It’s been a good year for markets, but you may want to consider making these three tweaks to your portfolio.
The S&P 500 has made two more all-time highs, cyclical sectors energy and financials have led the way, and interest rates are moving higher. The price action fits with our positive view of the U.S. economy and risk assets broadly.We argued that three pillars would support continued recovery and expansion, and drive corporate earnings. This week provided an update on two of them: consumer spending and the Federal Reserve.
- A U.S. consumer that is set to spend. U.S. consumption has been strong throughout the pandemic. Retail sales are nearly 20% above pre-pandemic levels, and there aren’t many signs that the consumer is running out of steam. Earnings reports from companies such as Dick’s Sporting Goods (which showed same store sales growth of 19%) and Williams-Sonoma (revenue growth of 31%) suggest that the appetite for goods is still strong. Impressively, consumers are still adding to the nearly $2.5 trillion in excess savings they have accumulated throughout the pandemic. Saving as a percentage of disposable income is still above pre-pandemic levels.
- Starting yesterday, central bankers, economists and academics have descended (virtually) on Jackson Hole to discuss economic policy. You have to be pretty wonky to follow some of the topics, but markets are watching to see if Fed Chairman Jerome Powell will give any hints about when, and how quickly, the Fed will wind down its asset purchase program. We think the move has been pretty well telegraphed at this point, and critically, market participants understand that the discussion around “tapering” is very different from the discussion of when to raise interest rates.
In 2013, when Ben Bernanke’s taper announcement led to near-term volatility, investors assumed tapering meant that rate hikes were imminent. This time, we think investors understand that the two conversations are on very different timelines. We think it’s most likely that tapering starts by the end of this year, and we don’t see interest rate hikes until the middle of 2023.
Just because we have a positive view doesn’t mean portfolios should remain static. We are focused on two important shifts. First, we believe interest rates are likely to rise through the end of the year and into 2022 as the global impacts of the Delta variant recede. Second, we believe a focus on quality companies is prudent as we transition to a mid-cycle environment. These two views also lead us to consider trimming from three areas.
3 areas to consider trimming
Before we dive in, we just want to say that non-strategic cash is our least favorite asset class, and has been all year. The yield you’re getting on your cash is pinned near zero, all while inflation rises. Cash is one of the few assets that we have a fairly high degree of confidence will have a negative real return over the next 1–2 years. Here are three more areas to consider trimming.
1. Long duration core fixed income.
- Why trim? Treasury yields are at levels that are too low to be consistent with our view of the economic recovery and potential growth in the U.S. economy. We expect rates to rise through the end of the year and into 2022. Remember, bond prices and interest rates move in opposite directions. This means that bonds that have a high sensitivity to movements in interest rates (long duration) are at risk.
- Why now? We believe the economic recovery and expansion will power through the Delta variant disruption and the Fed will continue to remove policy accommodation this fall. Both will likely lead to higher interest rates.
- Other considerations? Core fixed income is still an important buffer that could protect portfolios in an adverse growth scenario, but we would consider complements to core fixed income, such as direct real estate and dynamic multi-asset strategies.
2. High yield bonds.
- Why trim? The main driver of excess returns for high yield bonds is the additional yield they offer over Treasuries (also known as their credit spread). When spreads are wide, it signals that investors are demanding a premium for a higher risk of default. As default probabilities fall, spreads tighten and high yield bonds gain value (in this scenario, interest rates are falling and prices are rising). This is exactly what has happened since last March. But now, spreads can’t really get any tighter, and rising Treasury interest rates should pose an additional headwind.
- Why now? You know the phrase “buy low and sell high”? Well, high yield is high right now. Historically, when high yield spreads have been at similar levels, the asset class has only outperformed five-year Treasury bonds by 2% over the next year. That isn’t enough potential return for the risk that is inherent in high yield bond investing.
- Other considerations? High yield bonds can still offer a better return than Treasury bonds, for example, but we would rather allocate to active, income-oriented managers who can look both within and beyond fixed income to generate yield and return.
3. Speculative, low-quality equities.
- Why swap? Sounds simple right? “Buy the good, inexpensive companies, not the bad, overpriced companies,” but it is harder than it sounds. While the SPAC and clean energy micro-bubbles have deflated, their run-ups attracted a lot of flows. Another example, the energy sector has been the best performer so far this year, but we wouldn’t chase it further.
- Why now? Early-cycle environments are often marked by rallies in low-quality, highly cyclical stocks that have the most to gain from economic acceleration. We think the bulk of that move is behind us. At this point in the cycle, when economic acceleration is coming off the boil and the outlook is more balanced, we want to focus on high-quality companies that have solid balance sheets, robust growth prospects, and trade at reasonable valuations.
- Other considerations? No, not really. We think that was pretty clear.
It has been a very solid year for investors in multi-asset portfolios. These tweaks might make it even better as we move into the last few months of the year. Reach out to your J.P. Morgan team if you’re interested in exploring making any of these changes to your portfolio.
The NFT craze continues
This week, cryptocurrency entrepreneur Justin Sun made headlines because he bought a digital picture of a rock with laser eyes for $500,000. Listen, it’s easy to see stuff like this (along with the continued activities in stocks such as GameStop or AMC Theatres) and think it’s indicative of broader excesses in the financial system. We aren’t going to quibble with the idea that some of this is silly. In fact, we like to think of the investing environment as we did prom night: It’s an opportunity to have a great time, but you have to hang with the right crowd and get home by curfew.
What we disagree with is that this is indicative of an underlying bubble. Volumes on the largest NFT platform, OpenSea, are at around $2 billion for the month of August. So far this year, over $12 billion of Apple shares have exchanged hands every day. The reason that the S&P 500 is up 20% this year is because analysts were way too pessimistic about corporate earnings results, not because valuations are inflating.
And another thing: Isn’t finding out how much someone is willing to pay for something the purest way to determine value?
The bottom line for investors is that fads come and go. We focus on designing and implementing investment plans that are aligned with financial goals. NFTs could be part of that plan, but we suggest discussing it holistically, as we laid out in an article earlier this year.
Originally published by Jacob Manoukian, U.S. HEAD OF INVESTMENT STRATEGY, JP Morgan