing uncertainty surrounding long duration US government securities, the magnificent seven technology companies can offer a degree of safety for investors seeking to hedge against global uncertainty in the short to medium term.
Phil Adler:Thank you, Thomas. 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. Also, this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.