Portfolio Intelligence podcast: charting market headwinds in the second half of 2022

John Bryson:

Hello and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consulting and college savings at John Hancock Investment Management. Today is September 1, 2022, and summer is coming to a close. We've got kids going back to school, parents celebrating, equity and fixed-income markets getting volatile again. So we're ready for the fall. To navigate all of the different things we need to consider, I've invited back popular guests, Emily Roland, CIMA, and Matt Miskin, CFA, our co-chief investment strategists at John Hancock Investment Management, to help us navigate what's going on. Matt and Emily, welcome.

Emily Roland:

Thanks, John.

Matt Miskin:

Yeah. Thanks for having us.

John Bryson:

Emily, I want to start with you. Both stocks and bonds saw a nice bounce in the middle of the summer, let's call it mid-June to mid-August, but they're struggling again as we head into September. What's behind the recent volatility?

Emily Roland:

Yeah, John. So the U.S. stock market rally almost perfectly coincided with oil prices retreating, inflation fears moderating, and bond yields correspondingly falling. So, if you look at WTI oil prices, we got to a high of about $122 a barrel in early June, and then fell to a low of $85 a barrel in mid-August here. We really saw fears starting to emerge that maybe demand for oil would fall in the global recession. And then those falling oil prices really helped inflationary readings moderate. So the July headline CPI reading came in at 8.5%, which of course is very, very elevated, but much less than expected. And core inflation came in less than expected as well at 5.9%. So again, still very elevated levels, but providing some pretty solid evidence that inflation may have peaked in the first quarter of this year.

Matt and I also watch the ISM survey data really closely, manufacturing data, and services data. In particular, the prices paid component of the survey data has been tumbling, which is really, to us, added to the peak inflation narrative. So all of this good news on the inflation front really prompted investors to anticipate or start to price in a Fed pivot. We actually, at one point, saw futures markets pricing in three Fed rate cuts in 2023 based on the idea that maybe inflation wouldn't be all that bad. Then all of those things suddenly started to work in reverse. Most importantly, we started hearing a chorus really of Fed officials just really pushing back hard on the idea that rate cuts are coming next year and really reiterating that they are completely resolute in their goal of bringing inflation down.

We had Chair Powell's very short and very direct speech in Jackson Hole, really kind of shutting the door pretty firmly on the idea of a Fed pivot. And on top of that, we've seen some better-than-expected economic data in recent weeks, which of course is great for the economy, but it's a pretty clear indication to us that the Fed's job is just not done. So in the month of July, for example, we added a whopping 528,000 new jobs to the U.S. economy and we saw wage growth pickup. We saw job openings. They had been falling, they rose again just this week to over 11 million. So, well, well above estimates. And now we're back to two job openings for every unemployed person. And then the ISM New Orders Index, that's another component of that survey data that I mentioned earlier and one of our favorite leading indicators, actually rose in August after declining the previous two months, and then oil prices started to pick back up. So all of this is really added to sort of a reemergence of inflation fears, which pushed up bond yields.

And then to add insult to injury, we've also seen a move to a potentially more hawkish ECB; so we'll be watching the ECB meeting next week. There's a potential for them to raise rates by 75 basis points. So there's been a big backup in sovereign yield, which is bled over here to rates in the U.S. So just to kind of put it all together and tie a bow around it, we've seen this sort of macro risk pendulum swinging from, we have an inflation scare, then there's a gross scare back to an inflation scare, which has really created these big swings across the markets and frankly, created confusion among a lot of the investors that we talk to. We continue to remind them that this is fairly typical of a late-cycle environment. We should see some choppiness here and bond yield, some choppiness in the economic data. Eventually, the Fed typically wins out and growth becomes a bigger concern to the markets than inflation, but it may take some time here for that pendulum to settle.

John Bryson:

Gotcha. So we would be having a nice middle summer there and then the parents at the Fed said, "It's time to do your summer reading. Don't forget about that." All right. So, hey Matt, with all that kind of at play, we've got some new volatility to worry about in the marketplace, both in equities and fixed income here and abroad. How are you thinking about asset allocation in this environment?

