Published March 23, 2022
I spent the second half of last year wondering why the Fed wasn’t raising interest rates, and now I may spend the second half of this year wondering why they are.
I spent the second half of last year wondering why the Fed wasn’t raising interest rates, and now I may spend the second half of this year wondering why they are.
The past several weeks have been some of the most volatile in history for both stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates., with war, inflation, and a new COVID crackdown in China just a few of the crises causing tumult for investors. In this episode of The Adviser You Can Talk To Podcast, Steve Johnson asks our market experts about the indicators we’re watching and the moves we’re making in response, including:
No one with money in the market has come out of the past few weeks without a few more grey hairs. Let our experts provide clarity with some rational thinking and smart advice.
With headlines changing by the hour and with uncertainties all around, please join our portfolio managers and excellent research team on this The Adviser You Can Talk To Podcast as we explore how to navigate these turbulent waters.
Hello, this is Steve Johnson, portfolio manager here at Adviser Investments. I’m here with another The Adviser You Can Talk To Podcast. With all that’s going on in the world right now, I look forward to today’s discussion. Today I’m fortunately joined by members of our outstanding investment research and portfolio management teams to get their thoughts on the market today and get their advice on what investors should be focused on. As we know, investors have been bombarded with negative headlines: A horrific war in Ukraine, higher food and energy costs—in fact, Bloomberg told me I should buy lentils rather than meat this week—a Federal Reserve that’s now beginning the process of raising rates and, of course, ongoing tension with China. We’ve got a lot to unwrap today, so let’s get right to it. I’ll begin with one of our brightest minds on the research team, Senior Research Analyst Liz Laprade. Liz, China was in the headlines last week. We know President Biden and President Xi held talks on Friday about Russia. What are the implications of that conversation?
Yeah, so there’s a lot to unpack there, Steve. I’m going to try and keep it as high level as possible. But I think the ultimate goals for President Biden going into that conversation with President Xi was to try and first get clarity on where China stands on the Russia-Ukraine war, since they haven’t yet publicly denounced what is going on. And second, to make sure Xi knew that if they actually assist Russia and its efforts, either financially or militarily, there would be consequences from the West. Unfortunately it didn’t sound like there was too much progress that came out of that conversation. I think the fears of Putin and Xi joining forces and what the costs associated with that could be still remain. Costs, for example, of retaliation from the U.S. and Europe on China. For example, if that included sanctions on Chinese goods—in a country where supply chain disruption is already pushing inflation pressures up—that could rock Chinese stocks as well as global markets. And I think those fears and risks still seem to remain.
It’s interesting. You talk about the fears and the risks to the Chinese market. We know they have been a big driver in the global economy and have impacted markets here as well. Last week, the Chinese stock market had a huge rebound. I think the FXI, the ETF that tracks, was at one point last week up 20% on the day. Can you give us your take on what’s going on with China, their market and the economy?
Yes. So I’m going to put that big bounce into a little bit of context. It’s been a wild ride for investors over the last year or so if you’re investing in China. The volatility and beginning of a bear market in China began last year when the government started aggressively trying to shift regulation policies to foster this idea of common prosperity, which meant they’re basically trying to close the wealth gap by putting pressure on industries like big tech, for-profit education and real estate to kind of even the economic playing field. This triggered quite the sell-off last year in the iShares China ETF, which ended 2021 down 22%. The other markets stabilized a little bit earlier this year, but fast-forward to news of Russia invading Ukraine and Chinese stocks started an accelerated sell-off once again.
There was some contagion, I think, from the fire sale of Russian assets on the Chinese stock market. I think that investors maybe saw what could happen to China if they either followed a similar path as Russia and invaded Taiwan or if they were to help Russia. If they did either of those things, they’d run the risk of also becoming economically isolated. So as of March 15, the ETF was already down 27% on the year. Then all of a sudden, that downward trend reversed when the government stepped in last week and announced that they would work to stabilize their stock market and foster economic growth. Sounds like they aim to do that with market-friendly policies through monetary policy as well as by taking out new loans. On that news, as you’ve already mentioned, Steve, the Hang Seng index bounced 9.1%, the biggest one-day gain since 2008. You also saw some of the bigger tech and blue-chip companies bounce. Alibaba was up 27% and jd.com 36% in one day. Those are huge swings for investors over such a short time period.
