Portfolio Intelligence podcast: portfolio positioning for Q3 2023 and beyond

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John Bryson:

Hello and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consulting and education savings here at John Hancock Investment Management. We are past the halfway mark for 2023, so I thought it would be a great time to check in with two of our most popular guests, Emily R. Roland, CIMA, and Matthew D. Miskin, CFA, our co-chief investment strategists here at John Hancock Investment Management. Matt and Emily are the architects behind our quarterly capital markets outlook piece, titled Market Intelligence, and they just released the third quarter version. Matt, Emily, welcome.

Emily Roland:

Thanks John.

Matt Miskin:

Thanks for having us.

John Bryson:

You got it. Hey Matt, I'm going to start with you. The recently released Fed minutes indicated a more hawkish tilt for future rate hikes. What's your outlook on the Fed for the rest of 2023?

Matt Miskin:

Yeah, John. So, the FOMC summary of economic projections did have two more rate hikes penciled in for the rest of the year. So it was a weird Fed meeting where they paused or they skipped, we're going to say it's a skip now, it's not a pause because July, they're coming back. So the bond market is now pricing a 90% probability of a rate hike in July. But the bond market after that is saying they're on hold and they're done. The Fed is saying they might do another one after the July meeting. The data in June is really mixed. It's interesting because the ISM and some of the manufacturing surveys and business surveys are weakening, but the jobs market just stays exceptionally strong. So for now, the Fed is basically likely to raise rates one more time. After that, they're probably on hold. In our view, bonds are cheapening up here. The yields are really attractive and so we still believe we're in a late cycle environment. But it is tricky because in late cycle environments, the Fed can be continuing to put pressure on risk assets with these rate hikes.

John Bryson:

So Emily, let's talk a little bit more about that. What are the implications for markets specifically for fixed income investors?

Emily Roland:

Yeah, so John, we've done some work on periods in which historically the Fed has paused and ultimately cut rates, which is even if the Fed does potentially have one more in them later this month, it does look like we're getting to the end of this very aggressive tightening cycle. The bad news for investors over the last couple of years is that as the Fed has tightened, interest rates have risen, which has caused a lot of pain for bond investors. But the good news of course, with all of that is now that there's a very attractive entry point for fixed income investors, meaning that bond yields have risen quite meaningfully here. In fact, we're looking at an aggregate bond index yield of close to 5% right now. So we actually are looking at this as a period that's presenting a good opportunity for bond investors to lean into fixed income, let bonds do more heavy lifting in a portfolio, and really get that income.

Even if we do see more chop in terms of bond yields from here, which is pretty typical of a late cycle environment, which Matt talked about, we still look at that income as being very attractive. As we look at bond yields going forward from here, we do believe we're in this late cycle environment that does ultimately unfold into recession as that lagged impact of Fed tightening starts to bite the economy and in those periods we see bond yields fall historically.

So if we look at the last four periods here or four economic cycles, the 10-year treasury yield actually peaks right before or around the same time that the Fed ends their tightening campaign. So we could be getting closer, if not already been, in that environment, which again, not only means that income's attractive, but also we could see duration as a potential tailwind into the back half of this year and into 2024.

John Bryson:

Matt, you and Emily have talked about where we are in the economic cycle for the U.S. How does that compare to the rest of the world?

Matt Miskin:

So in terms of where everyone is in the economic cycle, most of the developed world is in the same page and that is likely a late cycle environment. The ECB's already raised rates a lot. The Bank of England is continuing to raise rates and so the developed world all looks late cycle. China is a bit of a wild card where their economy has already been decelerating. They've tried to re-accelerate through reopening after COVID. They've tried to do more stimulus to re-accelerate and a lot of it is not working, frankly. The economic start and stop backdrop in China just keeps happening here.

And for us, what we see is the U.S. is holding up the best in the world, even though it's late cycle, even though the Fed has raised rates aggressively, it hasn't slowed down the U.S. economy as much as we would've thought, and it's making us like U.S. economy or assets more frankly, because China looks weak, Europe already is in a recession, although the unemployment rate's low, the Economic Surprise Index in Europe just keeps getting worse and worse, meaning data keeps coming in worse than expectations. So that is putting us more to a tilt to the U.S. The U.S. is higher quality assets more broadly speaking, we like qualities of factor in a late cycle environment, and so it is complicated, but the U.S. is holding up the best globally right now, economically speaking.

John Bryson:

So Emily, when you're thinking about the forecast for the rest of 2023, what are some of the most important indicators you're paying attention to?

Emily Roland:

Yeah, thanks John. So building on what Matt said, we look at the data across the globe. In the U.S. we're looking primarily at the Leading Economic Indicators Index from the conference board. That's one of the primary indicators that we look at, which incorporates things like the ISM index of new orders that Matt referenced. It's things like manufacturing hours worked, consumer expectation, yield spreads, and all of those things have been flashing negative. In fact, the leading economic indicators right now, we're at about negative 8%, that's for the month of May, which is in deeply negative territory. There's a couple of bright spots here, things like weekly unemployment claims, building permits have bounced a little bit, but broadly speaking, the economy's very much in a decelerating growth environment. What's been challenging about this particular one is it's sort of the never ending late cycle environment where we're seeing risk assets hold in okay here, as that lagged impact of Fed tightening is still waiting to be felt, particularly through the lens of the labor market. So the labor markets remain the bright spot of the U.S. economy here, which has kept things buoyant.

And this is a period in which this late cycle environment, which we would characterize as a period where the yield curve is inverting, the Fed is raising to holding rates, that the LEI is negative. Typically these are pretty quick and that's because we haven't had to ring out this massive amount of inflation from the system. In fact, if we've looked at previous periods, again in between when the leading indicators have gone negative to the recession, and that average lag is about five months. We're going on about 10 months now in this late cycle environment. And what's really tricky about it, is you can see these big moves higher in risk assets during these periods.

