Portfolio Intelligence podcast: portfolio positioning for a moderating economy

John Bryson:
Hello, and welcome to the Portfolio Intelligence Podcast. I'm your host, John Bryson, head of investment consulting at John Hancock Investment Management. Today is April 5, 2022, and I've invited back two very popular guests, Emily Roland and Matt Miskin, our co-chief investment strategists here at John Hancock Investment Management. As you may remember, Matt and Emily are the architects behind our quarterly capital markets outlook piece titled Market Intelligence. And we're going to talk today about Market Intelligence.

John Bryson:
Hey, Emily, I want to start with you. We just finished the first quarter, and it was a tough one for both stocks and bonds. What stood out to you in terms of cross-asset class performance and how did your calls turn out in Market Intelligence?

Emily Roland:
Sure, John. So, thanks for having us today. And I think investors have been conditioned to expect pretty remarkable returns since the height of the pandemic about two years ago, and they got a little bit jostled to start the year as we're actually seeing pain across both stocks and bonds. To end the quarter, we saw a nice little rally in U.S. equities. We had been down as much as 13% in terms of the drawdown this quarter but ended the quarter down just about 4%. U.S. value stocks were just about the best place to hold up over the course of the quarter; they were essentially flat.

Emily Roland:
But when we look at sector performance, it was just all about energy stocks. Forty percent return year to date across energy stocks and just seeing a backup or a rise in oil prices to start the year, on top of the Russia Ukraine crisis, which exacerbated those gains. So, definitely, a challenge; energy just simply not being a big enough sector to meaningfully help out U.S. equities broadly. We did start to see some participation across sectors like utility and staples to end the quarter. But again, just all about those energy names.

Emily Roland:
When we look across some of the more challenged areas in the U.S., we saw really any place where investors were paying up for growth. Some mid- and small-cap growth was challenged over the quarter as some pressure came into play around that unprofitable growth space. Liquidity being removed from the market. I know we'll talk about the Fed today, but that being an issue with investors pulling away from those more speculative areas. We also saw some risks present themselves as it relates to Europe. They had been doing pretty well, European equities to start the year. And then of course the war emerged. Europe's been challenged by the more close geographic proximity to Russia, Ukraine.

Emily Roland:
The emphasis within European indices on areas like financials, where we expect to see some fairly significant write-downs or risks as it relates to Russian assets. And then again, just a really intensified lower growth backdrop playing out in Europe as a result of some of those issues related to the geopolitical conflict. And then China, really just tough, tough quarter for emerging-market equities. China, in particular, zero COVID restrictions in China have definitely dampened global economic or Chinese economic growth with the PMI data falling there below 50. So that's an indication to us that their economy is in contractionary territory, and that's certainly being reflected in lower equity prices.

Emily Roland:
But I haven't even gone to the really bad news yet, which was that bonds really, really struggled over the course of the quarter as well. The Aggregate Bond Index was down 6% in the quarter. And that is the third worst quarterly return since the inception of the index. The worst return was in Q1 of 1980. So inflation, rising rates, certainly eating away at bonds over the course of the quarter, making it a tough period for fixed-income investors.

Emily Roland:
There was a couple places to hide. Bank loans in particular with that lower or zero duration profile, helping investors out. TIPS, doing okay as inflation came back into the forefront, but areas like emerging-market debt, are really taking it on the chin as a result of significant spread widening in those areas. So we did also see a major development as it relates to Treasury yield curve. We saw an inverted curve at the very end of the quarter, which has some pretty significant implications, really notable dynamic there.

Emily Roland:
And then we've talked a lot about commodity prices, but again, that being a standout in terms of positive returns. As it relates to our calls and Market Intelligence, we were able to outperform modestly over the quarter. We've had an overweight to U,S, large and mid-cap equities that's relative to Treasuries, emerging-market debt, international developed bonds, which are underweight for us. Within bonds, we have had an overweight to bank loans, which has helped. The one real laggard there has been our overweight to investment-grade corporate bonds.

Emily Roland:
So that did not help us in the quarter, but we were able to overcome that. So I think we're pretty happy about the way we did, but of course broadly a pretty challenging backdrop.