I think that the Chinese government got to a breaking point with the market sell-off and realized that when companies really start losing money, that could mean layoffs and unemployment, which is absolutely not good for closing the wealth gap. As far as investing in China moving forward, I think the new position of the government might ease fears for those that maybe pulled capital out, and it could attract dollars back into the market. I would say it’s not realistic to expect 9% and more daily moves. That’s just not sustainable. I also think the unpredictability of the geopolitical risk, along with the uncertainty around their role in the war, will still hold back investors who are a bit more risk averse. I do expect volatility to continue, at least until their stance on the war is clear and we can actually see the real impact of policy changes on both the markets and the Chinese economy. What they did—is that working or did they underdeliver?
Well, it sounds like the Chinese government is a lot like us. They don’t like to lose money. So, Liz, finally, you are our international expert. You’ve done a lot of research around the funds that we use and have explored other areas. It has been a difficult period for international investors. We know that, but here at Adviser Investments, we do believe in diversified portfolios. Why should investors still be investing internationally? And are there particular opportunities that you see?
You’re right, Steve, it has been a difficult period to be invested internationally. Actually, for a short time earlier this year, international indices were holding up better than the U.S. major indices, but that has absolutely changed since the invasion. With a global shock like that, investors typically do flock to safe havens. And that tends to be U.S. bonds, the U.S. dollar and, to a lesser extent, U.S. equities. And then on top of that flight to safety, foreign developed countries—mostly those in Europe—have more to lose from deteriorating relations with Russia than the U.S. Russia provides about 25% of the oil and 40% of natural gas to Europe. In response to the war, the EU has said it is reducing Russian gas imports by two-thirds. And the U.K. is phasing out oil by the end of the year but still needs to find alternatives.
These changes come at a time of quantitative tightening in some places. So countries like the U.K. are raising interest rates, which is meant to try and slow a growing economy. It felt like a bit of a perfect storm. Despite heightened risks, sell-offs like this are when international portfolio managers can really make some money. A lot of portfolio managers invest based on the idea of being greedy when the market is fearful and fearful when the market is greedy. In the extreme foreign drawdowns that we’ve seen since the invasion, portfolio managers can and should scoop up companies they believe sold off for no other reason than panic selling. These companies are fundamentally sound, and the portfolio manager expects them to revert to the mean and then even grow further from there. So although it might feel very uncomfortable to be invested in foreign companies right now, situations like this are when international funds can really make some money for the long term. And we’ve actually already seen some recovery. The MSCI EAFE is up 10.4% from its year-to-date bottom, which is actually more than the S&P 500 return of 7.1%.
Great. Well, thank you. And that’s very comforting to hear as an owner of a diversified portfolio. Well, let’s switch gears. Thank you, Liz. From that excellent fundamental assessment, let’s move to another market topic. And I can’t think of a better person to discuss this with than our bond guy, bond veteran and manager of our individual bond strategy, Chris Keith. Chris, welcome today.
Steve, it’s good to be here with you.
Yeah. So Liz just gave us the macro view of the markets and stocks. Now let’s explore the world that you’re familiar with—bonds.
Well, Steve, I spent the second half of last year wondering why the Fed wasn’t raising interest rates. And now I may spend the second half of this year wondering why they are, especially if they do another six or seven hikes. In my opinion, the need for that many rate hikes is just not a foregone conclusion. I say this because nobody knows for certain where the economy will be at the end of the year. And there are economic consequences to raising interest rates and, by extension, raising the cost of capital. And we all know that access to capital, access at a favorable rate, is the lifeblood of a market economy.
But first things first. The Fed is under a lot of pressure to do something about inflation now. The risk is if they raise too much, they may slow the economy down as a result. Having said that, I don’t disagree with their act last week. I really just wish they had started sooner. But even before hiking rates, the Fed needed to stop digging the hole deeper with additional asset purchases. They needed to stop buying bonds. And they did that a couple of weeks ago. They ended QE. They ended their bond-buying program. As for how many rate hikes are in the future, I think they’ll need to carefully assess the need and the impact of additional moves along the way, Steve.
That’s interesting, Chris, because the market is now pricing in eight hikes. So Chairman Powell yesterday came out and gave what many consider to be a very, very hawkish speech. We saw bond yields move up pretty significantly. And now there’s a lot of talk about the Fed making a policy mistake. Many in the media are talking about inversion and, yes, the dreaded R word, recession. Can you tell us for the investors out there: What the heck is inversion and what does that mean for investors going forward?
