Spring cleaning for portfolios
Hot inflation and an aggressive Fed are steering the economy towards late cycle – how are your portfolios positioned?
Setting the backdrop for this week’s market price action was yet another multi-decade high inflation print in the United States, but at least it surprised to the downside. Heading into Thursday morning (this week’s last trading day; markets are closed Friday due to the weekend holidays), the NASDAQ 100 (-0.8%) and S&P 500 (-0.8%) were both down on the week.
What did we see in the details of the March Consumer Price Index (CPI) report? Core prices (which exclude food and energy) only increased +0.3% month-over-month, which was the slowest pace since last September. The aggregate measure, including food and energy, saw a much more significant +1.2% jump as the world digests the implications of cut-off Russian commodity supply.
To be sure, some other categories beyond food and energy ran hot, particularly those highly exposed to economic reopening and higher oil prices. Take airfares, up +10.7% month-over-month, as an example. On the flipside, many durable goods categories that drove broad price increases in 2021 showed signs of cooling (like used cars, which actually saw prices fall -3.8%).
Regardless, if you focus on which components are cooling versus heating up, the reality remains that the year-on-year pace for both core and headline inflation is untenable from both a political and Fed policy perspective. That said, the bond market has reacted in a way that suggests inflation could be peaking here, potentially giving the Fed the ability to slow down its rate hiking plans at the end of the year. Expectations for the year-end Fed Funds rate have fallen from 2.54% to 2.36%. Short-end Treasury yields are mostly down versus a week ago, with the 2-year yield having dropped around -15 basis points. Meanwhile, longer-dated yields have risen: The 10-year yield is up +16 basis points.
We still expect the Fed to hike interest rates aggressively in the months ahead in order to slow inflation and economic activity down. It’s worth starting to think through steps to prepare your portfolio for the evolving investment environment.
Spotlight: Spring cleaning: Portfolio edition
Like the seasons, investment backdrops change. Sometimes it just happens more quickly than you expect. In fact, over the past two years, our composite tracker of the U.S. economic lifecycle has shown the fastest move from recession to the middle stages of an expansion since 1975. At this rate, investors might find themselves navigating “late” cycle by year-end.
History suggests that looks like:
- A slowdown in economic activity. The broad economy continues to grow, but at a rate more in-line with the average. 2021 saw the U.S. economy expand by nearly 6% – we’re expecting something more like 3.1% this year and below 2% next year.
- Mounting headwinds to corporate profitability. Following the period of global lockdowns in 2020, companies saw some of their strongest quarters of earnings growth in history. Today, price pressures plus a slowdown in demand growth are conspiring to challenge broad market earnings growth, urging more selectivity from investors.
- Increasingly restrictive monetary policy. The Fed and other central banks have been loud and clear: In order to get inflation under control, policy rates need to move higher to cool things off.
There are still gains to be reaped in the later stages of the cycle and staying invested has historically served people well. But making tweaks to portfolio exposures can help optimize the tradeoffs we make between risk and return for the changing environment. Think of it as some “spring cleaning” – here are three high level considerations for investment positioning.
Be mindful of where you park your cash.
You’ve heard the saying, “Work smarter, not harder,” right? Apply that to how you think about your cash holdings. Given the torrid rise in interest rates year-to-date, stepping out of cash into even modestly longer-dated Treasuries can offer a solid pick-up in yield. Today, a 1-month Treasury yields around 0.2%, while a 3-month Treasury trades about 0.5% higher. A year ago, you got about the same measly 0.02% yield from both.
Why such a drastic difference today versus last year? The market knows that the Fed plans to hike overnight interest rates by somewhere between 50-100 basis points between now and the end of June. Given the current persistence of inflation, there are very few scenarios in which those plans would change. Investors no longer need to consider big tradeoffs to get more from their reserve and excess cash holdings – they just need to be smart about where they park it.
Sell high yield fixed income and move into core bonds.
Generally speaking, there are two reasons why an investor might choose high yield credits over higher quality core bonds. One is that the investor believes that the economic environment is strong enough to keep defaults at bay and the yield spread versus Treasury bonds tight. The other is that yields overall are so low that the investor is willing to accept additional risk for the sake of generating a respectable return.
Last April, both were true and many investors were willing to make the tradeoffs for a ~4% yield from U.S. high yield bonds. But now that rates have risen so meaningfully, investment grade corporate and high quality municipal bonds are back on the menu.
U.S. Aggregate bond yields have more than doubled over the past year (currently around 3.9%), and aggregate muni bond tax-equivalent yields are close to 4.9%. We are leaning into the renewed benefits of defensiveness and income generation that can now be found in core bonds.
As of one year ago, U.S. Aggregate Bonds’ yield to worst was 2.2%, U.S. Municipal Bonds’ tax-equivalent yield to worst was 1.8%, and U.S. High Yield Bonds’ yield to worst was 4.0%. As of today, U.S. Aggregate Bonds’ yield to worst is 3.9%, U.S. Municipal Bonds’ tax-equivalent yield to worst is 4.9%, and U.S. High Yield Bonds’ yield to worst is 6.4%.
Swap highly cyclical stocks for more defensive ones.
Upgrading the quality of assets held in portfolios isn’t just a fixed income conversation; it’s the overarching theme of how we’re thinking about all portfolio positions. Your equity allocation is no exception.
The early stages of an economic cycle tend to act as a rising tide that lifts all boats. Companies that display high degrees of cyclicality – meaning that their revenues and profits ebb and flow with the tides of the broader economic backdrop – tend to fare best in that environment. Now that the backdrop is slowing, we would prefer to take gains on early cycle winners to fund an increase in exposure to higher quality market segments.
We’re keen on identifying companies with:
- Strong competitive advantages and profit margins, so that they can pass higher expenses onto end-customers.
- Defensive revenue streams that tend to stay steady or grow modestly even as broad spending starts to decelerate.
- Secular growth drivers linked to long-term trends that gain more momentum over time.
To us, that puts sectors like health care, utilities, and segments of tech at the top of our list. We also think larger companies, which tend to be more established and sturdy, could fare better than their smaller-cap counterparts. At a more nuanced level, we think entry points in ever-important secular themes like cybersecurity look compelling here as well.
The bottom line
A maturing economic cycle calls for a portfolio tune-up, but not an overhaul. More volatility should be expected in the future, and the shifts discussed above may help smooth out the ride for investors. There are other considerations as the backdrop continues to evolve (e.g., using that volatility to add some downside protection while maintaining market exposure), and we’re here to guide you through them. Your J.P. Morgan Advisor can help.