Finding income for global investment portfolios
Tune in to hear Dr. David Kelly and Phil Camporeale, Portfolio Manager, discuss asset allocation in today’s environment.
David Kelly:
Welcome to Insights Now, a series of conversations designed to shine a light of clarity on the complex world of investing. So far this season, we've invited a number of different fixed income portfolio managers and talk about the opportunities in bonds after a very challenged 2022. But investors don't just invest in bonds, so investing requires a decision on how to allocate all the pieces of the pie within a portfolio.
In today's episode, I'm pleased to be joined by Phil Camporeale, a portfolio manager in our multi-asset solutions group here at JP Morgan Asset Management. As an active manager with a global opportunity set, he has to make that decision every day. What's the optimal mix of stocks versus bonds? And then how do you allocate within those sleeves? Where can you get the best bang for your buck in terms of returns, while also managing risk in portfolios amidst a number of uncertainties about the outlook?
These decisions largely depend on relative valuations, the outlook for interest rates and growth, and the relative attractiveness of yields. So I'm eager to hear from Phil in today's episode on how he's shifting the dials and portfolios right now, and the site he's allocated to fixed income. So Phil, welcome back to Insights now.
Phil Camporeale:
Thanks for having me.
David Kelly:
For starters, let's get a sense of your views on the current environment. How are you seeing the balance of risk for the economy markets right now?
Phil Camporeale:
Yeah, great question. And boy am I happy that it's 2023 and not 2022. So one of the things, as a multi-asset investor, David, that we care a lot about is the relationship between stocks and bonds. And I think 2023 is a return to normalcy in a way. And one of the things that really struck us about last year is that there was just nowhere to hide.
So I think before we get into what the balance of risks are, I think in a world where the economy is either going to hard land or soft land, we have the ability to navigate a lot better than what we did last year when bonds were the problem, and this year we kind of think bonds are part of the solution.
So just how we're seeing things, we've come a long way since even the end of last year. And I think once we got clarity on where and when the Federal Reserve would stop raising interest rates, it really gave us a lot of clarity into how we would asset allocate. And what I mean by that is we have a neutral allocation to stocks. What does that mean? In a 60/40 portfolio, means we have about 60% in stocks and we're a little bit overweight bonds. So call it 40 to 40, a little over 40% in bonds.
In our base case here, and don't kill the messenger, but our base case is that we do not believe we're going into a recession in the remainder of this year. We think it's going to be a close call, but our base case remains that we are not going into recession. We think that the hard landing scenario is really the scenario that would force you to get very underweight, either stocks or other risk assets. And that's not just a scenario that we see. So again, while it's a close call, we just don't see the US economy heading into recession into the balance of this year.
David Kelly:
Okay. So I get it that you're still looking for a soft landing and thank you for being brave enough to make that call. But that being said, what are the different roads you think that could get us to either that soft landing or a hard landing?
Phil Camporeale:
Yeah, so the window for a hard landing is closing really quickly. Again, if you go back towards the end of last year, and even the Jackson Hole conference that the chairman gave at the end of the summer last year, he used the word pain. That the economy may need to endure some pain in order for them to achieve their dual mandate. And at that point, David, the window for the hard landing was pretty open because that, for us, said, okay, they may need to break the back of the economy in order to have any hope on achieving their inflation target. Okay?
Now where have we evolved since then? We're now at the point where we have 10 straight drops in CPI, after 10 rate hikes. So the window that can get you to a hard landing of the Fed saying, "We have to take the federal funds rate back up through 6% or 6.5% Percent in order to control inflation, the probability of that and accelerating inflation from here is just a low probability event. So that's the one road that can get you to a hard landing. That fundamentally has changed over the last six months.
The second road that can get to you to a hard landing evolves around the regional bank story, David. Now, it's not that they're going to tighten lending standards. I think the whole world knows, and they were even tightening lending standards before the regional bank crisis in early March. I think the road that gets you to the hard landing is really acute and chaotic deposit flight from these institutions.
So again, not a tightening of lending standards, but something that shakes the confidence of the US consumer because they believe that their money is not safe in these institutions. And David, that is simply not happening on a systemic basis. There are stories and anecdotes, but there is nothing that we are seeing that is saying that there is chaotic deposit flight that would shake the confidence of the US consumer.
So again, that's the second road that can get you to a hard landing, which almost then by default puts us in a world where yes, there are going to be challenges, to growth, below trend growth, there are going to be some challenges to earnings. But we do believe that the economy is going to remain resilient enough through those challenges. And most importantly, there're going to be some companies that are better than others in dealing with the tightening of financial conditions that have occurred.