John Bryson:
Yeah, no doubt. And there's a lot that you covered. And I want to dig in on one because on our side, on the investment consultant team, we are having a lot of conversations. And I know you two are both having a lot of conversations around fixed income. It was a really tough quarter. There's a lot of pressure, a lot of stress, and a lot of people asking, "Hey, with rising rates happening and, in the future, should I own bonds right now?" Matt, what are you telling people if they're really stressed about their bond portfolios?

Matt Miskin:
So there's two major risks that you're trying to consider in a portfolio. And one is inflation risk and purchasing power risk for clients, which is usually able to be managed through the equity side of the portfolio. And then there's recession risk, and what we're seeing investors more broadly is really not considering much their recession risk. And there's not a lot of defense left in portfolios. There's a lot of offense because if you're selling your bonds and you're moving into another asset class that does better in higher inflation, it's usually more risk on asset class.

Matt Miskin:
And what we're seeing is a very aggressive Fed. We just had another Fed speaker today saying they're going to methodically raise interest rates. And they likely need to tighten policy quite a bit to bring down inflation. And, in our view, that likely decreases economic activity. And over time, the Fed has never been able to take down inflation without creating a recession. Every time that there's been runaway inflation, the Fed has had to raise rates and then create a recession.

Matt Miskin:
Now we're not there yet, but we do believe you need a part of your portfolio that is there for if the Fed raises rates aggressively and does cause a recession. And so, I know it is difficult to hold bonds through this part of the cycle where the Fed is ratcheting up their hawkishness. They're telling you rate hikes are coming, bond markets pricing that in, but in the next recession, perhaps you get that return back. If you think about it, the duration component of the bond market, you're losing it on that now. But if the 10-year Treasury yield goes back down in the next recession, if the Fed funds rate goes back down to around the 0%, then that return kicks back into your portfolio in a time when you really need it.

Matt Miskin:
Because that's when a recession, when your equities are actually down. I mean, stocks, I know it was a tough quarter, but I mean, they're only down 5% from all-time highs roughly now. Your bond part of the portfolio has been struggling, but we would not relinquish that part of the portfolio. We want to have that for recession risk, which we think could actually be, as soon as 2023. You're getting some really high income now, so we're looking about 4% income in parts of the bond market. Higher quality parts of the investment great corporate bond market. That's a compelling income stream.

Matt Miskin:
So we would not remove that. If anything, we'd look at it opportunistically as the year goes on. So, you can balance that portfolio and actually think about the next risk that could be on the horizon.

John Bryson:
That makes sense. And with yield at 4% right now, where we're starting to see in bonds, patience will pay off, you can make that money back, make that volatility back over time. So, nice. Hey Emily, you mentioned another thing that's more of a hot topic over the last couple of weeks, an inverted yield curve. So historically we've talked about when the curve inverts, it's been a classic signal that a recession is forthcoming. Now is it time to build in some defense or position a portfolio for recession? Matt hinted at it. I want to hear your thoughts.

Emily Roland:
So there's been a lot of inks filled over the last couple of weeks for the yield curve inversion. And to just lay out what that is. So when we think about the two-year, 10-year Treasury spread, which is the classic way to look at it, there's a number of different cuts you can take, and they all lead you to the same place. But what happens in every cycle is that the two-year Treasury or the shorter end, which closely reflects Fed policy or expectations for Fed policy moves higher as the Fed starts their tightening campaign. And ultimately the 10-year Treasury says the Fed's going to be moving too far, too fast based on the path of economic growth.

Emily Roland:
So that's really essentially what we've seen this time with additional really aggressive rate hikes being priced into the shorter end, the bond markets pricing in eight-ish rate hikes this year. And the 10-year Treasury in our view chopping along here sideways, but ultimately moving lower as the cycle progresses. So the thing to think about in terms of the inverted yield curve is it doesn't necessarily mean that you have to hit the panic button. It does lead to recession. Every inverted yield curve that we've had has ultimately led to a recession, but you do have some time.

