Positioning portfolios midway through Q1 2023

John Bryson:

Hello and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consulting and education savings at John Hancock Investment Management. Today is February 6th, 2023, and I've invited Emily R. Roland, CIMA, and Matthew D. Miskin, CFA, our co-chief investment strategists here at John Hancock Investment Management to our podcast. As a reminder, Matt and Emily are the architects behind our quarterly capital markets outlook piece titled Market Intelligence. Matt, Emily, welcome to the podcast.

Emily Roland:

Thanks for having us.

Matthew Miskin:

Yeah, thanks for having us.

John Bryson:

Hey, Matt, I'm going to start with you. Last week we had our first FOMC meeting of the year. Can you walk us through what happened, and what's the latest with the Fed?

Matthew Miskin:

Yeah, so the Fed raised rates 0.25% as it expected. This was pretty well telegraphed at this point. In terms of what Powell sees from here, he said several potential rate hikes, ongoing rate hikes, the job of fighting inflation is not done, but he did say disinflation a good amount. So while the absolute level of inflation is still elevated, they have been seeing the trend decelerate here and that disinflationary comment from Powell sparked a bit of a risk on rally across markets. In addition, Powell really didn't push back on what has been asked or talked about, financial conditions. So financial conditions are things like the dollar, high yield spreads, interest rates, and they've eased a lot in the last three to four months. They had been tightening and now they're easing. And he really said still they were very tight and the market kind of said, look, if you think they're tight, even though they've eased, that's a dovish view of that.

And market's also rallied on that. So he's actually speaking again tomorrow. There might be a bit of a walk back in some of his comments, a little more hawkish. At the end of the day though, it doesn't really change to us the trajectory much and the bond market is still pricing in one to two rate hikes in the first half to kind of conclude the rate hiking cycle and then unpause and then cuts by the end of the year. And that's still kind of the trajectory. The data has been mixed. It's all over the place, and that's really what's going to influence the Fed from here. But in terms of our first hurdle of the Fed and the first Fed meeting of the year, we've gotten through it. It's still a bit choppy, but the trajectory hasn't changed that much, all things considered.

John Bryson:

Okay. So Emily, Matt had said the fact that the Fed raised by 25 basis points wasn't a big surprise, it was forecast, but what was a big surprise was the jobs report. Can you talk about it and its impact?

Emily Roland:

Yeah, so massive upside surprise on the January jobs report, we saw payroll gains coming in at 517,000, well above the estimate for 185,000. We also saw big revisions to the prior two months, to the tune of 71,000 jobs. So just absolute blowout report. We do want to be mindful of over-emphasizing one report, especially this one. There's some odd sort of seasonal patterns that happen in January. There was also some adjustments to some calculations that the Bureau of Labor Statistics made around the population survey. So we want to be mindful that the data could potentially have been sort of a little wonky or distorted because of that, but still a very hot jobs report. And it does complicate the Fed's job.

So Matt talked about the mentions that Powell made on disinflation and that being a bit of a sort of dovish approach. And then two days later, here you go, there's this job report that indicates that the labor market's incredibly tight, unemployment at 3.4%, that's the lowest level in almost 60 years, really wage pressures cooling a little bit, but remaining really elevated at four point half percent almost on a year-over-year basis. So wage growth of course being a key element of inflation. And the Fed's goal here is to temper that.

So it's making things a bit more complicated. There were some things in here that the Fed was probably pretty happy with. The participation rate is one, so more people are reentering the workforce. That ticked up a little bit. And when more people are looking for work, of course that can help bring down wage growth, bring down inflation. So that was certainly something that the Fed probably liked. But in terms of the market reaction, it was definitely a good news is bad news one. So in other words, the tighter the labor market, it really sort of decreases the likelihood that the Fed can pause here sooner rather than later. So we saw stocks lower, bond yields higher, a stronger dollar, which is something that Matt and I have really been pointing out as one of the key dynamics that's been sort of responsible for a lot of the cross asset performance, and we'll talk about this, but the weaker dollar really starting in the fourth quarter into this year has really been supportive of the rally and risk assets and the stronger dollar is basically the opposite of that.

So I think that was a notable element of the market reaction there. And then happy to talk about investment implications, but we may get to that shortly.

John Bryson:

Yeah, definitely will. So Matt, it's interesting, Emily said twice the data is complicating matters. I think the other thing that's complicating matters is the fact that we're about halfway through earning season and it might not jive with a risk on environment. So how's earning season been going?

Matthew Miskin:

Yeah, it's holding in okay, but then when you look at it relative to the last several years and even you strip out COVID and you just think about how typically earnings come in, it's frankly not great. Last week for example, you got the biggest market capitalization companies in the world, some of those big tech stocks reporting earnings and most missed estimates. Some are now doing buybacks. There's a big buyback revival right now, which is helping in essence the market's response. And the thought being, if you take away share count, that can help mitigate kind of the earnings downside. But we are tracking about two and a half percent earnings estimates growth for 2023. We were at five just to start the year. So there's been a decrease in earnings revisions in 2023. What we're seeing in terms of what the leadership is, some of the cyclical sides of the market, like financials, consumer discretionary had really high estimates. Their earnings in Q4 weren't great. So they need to really come up with a recovery to meet the higher bar.

The market has rallied as earnings estimates have gone down. So now we're looking at over an 18 times forward price to earnings ratio, which is pretty elevated versus history. So when we put this all together, it's a tough backdrop, frankly, fundamentally, and we're trying to look for companies that have better balance sheets because if they need cost of capital to survive or they need capital to survive butt the cost of capital's too much right now, we're looking for companies that aren't overly expensive, trying to mitigate valuation risk by not looking at the most expensive parts of the market. And for us, it's kind of leaning on certain factors in the markets and from a bottom up basis looking for those strategies that have a process where quality and value are two key tenets to navigate this challenging earnings backdrop.