Sure. Let me begin with the Fed and the policy mistake. So there’s no shortage of criticism being heaped upon the Fed right now. And the policy mistake that you referenced includes digging in on their expectations that the recent inflation spike would be transitory instead of longer lasting—and not for nothing, but it’s also at a higher rate, too. And then the other mistake was waiting too long to address it. I understand the precise rate of inflation is hard to predict, but the Fed and their army of economists missed this one by a country mile. As a result, the task, and really now the dilemma, is to battle inflation by tightening economic conditions, which means raising borrowing costs just as the economy may be slowing down and even facing new headwinds from recent events in Europe.
Now, when the economy slows, investors have been known to favor safe-haven asset classes, such as Treasury bonds. With the Fed raising short-term rates and longer-term rates not moving as much—or even moving lower in yield, on renewed demand—it leads to a flattening of the yield curve, a narrower spread between long-term and short-term bond rates. If this keeps up, it leads to an inversion. We have front-end yields on shorter-maturity bonds offering more of a return than longer-maturity bonds. The reason analysts focus on this dynamic is because an inverted bond market or an inverted bond market yield curve has been a reliable predictor of a period of economic weakness or an outright recession ahead. For investors, a weaker economy would be seen as beneficial for higher-quality bonds.
Thanks, Chris. Well, I know we’re not there yet. The curve is a little bit flat. And so perhaps, Chris, you can talk about that, because it’s been a difficult year for bond investors. I actually was reading that it’s been one of the worst periods since the early ‘80s. So I’ll ask you the same question that I asked Liz: Why bonds now for investors? And are there particular areas that you’re looking at that might be attractive to our clients?
Well, you’re right. The bond market has had a difficult start to the year and believe me, that makes my life as the bond guy just a little bit more difficult. We’ve already touched upon the inflation factor and the Fed’s overdue response to it. And now we have the potential wild card from geopolitical events, from the war in Ukraine and tensions with other big world powers. All of this leaves investors in many asset classes with an anxious feeling, but none of this prevents bonds from doing their job of balancing risk and investor portfolios or providing income over longer time horizons. Recent bond market weakness has lowered bond prices and raised yields. So every dollar invested or reinvested today is being done so at a higher rate than we could have earned not that long ago.
I guess the final point I’d like to make is that we’ve been patiently waiting for higher yields for a long time. Now that they’re here, I want to take advantage of it. It won’t always be smooth, as we’ve seen the way this year has begun, but I am comfortable maintaining or even increasing the allocation to high-quality bonds. But it does take discipline. And remember, you need to think about what bonds do for your portfolio over the longer term, not just what’s transpired over the past few months.
Thanks, Chris. As an income guy, you know that I’m excited. I never thought I’d be excited, but 2.3%, 2.4%, around that for two- to three-year bonds, that’s pretty exciting to me. So thank you, Chris. Thank you for that wisdom on the bond market. I’d like to now introduce another bright mind, our quantitative investment portfolio manager, Josh Jurbala. Josh, good morning.
Hey, Steve. Good to be here.
Now, Josh, you head up our tactical strategies. First, let’s take a step back for investors. What exactly is tactical?
That’s a good question. Tactical is just a way of actively trading and adjusting a portfolio in reaction to market conditions. So tactical strategies will trade more frequently and make more changes to the overall portfolio allocation than might be made in traditional buy-and-hold core portfolios that clients are used to. So our strategies will trade between different asset classes, maybe different sectors or regions when they’re trending, but they can also shift to cash when markets drop and there’s fewer positive trends. And the key point to tactical is that trade decisions are made using a rules-based system or an algorithm.
I know algorithm’s an intimidating word, but we really use algorithms every day to improve decision making. For instance, on a long road trip, we might use Google Maps to guide us. It might signal an accident or traffic up ahead and tell us a better route to take or when to slow down. So, in the case of tactical, algorithms are just a set of structured rules that signal whether to buy when there’s opportunity or sell when there’s high risk. And so the goal is just to take advantage of near-term opportunities for growth and income, maybe in riskier parts of the market, while actively managing that extreme downside risk that sometimes comes with that. So that’s basically tactical in a nutshell. The three main ideas are: Tactical’s active, it adapts to the market and it’s algorithms.
So, two questions: Why would an investor use a tactical approach, and what kind of investor is this best suited for?