Matt Miskin:

Yeah. So in Market Intelligence, what we did to begin the quarter was, we went neutral stocks, bonds, and we had a modest overweight to equities really since the end of 2020. And really, what we were looking at before wasn't expanding economy, rising earnings, and what we saw really develop, as Emily was talking about, is a late-cycle backdrop unfolding over the course of the summer. So that's when we pivoted more neutral on stocks, bonds. And then within each of those buckets, we moved to more quality parts of the market and more defensive parts of the market.

So thinking about on the equity side, for example, earnings estimates have held in okay. For the S&P 500, at the beginning of the year, the estimate for 2022 was 10%. It's now 8%, which isn't that bad, all things considered, but in our view, that's probably going to come down some more, and we want to find those companies that can hold up earnings the best; so whether that's the quality type businesses with good balance sheets, good margins, good cash flow, or even defensive parts of the market. Think about utilities or things that are more about what people need versus what they want, less cyclical businesses. So that's what we've done on the equity side.

And then on fixed income, we've trim risk there as well. Credit has actually held in really well amidst all this volatility that Emily has described. But in our view, the lower quality businesses are going to struggle with this higher cost of capital, these higher interest rates that they're going to have to pay, and the better businesses are going to hold up better or going to be able to pay those interest payments to holders. So in the fixed-income space, still looking at investment-grade corporate bonds, mortgage-backed securities, and even municipal bonds, we've added as an overweight in Market Intelligence.

So looking for high-quality income, we are now close to 5% in terms of these high-quality yields; Treasuries are three. But you go to securitized or corporates, or even munis on a tax equivalent basis, you're looking more like four to five. So if we can get four to five on the fixed-income side, we can have on the equity side, earnings hold up for the companies we're looking to allocate to. We think those are decent places, but quite frankly, we may need to look out of the box a little bit more in this late-cycle environment because managing risk is becoming more difficult. And that's certainly something we can discuss more.

John Bryson:

Yeah, let's do that. I mean, we've talked in the past about long-term investing and risk management and things that are critically important in the portfolio. And we spend a lot of our time talking about equities and fixed income as the core components, but there are other options out there, alternatives specifically, that can play a role in a portfolio. Talk to me about alternatives. Talk to me about infrastructure opportunities on the equity side and how people can put different, more unique asset classes into play in their portfolio.

Matt Miskin:

Yeah. I mean, that's really, the more we go through this late-cycle environment, the more we're looking at alternatives opportunistically here. I was talking about utilities, for example, on the equity side. And if you wanted to map that over in terms of defensive equities and utility-type businesses on the alternative space, it would be infrastructure. When we look at the alternative space, there's kind of more traditional alternatives and then there's more hedge fund like, very active, kind of go anywhere manager alternatives. So the traditional ones, in our view, are commodities, real estate, and infrastructure. These have more equity or beta to them, but real estate and commodities to us are much higher risk. In fact, their standard deviation, a measure of risk, is actually higher than global equities. So global equities have about 18% standard deviation over the last three years. Real estate has almost 22 and commodities have about 19.

So those parts of the market are much higher risk traditional alternatives. And we don't like that, but in the infrastructure space, and if you're more utility driven in the infrastructure space, you're able to take down the beta. So you're looking at standard deviation. So that's one of our favorite places: Businesses, you can look under the hood and understand the business. They throw off good cash flow. The dividend yield is decent. It's, again, what people need versus what they want. They can be a little bit of energy sensitivity, but we wouldn't go overboard there. So infrastructure's one of our favorites in terms of alternative investments, again, having more utilities, and that's a sector that we like in Market Intelligence. So there's that.

