December 1, 2023

Headwinds and Tailwinds

The seasonality of the markets has not disappointed us so far as investors in 2023. I’m referring to the Winter months (November-to April). On October 23rd, the 10-year US Treasury yield crossed the 5% threshold, nearly repeating the feat on the 26th, and now sits around 4.4%. A 40 to 60 basis points move in just over a few weeks is, by all standards, extreme and had a profound impact on the markets. This has lifted asset prices across the board giving both Bond and Stock investors something to celebrate.

As we close out this year and position Portfolio’s for 2024, let’s discuss some of the Headwinds and Tailwinds we must face.

HEADWINDS
Recession Fears
I feel like this has been a fear on investors minds for over a year that has not materialized. We published a piece in August 2023 stating we thought recession fears would be pushed out because of the strength of the labor market. At the risk of sounding like a boy that cried wolf, that facts are signs that higher interest rates may finally be showing up in the economy are evident with the Unemployment rate increasing from 3.4% to 3.9%. The SAHM Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. So could we be entering a recession now, maybe. However, the official statistics won’t be published until well into the first or second quarter so I do not think we need to adjust portfolio’s just yet.

Geopolitical Risk

Caveat- I am not an expert in geopolitics, but here is a low-level summary.
RUSSIA & UKRAINE: The war between Russia and Ukraine seems to be entering a stalemate and US support to supply weapons to Ukraine seems to be waning. We will have to wait and see what Russia’s next move will be. We can only hope for peace.
ISRAEL & HAMAS: It appears that Israel is making progress towards eliminating Hamas as a military threat. This effort will likely take months versus days with unfortunately the risk of civilian casualties. The biggest risk to global markets would be an escalation which includes additional countries.
CHINA & UNITED STATES: A recent meeting between President Biden and Xi in San Francisco seemed to go well. My expectation is that these two nations will work together to relieve global tensions. This would be viewed positively by global markets.
TAILWINDS
Now for some positivity!
Fixed Income
The Federal Reserve may have stopped raising short-term rates in July and the long-rate (10 year Bond) may have peaked in late October. In the past when the Federal reserve stopped raising rates, on average the yield on the 10 Year Treasury Bond dropped 1.31% over the next 10 months. When this has happened in the past, investors have made money by extending the duration of their bond portfolios. The primary impact can be observed on maturities 5 years and longer. We will focus on High Quality Corporates and Treasury Bonds.
In our opinion, the sweet spot for the 10 year rate to hover is 4.25-4.75%. History suggests that we will eventually be below 4.25% on the 10 year. If and when this occurs, I expect the Recession talk to get louder. Until then, we remain in the sweet spot.
Equities
The SP500 is having a great year which by all accounts is being driven by 7 Mega Cap Technology companies (The Magnificent Seven).
Many portfolio managers are lagging the Cap weighted Index and I expect these managers will over-weight the lagging sectors to close the gap on the SP500. This can be done by investing within the equal weighted index. We have been adding to the Equal weighted portfolios all year and I do expect outperformance into year-end.

Another area within equities that we think can outperform is within Small Cap Stocks (Companies under $5Billion in market cap).

These companies have dramatically underperformed the Large/Mega Cap companies recently. Small caps are trading at their lowest levels versus the SP5oo in almost 23 years! Due to the lack of performance and underinvestment, the small caps now make up less than 4% of the Total US Stock Market. As a matter of fact, both Apple and Microsoft are both larger than market caps than the entire Russell 2000 combined. Valuations are trading at 60% of the valuations of the large-cap index. When small-caps have traded at 12X forward earnings in the past 38 years, they often annualized at or near double digit rates over the following 10 years. It’s easy to see how the big companies could go on a buying spree to add growth using their premium stock price currency value.

Bottom Line
  • We are extending the duration of fixed income.
  • We are adding to equal weighted large cap portfolios.
  • We are adding small cap US stocks.
  • We are mindful of rising unemployment and recession implications in 2nd Qtr of 2024.
  • Sweet spot for 10 year is 4.25-4.75%
  • Short-term rates likely to begin to fall by end of 1st Qtr 2024.
As always, stay true to your individual goals and risk tolerance and invest accordingly. We are always available to answer any questions you have concerning your financial needs.
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