Emily Roland:
In fact, we looked at the last eight major rate hike cycles in the U.S., and we found that equity markets peaked after the yield curve inverted, actually. So, on average 10 months after the yield curve inversion is when the equity market has peaked historically. Now averages are tricky. You don't want to get too cute with it, but it's a playbook to consider here. Remember the Fed's raising rates into a solid growth backdrop, perhaps it's not accelerating quite as meaningfully right now, as it has in previous cycles due to elevated inflation.

Emily Roland:
But earnings estimates are still moving higher and there is fundamental support for stocks right now and for credit. So, the basic playbook, again, 10 months after the recession, you get the market peak. And then on average, you see recession four months later. And that fits pretty well with what Matt was talking about in terms of our base case of a recession in 2023. And I think the idea again, and Matt highlighted this, is we're not there yet. Matt joked the other day thinking about his kids in the back of the car asking, "Are we there yet? Are we there yet?" And it's just what it reminds us of right now.

Emily Roland:
We're not. Right now, we want to continue to emphasize stocks. We want to be careful about how we do that. We want to continue to emphasize parts of the credit market, core plus bond strategies. We have a satellite to bank loans right now. We still feel that's appropriate, but we want to start looking at where the puck is going and in periods where the yield curve inverts, we know there's ultimately going to be a late-cycle dynamic playing out. And then a recession. You want to start thinking about incrementally adding duration to portfolios.

Emily Roland:
You want to start thinking about being a little bit more defensive on the equity side. So, over the coming quarters, as this trajectory continues to play out, that's what we'll be doing. Again, just thinking about not necessarily where we are right now, we're positioned comfortably for this current environment, but thinking about, again, leaning into those bond positions, which is exactly frankly, John, looking at the flow data, the opposite of what investors are doing. So we're seeing everybody throwing their hands up, fleeing bonds.

Emily Roland:
It's probably going to prove to be just about the wrong time to do that. And we know from experience that investors tend to hate bonds right before they love them again. So we're mindful of that and we want to help investors potentially avoid making any mistakes by doing that.

John Bryson:
It's a classic pattern we see over and over again, unfortunately. Hey, Matt, I do want to go a little bit deeper. Emily had mentioned potentially eight rate hikes by the Fed, play it forward for us. How aggressive do you see the Fed this year and into next year? What are you anticipating?

Matt Miskin:
So we're skipping a ... Well, we don't have an April meeting, but then there is the May meeting. And we do see them raising rates, obviously at this point, and introducing quantitative tightening. So they're going to start unraveling the balance sheet. And if FMC, Vice Chair today, Lael Brainard 00:14:32 quoted aggressively unraveling the balance sheet. So they could go 50 basis points. Also, we'll have to see in terms of the April data, we'll have some data here, at least in between, but they're basically again, willing to almost create a recession to dampen this inflation.

Matt Miskin:
And to us, it's really a difficult position they're in because a lot of this inflation is supply driven. Meaning it's not a demand.; it's not that it's over demand. I mean, you could say it's perhaps parts of the housing market, but the commodity spike as of late is really because of the Russia-Ukraine war. And oil prices rising because of that. You had supply chain disruptions still, as it relates to China and COVID and lockdown, and that's causing semiconductor shortages; which is, then again, the car manufacturing is being stunted because of that.

Matt Miskin:
So raising rates isn't going to help the supply side. It's not going to help the supply inflation that's happening. So they're going to try to bring down the demand side of the equation and to us; it's a matter of duration, not magnitude here in rate hikes. Because the two-year yield again is already pricing in eight rate hike. So, if they do eight, then that's already priced in the bond market. If they do less than that, though, then that means a two-year treasury yield is actually too high and as is the 10-year Treasury yield.

Matt Miskin:
So there's two basic scenarios we see that could happen here. One is they actually do less rate hikes than the bond markets pricing. And this would be the soft landing camp. This would be awesome. So basically, the supply chain disruptions come off, the commodities come down because the war is resolved and we're in a much better place. Inflation comes down, the Fed doesn't rates as much. But then actually that means Treasury yields fall. And that's good for bonds.