And then there's the other kind of go anywhere alternatives. What we want to do is, we want to be really thoughtful about risk management. The way that we kind of think about alternatives is, how much risk are we willing to take for the return that we're going to receive? We also don't want to take too much concentration risk. In the alternative space, if you have one manager or one strategy and it's only going to outperform in some sort of environment, there can be a volatile performance profile or blueprint, if you will. But if you have a strategy, for example, that's maybe multi alternative or absolute return that has a couple different levers in it, that can diversify the return stream and make it less volatile. You can also just do multi-alternative, where you have a strategy that picks various different managers, various different strategies, and you're diversifying away the risk.

And again, to us, it's all about risk management, this late innings of the economic cycle, of the market cycle. And alternatives, overall, that's the one thing that really has shown through, is that they typically have lower risk than equities in other parts of the market. So leaning in more there and then finding more diversified implementation there is kind of becoming more and more of an important part of what we're looking at cross asset today.

John Bryson:

Excellent. So, Emily, as we look forward to the second half or really the last section of the year, the next couple of months, what are the catalysts that you're looking for to give us more direction on where things are going?

Emily Roland:

Yeah. I mean, all roads really lead back to central bank policy. We have another Fed meeting on September 21, so circle your calendar. We've heard Fed officials essentially tell us that they are now very much data dependent between now and then. That's a bit of a shift because ever since the first hike in March, the Fed has made really extensive use of forward guidance, which is just basically their words to tell us exactly what's coming next. This time they've told us they're waiting to see how the data unfolds. And that creates a lot of uncertainty. Just to reiterate Matt's words, I think he used risk management a bunch of times, and I think that's right, given the uncertainty on that front and the fact that these late-cycle dynamics are playing out. The Fed typically raises rates until something breaks. And that's what we're watching for.

We have some pretty important data between now and that meeting on September 21. We'll get another read on inflation with the August CPI report, that comes out on September 13. We have another jobs report, very imminently here, and the Fed's really looking for labor demand to cool. And we just haven't seen it yet. So the jobs report's going to be really critical in terms of looking at the participation rate, looking at how that impacts wage growth. And then of course, we'll be keeping a really close eye on oil prices here. The energy market has essentially taken monetary policy hostage with the significant impact that oil prices have on inflation. So we'll really be watching that. Of course, there's the Russia-Ukraine war, which has had a significant impact on energy supply. It's really hard to handicap that, but we'll be looking at the geopolitical backdrop. We'll be looking at the supply demand dynamics to understand what's next for oil prices and how that impacts inflation.

But again, given the uncertainty, given this very choppy late-cycle period, given inflation dynamics, I think swinging for the fences, which is what a lot of investors were doing during that sort of midsummer period that you highlighted, John, in our view, probably isn't the best move here. And I think notching up on quality, getting more defensive, looking at four or 5% yield on higher quality bonds really makes a lot of sense as we sort of sit through this late-cycle period and get through some of this before we can start to add some more offense potentially in 2023.

John Bryson:

Excellent comments. You mentioned the midsummer opportunities that people were taking advantage of. I'll go back further. I think we know at John Hancock, investing is never easy. If you go before COVID, the 10 years before COVID, it was easier. We had a lot more tailwinds than headwinds. We're at a period now where we're heading into more headwinds. If you are looking for help on how to navigate this late-cycle market, we've got a ton of insight here on our website, and through our business, we have consultants to help you with that.

Matt and Emily have a great piece on investing and late-cycle investing on our website, jhinvestments.com. We will continue to stay on top of this through our podcast, so we hope that you subscribe. But if you need some help in how to find the opportunities, because the other thing is, there's opportunities in every market, reach out to your local business consultant, check out our website. We're always looking for those opportunities, trying to help you deliver better outcomes for your practice and your clients. Matt, Emily, always great to talk to you folks. Thanks for listening as always to our show.

Emily Roland:

Thanks, John

This podcast is being brought to you by John Hancock Investment Management Distributors, LLC, member FINRA, SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and other conditions warrant, and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment strategy discussed will be successful or achieve any particular level of results. Any economic or market performance information is historical and is not indicative of future results, and no forecasts are guaranteed. Investing involves risks, including the potential loss of principal.

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