Another good question. Tactical’s ideal for investors who want to see more activity in their portfolio and more changes in that overall allocation based on market conditions. It’s specifically meant for someone who might want to hold riskier assets that offer greater return or diversification benefits, but it can also be too risky for them to hold—whether that’s because they’re a retiree and pulling money soon and can’t afford to withdraw that money when markets are down, or whether it’s because they might behaviorally just know that they can’t stick with a large drawdown. They might have gone all cash in March 2020 and never bought back in. So, tactical’s basically for investors who want a more active approach and want that systematic approach that dictates when their portfolio adjusts risk.
Great. Yeah, I think we’re seeing more interest in that. Obviously, with volatility, that’s increased. Also with fears about where bond rates are. So that’s a great point, Josh. Thank you. I know you run multiple tactical strategies—some that focus on the bond markets, some that focus on global, some that focus on the entire picture. How are they currently positioned, and are there any trends that you’re seeing now?
Sure. So the strategies are relatively defensive right now. They hold large portions of the portfolios in cash. Pretty much across the board, we have four strategies and most of them have a healthy portion in cash right now. They’re signaling that it’s a high-risk environment with less opportunity for gains, but there’s still a few positions held in stocks. Some are relatively defensive or value-leaning parts of the market. We have dividend stocks held in one portfolio right now. Since the start of the year. We did see them get defensive, shifting gradually to cash as markets got more volatile—especially with that initial drop in January. And that’s how we design these portfolios. To go back to the driving metaphor, we’ve designed them to tap on the brakes when there’s traffic up ahead. So you’re not forced to slam on them all at once. And they also are ready to reaccelerate if positive trends reemerge and traffic clears. So we’ve seen that even after the last week, some signals of positive trends are maybe reemerging, and the strategies might start reinvesting into stocks or possibly high-yield bonds, like our Tactical High Income strategy.
Josh, thank you for that. And it’s interesting how the strategies are currently positioned. Are there any particular trends that are emerging today?
Yeah. So even after last week’s rally, with the market gaining over 6% over the four days, I think it’s safe to say the general trend is the market’s pretty much still down. It’s about 7% off of highs, looking right now. And 10 of 11 sectors are still down year-to-date. Three heavyweight sectors like tech, consumer discretionary and communications are down more than 10% still. And for most of the quarter, we saw those value-leaning stocks and cyclicals outperform. But I think when Russia invaded Ukraine, there was more of a systematic shock. So a lot of those sectors also took a hit, and on the bond side, Chris covered most of it, but we’ve seen most bonds down so far this year. And you know, that’s been partly a reaction to the rise in interest rates, but we’ve also seen more risk priced into high-yield bonds, which explains why our Tactical High Income strategy’s pretty defensive right now.
We haven’t seen those spreads widen—the yield spreads above Treasurys widen—to extreme crisis levels yet. So that’s good news, but really the only consistent positive trends we’re seeing are in the commodities and energy space, obviously. They’ve clearly benefited from the supply shock due to the war, but we’re also seeing how volatile those prices can be. Just this month, the price of oil spiked from $100 to over $120 and then fell back below $120. So we’ve seen that crazy price action in commodities like nickel and wheat as well. Clearly the commodities are not a great buy-and-hold option for people, but investors are in a tough spot because it’s really what’s added diversification this year. It’s really the only spot that’s added diversification, but that’s why we use a tactical approach. It’s because people can’t really afford to hold commodities for the long term. So that’s why we hold riskier assets like commodities and high-yield bonds in our tactical portfolios.
Well, thank you, Josh. I think that’s a great point that you just made there because I think so many people have tried to be their own macro manager and tried to own commodities or high yield, and then they hear something on TV about how maybe they should invest in nickel, and they try to buy the ETF and they’ll end up losing money. So having a tactical strategy, knowing that it’s a rules-based one that you’re running makes a lot of sense. So thank you.
Now I’m going to turn it over for an entirely different look at the market. I’d like to now introduce one of our newest portfolio managers at Adviser Investments, Adam Johnson. Adam is the portfolio manager for our new American Ingenuity portfolio, which is well positioned to play a role in the growth portion of a long-term investor’s portfolio. Adam, welcome.
Hey, thanks, Steve. Great to be part of Adviser and great being with you today.
Well, thank you. So let’s start off basically here. What is American Ingenuity and who is this suited for in terms of a strategy?
