Many business owners and investment professionals believe the Fed’s actions to reduce inflation will result in a recession. Last week, the Federal Reserve (Fed) hiked the Fed funds rate by 50bp to 0.75-1.00%, the first back-to-back hike since the second quarter of 2006, with expectations of a series of rate hikes. Additionally, they announced that starting June 1; they would begin the start of Quantitative Tightening by shrinking their balance sheet by $30bn per month in US Treasuries and $17.5bn in mortgage-backed securities (MBS)[1]. This indicates the Fed has prioritized inflation risk mitigation as its primary objective, leading to a recession.
A recession does not automatically translate into a downward market, as discussed in our last video. Yet the primary markets, both stocks (down more than 15%) and bonds (down by more than 10%), pause. The losses in the bond market are particularly frustrating because fixed-income assets are supposed to protect portfolios due to their lower volatility and low or negative correlation to equities. Currently, bonds are not doing what they are supposed to do, but that doesn’t mean the markets won’t correct and allow bonds to return to low/negative correlation periods.
While both the equity and bond markets are down, our portfolios contain a third leg – the “enhancer” asset classes. This year these asset classes have kept you from experiencing the same decline many are experiencing if their advisor has them fully invested in the market or if they have them in a 60/40 portfolio. For decades, investors relied on the so-called 60/40 portfolio—a mix of 60% stocks and 40% bonds to generate stable growth. Our portfolios built using financial science and mimicking the largest endowment and pension funds feature this third group of asset classes of alternative sectors with unique risks to create more “efficient portfolios” (less chance for any given return). Our tilt towards value has also diminished the impact of the market decline, value stocks are not overvalued as are growth stocks which have suffered the most in this market.
The 60/40 mix of stocks and bonds have yielded superior returns in some markets but inferior returns in others. Over the past twenty years, market volatility has led a growing number of academic researchers and educated investment professionals who are not hampered by a parent company or commissionable products to recommend a broader allocation of assets to achieve long-term growth with a reasonable level of risk. Financial science selects these “alternative” investments requiring a statistical analysis incorporating numerous mathematical concepts. When speaking with clients, we focus on the three primary statistics; (1) Expected Return, (2) Standard Deviation (a measurement of variance), and (3) Correlation. Using these three statistics, we demonstrate how volatility can be dampened.
Using these statistics and others creates an all-weather strategy, enabling you to stay invested whether we experience a recession or whether the markets continue to misbehave. When the market misbehaves, we don’t have to make matters worse. Maintaining the discipline to keep to this strategy is a significant advantage.
You may view the video here or on our YouTube channel: https://www.youtube.com/channel/UCWSB3UQN3y4IXAUh7dEBMzA
[1] The two ways the Federal Reserve can try to “control” inflation is by raising rates and by Open Market Operations) where they sell bonds or do not reinvest the proceeds as they mature. Open Market Operations can increase (purchases of bonds) or decrease (sales of bonds or not reinvesting proceeds) the money supply.