David Kelly:
Okay, so I get that perspective, but I just want to talk about different perspective. Because markets or the futures markets are currently pricing in a pretty sizable pivot from the Fed with multiple rate cuts before the year end, while the stock market is actually still up double digits this year, seemingly pricing in more of a soft landing. Are stock and bond investors simply at odds with each other on the Fed outlook or what exactly do you think is priced into markets?
Phil Camporeale:
Yeah, that's a fair question. And I would admit even something that is possibly a near term risk. It's like when Jerome Powell, time after time, has to say, "We're not easing, we're not easing, we're not easing." We don't have an easing priced into our view until, the earliest, December of this year.
And David, as you correctly stated, there is roughly 40 basis points of easing priced into the back half of this year. That has recovered somewhat over the past couple of weeks, and we think that that's appropriate. Remember the chairman of the Fed before Paul Volcker, was the person that was blamed for letting inflation run rampant. His name was Arthur Burns. And no one at the Federal Reserve wants to have the legacy of saying, "We took our foot off the pedal too soon and allowed inflation to re-accelerate."
Now, that being said, we don't have the Fed come back in to tighten. I think that's one scenario we're not positioned for. If the Fed had to come back and say, "You know what, we have to do 50 basis points again because inflation is accelerating." So I think the pause is almost like the new tightening at this point from markets, where the market in the near term could be somewhat upset that they're not going to get the easing that they imminently want.
But David, that easing is coming. It's either going to be because of a hard landing scenario, which again, not our base case. But in that scenario, of course, the Fed's dual landing is full employment and price stability. And if the unemployment rate starts to go up and growth starts to go down, then you don't need this restrictive federal funds rate anymore, so the easing would come then.
But our base case is more of the fact that by the end of this year, year-over-year CPI looks more like a three handle. We have a shot at a two handle, but more like a low three handle on CPI, and then there'll be a lot of pressure on the Fed of saying, "Why do we need a five and a quarter percent federal funds rate if inflation is closer to three and not five, six, or seven?"
So in that environment, that's where the ease comes in. But again, we just don't think, again, because of that Arthur Burns type legacy that nobody wants, and you can't wave the victory flag just yet, we don't think that easing could be priced in until at least December, but more likely early 2024.
What I think are at odds with each other is the bond market and the bond market. So the yield curve is saying you are very, very flat here. You have a yield curve that's inverted and usually that portends, there's DR yield curve as I like to say, no offense to Dr. Kelly, but there's a Dr yield curve, who's a great economist, that says that's going to be a recession.
But I think what the credit markets are saying is something that looks more like our base case, David, where investment grade corporate bonds are trading about 150 over, high yield bonds are trading about 300, 400 over. And that, for us, looks more consistent with our base case view of, yes, still somewhat challenged growth, but not a hard landing view.
David Kelly:
Of course it could be that it's very unusual also to have the Federal Reserve explicitly forecast that they are going to cut short-term interest rates over the next few years and that their long-term view on the federal funds rate is about half of where it is right now. That's very unusual and that also, I suppose, may be having some impact on shaping the yield curve in what looks like a somewhat more pessimistic perspective than your perspective or the stock market's perspective on the economy.
Phil Camporeale:
And remember, David, as you know, and as we live through, the Fed moved by 525 basis points in 10 meetings. They went four 75-base-point rate hikes in a row. What that did to the front end of the yield curve, we don't believe the back end had any chance of keeping up with because it was moving so violent later, the upside and the front end. I think the flatness or inversion of the yield curve is tend to be a little bit overstated in terms of its impact on growth.
David Kelly:
Having said that, are we going to, at some stage in the next few years, see a normal upward-sloping yield curve again and what would it take to get there?
Phil Camporeale:
Yeah. Listen, on our long-term capital market assumptions, as you know David, we are forecasting a positively sloped yield curve. We have the fair value of the federal funds rate at about 2%, the fair value of the 10-year treasury at about three and a quarter. So we do have this positively sloped yield curve on a long-term capital market assumption standpoint.
But as you know, we can't just tell our clients, "Don't look at your statement for a decade and everything will work out." I think the normal or the traditional path to getting the yield curve to be less inverted has to come, again, either because the Fed is fighting a recession and has to drop the front end of the curve, and then the curve kind of re-steepened, so all the work is being done by the front end.