To me, American Ingenuity is about the people and companies driving the world forward. Try to imagine what it might have been like to uncover a Facebook or a Google or an NVIDIA or any one of these companies that are now household names. Imagine if we could have uncovered those 10 or 12 years ago. That’s what I’m trying to do now. And what I like to try to do, Steve, is find companies that have a long runway for growth. I do that by identifying themes that we can understand. I don’t want to have to try to reinvent the portfolio every quarter. So if I can identify a theme like clean energy and then uncover different companies that express that theme—it might be a battery maker. It might be an electric vehicle charger manufacturer. It might be a solar panel installer. It might be a maker of electric buses. There’s so many different, exciting angles to clean energy. That’s a powerful theme. And again, we don’t have to reinvent the wheel. So I’m trying to find these companies, the people and companies that are driving the world forward, whether it’s clean energy or blockchain or the velocity of money, etc. These, to me, are very exciting, and they give us an opportunity to build wealth over the long haul.
Great, well, that is very exciting. Coming from a guy who helps manage a dividend portfolio that invests in toilet paper and banks, you’re providing a very good perspective—especially in light of all the technological change that’s going on. And I think that’s clearly an opportunity and investors need someone to guide them there. Now, I understand there has been volatility in the market over the last couple of months. Tell us what your outlook is for growth now in the U.S. And are you finding particular opportunities in the strategy?
Yeah, there’s actually too much opportunity. I mean, you look at the sell-off that’s happened over the past several months and I’ll tell you, Steve, it’s staggering to me—the number of high-quality, proven, leading, best-in-breed companies that have been taken down 60%, 70% and in some cases 75%. Square, PayPal, Affirm, Facebook, salesforce.com, Twitter. I mean, the list goes on and on. On the one hand, it’s very exciting because you get an opportunity to come and buy some of these companies at what I consider to be very attractive valuations. The catch is if you’re already long, and I have been—I’ve taken some hits, but that’s all right. What I have done over the past month, Steve, is pivot the portfolio toward what I consider the highest-quality names. In other words, when it’s a bull market—go back 18 to 20 months ago—you could almost buy anything and it would go up. But as bull markets start to mature and especially as rates go up, people get more particular.
So a company that might have been given the benefit of the doubt probably comes under more scrutiny. I’ve sold some of the lesser-known names that you probably haven’t heard of, and I’ve added to or gone out and actually bought entirely new positions in some of the larger ones—like those I just mentioned—that are just down too much. And Josh just mentioned the notion of trading tactically. I mean, that’s his whole strategy. And I have found that the current market has given me, too, an opportunity to think more tactically simply because so many of these high-quality names have gotten hit. And you say to yourself, “Okay, fine. Some of my names have gone down. I can hold on to them, or I can take a look at what else is down and try to figure out what might come back the soonest or the strongest as this market finds its footing.”
Because, Steve, you know me. I’m an optimist and I think you are too. Over time, markets recover. And so the question is what’s going to come back the fastest. You actually asked me a question at the very beginning. You said, “Who’s this appropriate for?” and I never answered. I actually think this strategy is appropriate for everybody. It’s just a question of how you size it. If you are a younger person with a longer time frame, you can probably afford to have a more volatile slice of an American Ingenuity allocation in your portfolio. The older you get, the more you need the dividend approach that you focus on. And so I think actually striking the right balance—depending upon your risk profile and your age—between dividend-paying-income, balance-sheet companies and then young, exciting growth stocks that could double or triple or quadruple in the case of some biotechs over the next few years… I think striking that balance is really important for everybody.
Adam, I love your enthusiasm. And I think in this kind of environment, where we’re battling inflation, the names that you were discussing provide opportunity for growth that will have earnings growth over the next six months to 12 months. So as you mentioned, it’s an interesting balance. And I think what we’ve offered you here today is just a lot of different perspectives. My thanks to Liz, Chris, Josh and Adam for providing their thorough, well-thought-out, diversified views on the stock and bond markets. We know there are going to be many headlines in the days and the weeks to come. Volatility will probably remain heightened. But one thing is for certain: No matter how volatile the days and weeks to come are, we look forward to helping you secure your financial future like we have for the last 25 years.
Please look to our podcast as one way in which we are always not just on your side, but by your side every step of the way. On that note, this has been Steve Johnson and key members of our Adviser Investments research and portfolio management teams. Many thanks to each of today’s participants and to all who listened in to another The Adviser You Can Talk To Podcast. Thank you, of course, to Kailey Steele and Ashlyn Melvin for their great work in producing these podcasts. And if you enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts. Your feedback is always welcome. And if you have any questions or topics that you’d like us to explore, please email us at email@example.com. Thanks for listening and stay safe.
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