As sentiment shifts, investors become more positive. As Matt mentioned, the data in some cases looks like it's balancing. So you want to participate in these markets, but you want to be careful about taking on too much risk. This is not the longest late cycle environment we've had. There was one that was about 16 months back in 2006 to 2008. And again that was a time that you wanted to be there, but it's really now about managing risk, participating in this period owning higher quality assets. These are companies with great balance sheets, lots of cash, a limited need to go to the capital markets in order to maintain durable profitability. So it's really about being there, but again, be being mindful of reaching too far for risk in this environment.

John Bryson:

Thanks Emily. So Matt, Emily mentioned a couple things about risk assets hanging in there or even rallying recently. Equity valuations are interesting. How do you feel about them right now? Is the recent rally we've seen, sustainable?

Matt Miskin:

Yeah, so all the recovery really from the October low to now, has been multiple expansion driven. So what does that mean? The PE ratio on a forward basis was about 15 times at the low of the S&P 500 in October and now it's about 19 times. So that is a huge multiple expansion period. Really it's a lot about sentiment. And Emily was talking about this choppiness of treasury yields and markets and really it is, it's a sentiment merry-go-round that we're dealing with in a late cycle environment. One second, we're concerned with a recession risk when there was the regional bank issues. Now we're concerned with too much economic growth as of late because the jobs market's so strong. And so we've gone from hard landing to soft landing to no landing, and we might do that all over again. And so it's easy to get whipsaw in these kind of environments.

We're really trying to be disciplined, focus on those higher quality assets that Emily referenced, but also try not to pay too much for them. And one of the places we are finding a lot of value today, frankly, is in just mid-cap U.S. stocks. You go down from the top stocks in the S&P 500, just down into the more middle of the capitalization range, and you're trading at around 13 times forward PE and you're trading at almost a 30% discount, a large cap. And so I know large caps have on a huge run, but you might want to consider rebalancing some of that into mid to get you some cheaper valuations, less valuation risk. And to us, the U.S. is looking the best economically speaking, we like U.S. assets the most globally, but we just don't want to pay too much for them. By going into mid, you're getting that lower valuation starting point in a nice strong economy. So that to us is a nice place to look to manage some of this valuation risk.

John Bryson:

Thanks Matt. Emily, can you kind of expand the conversation internationally? What's your thoughts about investing outside the U.S.?

Emily Roland:

Yeah, sure. So international equities started to see a really nice run back in the fourth quarter, really the end of the third quarter last year. There were a couple key macro developments that really helped. We had a warmer winter in Europe, which mitigated fears of a full-blown energy crisis there. We also had China reopening, which is really caused a risk on a shift in sentiment across those markets. So we saw a lot of investors really starting off with short covering. I think a lot of investors had been underweight those areas. And then we saw momentum and sentiment really pushing those markets higher, starting in the fourth quarter. That's starting to shift a little bit. There has been a challenge to the China reopening narrative. It's a little bumpier than I think many expected. That has been counterbalanced with stimulus coming out of China, as Matt talked about earlier.

And then we're seeing again the economic data starting to roll over pretty significantly in Europe. You know we look closely at things like PMIs, purchasing managers indices, which give us a good sense of the health of an underlying economy. If a reading's over 50 it's expansionary and below 50 it's contractionary. And we look at Germany for example. The PMI that was recently released came in at 41 for the manufacturing sector, which is very much a recessionary reading. And of course Germany being the manufacturing powerhouse in Europe. Services PMIs have held up pretty well. I feel like everybody you talk to has been to Europe on vacation over the last few months, including myself. And I think the services side of the economy continues to expand, but we think that those will ultimately converge. And we do see the economic data decelerating pretty meaningfully there. So we have been overweight the U.S. versus international equities. A key reason being if you want to own quality, you're going to find a lot more of it in the U.S. given our relative overweight to the technology sector. So that's really where we've wanted to be positioned.

European assets tend to be a bit more cyclical, may do better in an early cycle environment. We still have it. We do have a preference for Europe over emerging market equities, but again emphasizing the U.S., sticking with domestic assets over international.

John Bryson:

Excellent. So Matt and Emily, you shared a number of different positioning points. Matt, any final thoughts on how investors should be positioning their portfolios?

Matt Miskin:

I think it's looking at the back half right now, I know the backup in bond yields has been troubling and challenging for those that have put money to work over the last six to 12 months in the bond market. And in our view, of course we'd love to see bonds rally and see a huge return out of the bond market, but you got to be careful what you wish for. If bonds rally and yields plummet, then the return potential of all forward-looking cash flows and investments into bonds are going to have lower return potential. The fact that yields are higher is still giving you this opportunity to lock in higher yields, to put money to work to get high income for years to come.

And so we look at this backup as an opportunity. We see a lot of value in the bond market today, and I know stocks have had a great run and stocks have been outperforming bonds year-to-date pretty meaningfully. But I wouldn't look at that as basically the end of the bond market right now. I think actually, you know, get to points and inflection points where yields really back up and those typically in a late cycle environment, are great times to be opportunistic. So that's something we would take a look at as we get ready for the second half.

John Bryson:

Matt, Emily, it's always great to talk to you. Folks, if you want to follow them, I highly recommend it. You can follow them on LinkedIn at emilyrroland and matthew_miskin. You can also get the latest information from them on our website, jhinvestments.com, where you can learn about the Market Intelligence quarterly piece and other viewpoints that they are releasing. As always, folks, thanks for listening to the show.