Or, David, you get kind of that soft landing scenario which just takes longer. The curve is going to be inverted for a while through that soft landing kind of gradual disinflation story. So if you want a yield curve to be positively sloped overnight, I think you need a hard landing. I think the flatness of the yield curve is going to be with us for a while, as this disinflationary process takes a little time to go from kind of 3%, where we have it at the end of this year. I think it might take another year, David, in order for inflation to get back to Fed target it at about 2%. And in that environment, yield curve is going to stay pretty darn flat.
David Kelly:
Okay. So maybe we can broaden the discussion a little bit beyond the bond market. Because, of course, you manage global multi-asset portfolios and so you're not wed to fixed income when you're just trying to get income. So what opportunities do you see outside of bonds, to take advantage of right now?
Phil Camporeale:
Yeah. So I grew up in the bond market and I really do believe that the risk free rate is kind of the straw that stirs the drink. I know you're a big Yankees fan, David, so I use the Reggie Jackson reference for you there.
David Kelly:
I think a Red Sox fan, but go ahead.
Phil Camporeale:
Yeah. I know. I know where your loyalties lie. But I do believe that there are really good opportunities outside of the U.S., David. And you guys in the guide to the markets have that really great slide, which shows the cumulative outperformance of the U.S. versus non-U.S. asset classes. And that gray shaded area, which is U.S. outperformance, seemed like it would never end. And I think if you look closely on that slide now, David, over the past year and a half and certainly year to date, you see significant non-U.S. outperformance.
This is a trade we still believe in. Fundamentally speaking, the US exceptionalism that occurred in interest rate markets when the Federal Reserve was tightening rates from 2015 to 2018, and the rest of the world, particularly the European Central Bank, were caught in a negative interest rate environment and couldn't get out of it, and the upward pressure that that put on the dollar was a really tough trade to fight against.
And then you add on top of that what happened in the pandemic through the Russia, Ukraine crisis and up through about the third quarter of last year, when the Fed finally signaled that they could be less aggressive in their tightening cycle and the dollar was on a tear.
And when you're a U.S. investor investing abroad, you kind of have two bets on. You have the bet on, yes, that international company. But you also have the bet, and again, if you're a U.S. investor that want dollar returns, you have the bet on the U.S. dollar at the same time. And now, at this point, we can kind of definitively say that the strength of the dollar and the upward pressure that the U.S. exceptionalism, in terms of interest rate policy, put on the dollar, that field looks a lot more level now. European Central Bank needed a pandemic, and the inflation that came out of the pandemic and all of the policy decisions they made during the pandemic, but they finally got the window to get out of negative interest rate policy. That's the first thing.
The second thing that I think is really important with Europe is that there's a huge, huge home country bias in this country, and it's an under owned asset class. I go everywhere around the country and everyone is asking this question why? Because they don't own it. So I think the technical around the bid for non-US asset classes when it is performing, at a time when the dollar isn't just eroding all of your returns away, I think are pretty spectacular.
And then the last piece that I'd put on this from a more tactical perspective is there's plenty of debate, even internally, David, as you know, with whether the US is going to go into recession or not. But the story that Europe is going to avoid recession in 2023 is really widely held and there's a different trajectory of earnings based on that confidence of growth staying positive in Europe, that simply doesn't exist in the US.
So you put all that together, the dollar behaving, the good tactical fundamental story, until we head into next winter, and the fact that it's under owned, David, and you're creating a really good story. Also, you have a 5% dividend yield in international stocks. The S&P is closer to four.
And then just as an aside, some of the other things that we're taking advantage of outside of traditional bonds for income, preferred equities still belong in an allocation for us for income, yielding about 6%. Again, that's akin to the bond story, where we have plenty of clarity now, we think, on the terminal rate of federal funds. So preferred equities yielding 6% are also an interesting place for us to take advantage of income opportunities.
David Kelly:
So let's talk a little bit about balanced portfolios. As we predicted in our long-term capital market assumptions, which were published late last year, we thought the 60/40 portfolio would do a lot better in the long run. And actually year to date, it's doing pretty well, about 7% after a truly gruesome 2022. Do you think this performance of a 60/40 portfolio can be maintained?
Phil Camporeale:
Yes, absolutely David, and it's because we think you can continue to get return from both the 60 and the 40. I think you've said a lot of great one-liners over the years, but the one that I've stolen the most from you this year is you don't position your portfolio for things that happen once every 50 years. And as you've correctly observed and your team has correctly observed, last year was the first year since 1974 where the 60/40 was down with both the 60 and the 40 being down.