Matt Miskin:
That's a soft landing. We're not putting that as a high probability at this point because COVID is really bad in China. And this war is not unfortunately improving much at all. It's still an awful situation. The hard landing camp is the Fed just got to raise rates until basically they cause a recession. And they're going to do QT, all these things. The other side of this though, again, it's brutal in 2022, probably for bonds, but then we're probably looking at a recession next year and then bonds come back. So there's two different scenarios that really could play out, but hardly enough because bonds have priced in such strength and tightening so much hawkishness from the Fed.

Matt Miskin:
There's room for disappointment, I guess in terms of rate hikes, which would be bullish for bonds. But our outlook is they're right now, not playing the soft landing game. They're playing the hard landing game and they're going to be raising rates aggressively over this year. They're going to start unraveling the balance sheet. But in our view in the next six months, they're going to realize that growth is slowing significantly and that eventually they pull off the breaks and they let the economy run on its own two feet, which I think they should actually do sooner, but because inflation's elevated, they don't have another choice.

Matt Miskin:
And then eventually we have to see where the economy stands then. Emily highlighted a lot of the cross-asset implications of that, but that's our outlook in essence for the Fed from here.

John Bryson:
So just to clarify, Matt, what is your higher probability, a soft landing or a harder landing? Just want to make sure I heard you right.

Matt Miskin:
Hard landing is the higher probability.

John Bryson:
Is the higher. Okay. All right.

Matt Miskin:
I wish that soft landing was a bigger probability and things change here quickly. COVID came, left, came again I mean, things change quickly as relates to COVID. Things change quickly as it relates to geopolitical risk. You could wake up tomorrow and there could be a huge diminishing of this war. It doesn't look like that at this moment, but those would be really welcome developments for everything else, obviously.

John Bryson:
Right. And all in all, if in this environment you'd probably rather be better positioned, slightly defensively than aggressively, prepare for the worst-case scenario, if it's more likely than not. So good overview. Last question. So, Emily, I know that the Q2 version of Market Intelligence was just released. Any big changes you want to highlight for our listeners?

Emily Roland:
So we are staying put right now. What we're doing in Market Intelligence is we are continuing to emphasize stocks modestly over bonds. We do think that equities can do the heavy lifting here. In portfolios, we look at economic growth still being solid, although decelerating and still solid. We see the next 12-month earnings growth continuing to move up. So the fundamental backdrop is there more so in the U.S. than anywhere else. So, we are emphasizing the U.S. in portfolios based on those better earnings growth prospects. But there is potential slowdown ahead, as we've been highlighting on the call today.

Emily Roland:
And we want to be careful about how we position portfolios for that. It's a bit of an unusual backdrop because you have elevated inflation. So you want inflation protection, but you also have decelerating growth. It's a kind of odd combination. So for inflation protection, we're still looking at an overweight to U.S. value stocks. We actually want to move down in market cap to mid-cap equities. On the value side, that's really where you're going to get a lot of that great operating leverage, industrial sector exposure. And it's going to allow companies that have greater pricing power to potentially outperform as inflation persists here.

Emily Roland:
But we want to barbell that with quality, so we want to own sectors and stocks that have great earnings prospects, good organic growth drivers, great balance sheets, and return on equity. So that's bringing us to a combination of value and quality. We and then on the fixed income side, we've talked a lot about this progression of the cycle yield curve inversions. And we want to look at areas like core and core-plus bonds that tend to do better across fixed income in these periods.

Emily Roland:
So again, a difficult quarter, really difficult quarter for investment-grade corporate bonds, but we do see them to have the potential to rebound as the cycle moves into the later stages here. So, we're excited about the new version of Market Intelligence. We have a lot of new content, particularly in our fixed-income section. So please check it out on our website.

John Bryson:
Well, folks, it's a delicate time to be investing, but Matt and Emily are all over it. So you should check out their next call. You should follow them on LinkedIn and on Twitter. And if you are interested in more volatility management, reach out to your local business consultant, John Hancock's here to help. Our investment consultants can look at your portfolio and our website's got a bunch of great information keeping you up to speed.

John Bryson:
So everybody thanks for listening to the podcast. Matt and Emily, thanks for sharing your insight today. We very much appreciate it. Folks, if you want to subscribe, please subscribe to Portfolio Intelligence on iTunes or visit our website, jhinvestments.com. And thanks so much as always for listening to the show.

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.