Summary
- The financial, emotional, geopolitical, demographics, financial and economic impact and effects (especially exposing the system vulnerability and behavioral finance) from the Pandemic have a very long tail. Changes in some areas are more structural and fundamental rather than simply a passing moment in time and returning back to the past.
- We started with the shortest and severe recession on record combined with the largest fiscal transfer with uber dovish monetary policies unleashed. Since then, supply chain recovered and exposed vulnerabilities with national security implications; inflation spiked, and price levels gradually stabilized. Labor market was tight initially due to immigration, long COVID and retirement and now closer to a supply and demand rebalance. The economy also grew with companies showing their ability to pass on increased prices and consumers’ willingness to pay which led to higher revenue and profit; thanks to higher inflation and the Federal Government for the bail out money.
- Soon or later all these temporary conditions will come to an end, as they should, and “normalcy should step in. We are still experiencing that journey today with higher inflation, higher interest rates, and discontent around the world about their government and how the Pandemic era policies and inflation have further exacerbated the income and wealth divide. Let’s also throw into the mix the geopolitical instability from Russia-Ukraine-EU to Israel-Hamas-Middle East to US-China as well as country specific political instabilities. It seems that we cannot stay in power if we play nice and get along. We have a grievance-stricken world where the majority are dissatisfied. Oh, don’t forget about how climate change effects are and will continue to have real impacts on all of us, but even more so on the vulnerable.
- The future is always uncertain and unpredictable no matter how much we try to anticipate. It is unknowable. As such, from a portfolio construction standpoint, what has been tried-and-true should continue to be the foundation for asset allocation – DIVERSIFICATION. Even investment professionals fall prey to the tradeoff between greed and fear. Emotion and the justification for such behavior would cause us all to sooner or later make mistakes. We all understand that, at times, an asset class moving upward seems unstoppable, and draws people in. This has seldom ended well. In times of enhanced uncertainty, confirming investment objectives, time horizon, liquidity needs, and expectations is critical. Thereafter, properly diversify the investment portfolio among investments that are not highly correlated (i.e., moving up and down at the same direction at the same time). Then finally, rebalance over time the portfolio back to the “neutral” position.
- The benefit of diversification is NOT delivering the highest return possible under all market conditions. Quite the contrary, a diversified portfolio is one that offers portfolio stability, within reason, where the extreme ups and downs cancel each other out and we’re looking for a long-term payoff. Never confuse investing from trading.
- We continue to favor quality stocks with high free cash flow. This is the same for fixed income. We prefer investment grade and high up in the capital structure. As the economy slows from here forward, more caution about taking risk is warranted.
- We are in the one rate cut camp for 2024 unless the economy and employment show more severe warning signs of a slowdown. As such, short-term high quality fixed income is an easy decision for now even considering re-investment risk.
- There are opportunities in emerging markets, but watch out for currency exchange risk. Every currency pair may have its own unique reasons for strength or weakness. However, with the higher for longer US interest rate and a strong (thus far) economy and the occasional geopolitical risks, the Dollar remain resilient against other currencies.
- Private markets (assuming a good understanding of liquidity need) such as infrastructure, private credit, and long-term private equities remain interesting. But picking the segment of the private markets where exposure makes sense and selecting the manager carefully is the key.
- Finally, the labor market is now the cannery in the coal mine for Fed policy. We do not take the position that the labor market will significantly weaken from this point. We believe that a major part of the recent weakening trend is likely a normalization or continuing rebalancing of the labor economy. Even a 4.3% unemployment rate is not necessarily a disaster. However, we are more concerned about the consumer (bottom 70%) and their ability or willingness to continue spending at the current high price levels. Service sector represents roughly 70% of the US economy. Perhaps what we are seeing is just the beginning of the end of an extraordinary economic cycle punctuated by the Pandemic.
- We maintain that core inflation (sticky CPI or PCE) will remain higher than the past (we are not talking about super high here). This means even when the Fed cuts it will be more controlled and contained.
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