And what that did was set us up for success as we came into 2023, if you believed that the kind of inflation consequence that we saw in 2022 was a cyclical byproduct of the pandemic and not something structural that was going to last forever. So if you just believed that, that it was a cyclical byproduct of the pandemic and not something that would last forever, that's where we get the power of the bond story. Where all yields, whether it be the front end or the long end, we think now have a duration or an interest rate sensitivity tailwind and not a headwind.
So we think the bond market, that's probably our highest confidence view, you can get a little bit on top of the traditional government bond story by using places like investment grade credit or even high yield, if you have an income mandate, David. But also the equity side. I think the equity side is also important.
In our long-term capital market assumption swing, which is when we went from 4.3% annualized to 7% annualized in just one year, we saw, in the equity side, so the 60 side of the 60/40, a 290 basis point annualized swing in valuations coming from the equity market. So in other words, when the 60/40 was only delivering 4.3, equities looked expensive. After last year, now we have a tailwind on valuations that we think can continue, especially the globally diversified equity.
We mentioned non-US equity a couple of minutes ago. The normal PE discount on international equities is about 15%, PE discounts in the US, and it's now trading closer to 30. So there still is a lot of valuation to take advantage of on both the 60 and the 40. And remember, that 7% that you quoted, that's just beta. That's just buying the indices, buying the stock index and buying the bond index.
What's really exciting about the forecast, in my opinion, is that if you throw alpha assumptions on top of the beta, in most of our multi-asset portfolios, you're getting between a hundred and 150 basis points of alpha coming from tactical asset allocation and security selection. Where if you put that on top of the 7.2% return, we think the achievable total, David, can be eight and a half to 9%, which is really exciting, and again, something that we think we can sustain and maintain.
David Kelly:
That is pretty exciting. But then I've got to sort of think a little bit about investor behavior. And I guess this is my last question to you. I think, and investors have been pretty active so far this year, but the risk free rate is at about 5%. So you can sort of see why it makes sense that so many people are putting money into money market funds rather than the market. Do you think those flows are going to continue? Or you think it soon is going to be time for investors to add risk back to portfolios?
Phil Camporeale:
Yeah, David, unfortunately, I think it's going to continue until they finally see the easing. So I used to call a lot of other folks, my competitors over the years, and now my biggest competitor is the three-month T-bill. Because people are just piling into the front end, looking for that yield, believing that it's risk free.
Now, for cash investors, congratulations, you're now getting a meaningful return. Right? If you are a cash investor, for the first time since before 2008, when rates got taken to zero for a prolonged amount of time. So those investors are happy. I'm happy for them, congratulations. The people that I'm talking to, David, are the folks that de-risked last year into cash, because it was the only thing that was working. And last year, that was really the only solution. Because as I mentioned, first year since 1974 that both stocks and bonds went down, with the 60/40 being lower.
What I'm trying to get out there and tell people is that once the Fed paused, which we think they did in their May meeting, that now raised the opportunity cost for investors that have de-risked away from balance returns. As you just said, the 60/40's already up this year, depending on which one you're looking at, between six and 7%. Even if you're getting 5% in cash, you need a full year to get it. And every three months, if you're investing in the three-month T-bill, you got to roll that thing.
And I'm not sure whether it's going to be the fall, December, the first quarter of next year, the middle of next year, but at some point over the next 12 months, David, we're probably going to be talking about the Federal Reserve optimizing rates a little bit lower, to deal with either a different inflation or growth forecast. And in that environment, that reinvestment risk becomes real. And David, those are the folks that I'm looking for.
Now, again, I don't think it's going to change until the Fed actually reduces rates, because people believe that that's a risk free rate. I'm talking about the opportunity cost here, for investors that de-risked last year, that are going to miss either on the 60 or the 40 side in a diversified portfolio.
David Kelly:
That's a great piece of advice for long-term investors. I think people forget they're long-term investors and the problem is what happens when rates come back down again? Thank you so much for joining us, Phil, and thank you all for listening.
Phil Camporeale:
Thanks David. Great to be here.
David Kelly:
Please tune in to our next episode, where we will conclude this season of A Bond's Eye View with a conversation with Bob Michael, Chief Investment Officer and head of our fixed income strategies here at JP Morgan Asset Management, to round out this season with the outlook for bonds for the remainder of 2023 and beyond.
Until our next episode, I invite you to read or listen to my Notes On The Week Ahead podcast, where every Monday I share commentary on the latest in the markets and the economy, to help you stay informed for the week ahead. For even more timely insights, you can also follow and subscribe to my content on LinkedIn.
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