John Bryson:

So Emily, I'm going to complicate it a little bit further and then ask both you and Matt to kind of pull it together for us. But one more complicating factor I'm going to throw out there is the US-China relations and its impact on globalization trends. What are you seeing there?

Emily Roland:

Yeah, so definitely switching gears a bit here, but there has been some developments as of late that have really shown a spotlight in the challenges we've seen to US-China relations. And I'll start by saying that we rely on a network of political strategists to help inform our thinking here. And it's really difficult to make immediate investment conclusions based on this, but there are some longer term trends in place, and one of those is de-globalization. We've seen over the past number of decades, we've seen globalization really taking hold. US businesses creating consumers outside of the US, moving supply chains. And we've seen policies start to move in the other direction here as geopolitical risks increase. So what we're seeing is this recognition from a lot of CEOs, and not only is it here, it's in other parts of the world, realizing that they don't want to be overly reliant on global supply chains.

And there's a recognition in the US that if you're going to sell it here, you're going to increasingly be making it in the US. And we're seeing that reflected in, back to tying it to earnings, earnings calls, we're hearing over and over these words of on-shoring and re-shoring, again, bringing supply chains back here. And Matt and I are frequently on the road and I think we can see it. Middle America I think is fertile ground for this sort of new industrial revolution that's happening in the US. And we look to think about this more secular trend and how it benefits companies in the middle America part of the country as well as mid-cap equities which have over-weights to areas like industrials, materials, think sort of building, construction, trucking. There's a lot of infrastructure spending going on here as those supply chains relocate. So that's the way we're thinking about this longer term trend around potential de-globalization.

John Bryson:

That's really helpful. Maybe now I'll ask because we've hit a couple of different topics between the Fed, the economic data, earning season, et cetera. Emily, how are you talking to clients about pulling it all together and how they should be positioning their portfolios as we're one month into 2023? And then Matt, I'll ask you to comment anything else you'd add to that story?

Emily Roland:

Yeah, I think Matt did a great job of highlighting how tricky this backdrop is because on one hand, we're getting evidence that we're not in a recession. I think it's tough to say with the unemployment rate at the lowest level in 60 years that we're in a recession. But the other economic data that we watch really closely, things like the leading economic indicators, that negative 6% year over year, the yield curve inverted to the tune of almost 80 basis points. The PMIs, which is purchasing managers indices, a really timely read on the health of an underlying economy, suggesting that we're in contraction here and that economic growth is decelerating across the globe. But you're getting this, again, this choppiness in economic data, which makes it tricky. And we're seeing a sort of mismatch between what we would expect in terms of cross asset performance given those leading indicators, the yield curve, the PMIs, would be a risk off period.

But we're seeing this kind of really very cyclically oriented risk on move in the markets as investors sort of celebrate, for lack of a better word, the slow-down in inflation, which has been one of the biggest enemies to the market over the past year or so. So we're advising investors to be careful. It is incredibly easy to get whipsawed in this type of environment. We don't want to be reaching for returns in the riskier corners of the market. And as Matt mentioned, we continue to suggest that investors increase quality, emphasize value, look to more defensive equities, and frankly, we continue to see the income on high quality bonds is really extremely competitive versus other options given our analysis, which suggests that a recession does likely unfold later in 2023.

John Bryson:

Excellent. Matt, what would you add? I know you're cautious by nature and a long-term investor, but what would you add to Emily's comments?

Matthew Miskin:

Yeah, I think on the fixed income side, it is also challenging. I mean, we keep having the 10-year treasury yield kind of back up or hit around 3.40% and then bouncing, it feels like it's about to break down. And now we're almost at 3.6 this morning. So we're kind of in this trading and choppy range, even for treasury yields, which is then influencing broader bond markets. But we would be patient and look for high quality yield here today. The last couple rate hikes of the Fed, usually the scenario is that the 10-year treasury yield peaks out before the Fed funds rate peaks out within months of it. So if the Fed funds rate is going to be peaking in terms of its cycle high in the next several months, usually the 10-year treasury yield is peaking several months before that. So where we are now. In addition, in recessions, the average decline over the last three recessions of the 10-year treasury yield is 2.65%, and the average amount of Fed cuts is 4.25%.

So what we want to do is make sure we don't miss that duration tailwind, meaning interest rates falling into a recession because if you miss that, then you can't lock in or you can't basically move into that duration and get that longer maturity. And we're looking at seven to 10 year maturity type fixed income options in the higher quality profile because we want that not just for next year, the year after that, the year after that, and the year after that. And what we're looking at is about 5 to 6% in high quality income. We think that's going to be really competitive longer term. And so again, to Emily's comments, not getting whipsawed here, making sure you're thinking about the next phase of the cycle and in bonds right now, we think the return potential is actually really attractive given what we see unfolding in leading economic indicators.

John Bryson:

Folks, it's a fluid market out there. There's always new data being put forth, but Matt and Emily are both all over it. They are producing more and more insights on a regular basis. If you're not, you should follow them on LinkedIn or on Twitter to get their latest. And if you want to hear more from us, please subscribe to the Portfolio Intelligence podcast on iTunes or visit our website, jhinvestments.com to read our viewpoints on macro trends, portfolio construction techniques, business building ideas, and much, much more. Matt, Emily, thank you. And to the audience, thanks so much 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.