{"id":396,"date":"2021-08-02T18:12:59","date_gmt":"2021-08-02T18:12:59","guid":{"rendered":"https:\/\/winthropcm.com\/reports-and-profiles\/?p=396"},"modified":"2021-08-02T21:14:01","modified_gmt":"2021-08-02T21:14:01","slug":"cio-portfolio-structure-report-3q2021","status":"publish","type":"post","link":"https:\/\/winthropcm.com\/reports-and-profiles\/cio-portfolio-structure-report-3q2021\/","title":{"rendered":"CIO Portfolio Structure Report 3Q2021"},"content":{"rendered":"\n

PORTFOLIO STRUCTURE SUMMARY<\/h4>\n\n\n\n

3Q 2021<\/em><\/p>\n\n\n\n

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With the reopening of the economy following the pandemic, the domestic economy has shown exceptionally strong growth. Retail sales, consumer confidence and a solid $4.5 trillion in accumulated savings underscore the strength of the consumer sector. We expect continued solid growth in the second half of the year; however, the pace will likely slow from the peak levels of the first half. In spite of strong stimulus, the manufacturing sector is showing signs of weakness. We expect the continued reopening of the economy and President Biden\u2019s initiatives for an infrastructure program will ultimately provide a catalyst for near-term growth. Given the solid growth of the economy and progress in the labor markets, we expect the Federal Reserve will begin to change its messaging to the markets and back off the aggressive bond purchase program by December. In the global economy, aggressive monetary policies are being used in an effort to stimulate growth in the absence of fiscal discipline in most developed countries. The results have been underwhelming and include slow growth, high unemployment, instability in capital markets, growing budget deficits, and a growing debt burden. Investors are challenged to navigate the capital markets with strategies that can meet objectives with an appropriate level of risk. Compounding this challenge, expected returns on financial assets will likely be lower in the coming year given the elevated valuations of financial assets and the increased likelihood of volatility spikes as the Fed attempts to reduce its current level of monetary support. As a result, our theme heading into the second half of 2021 is generally risk reduction in portfolio structures. We acknowledge that a spread in the Covid variant, which forces measures to restrict in-person gatherings, could likely lead to a slowdown in economic growth.<\/p>\n\n\n\n

Domestic Equity: Maintaining our current allocation and look to increase allocation to China.<\/strong>
We expect earnings on the S&P 500 to be roughly $175 in 2021, a 35% increase from 2020. While this increase is largely a result of base effects, the fact that the global economy is accelerating is undeniable. At current earnings, the S&P 500 is currently valued at over 24.5 times earnings, a steamy level by historic measures. The reflation trade has fared well for smaller capitalization companies that tended to suffer more from the pandemic. However, we expect earnings growth to slow in 2022.<\/p>\n\n\n\n

Domestic Fixed Income: Moving up in quality and shortening duration.<\/strong>
The rate on the 10-year U.S. Treasury has increased 21 bps through the first half of 2021. With inflation running at 3.5%, and the yield on the ten year U.S. Treasury at 1.25%, we have negative real interest rates. With interest rates trending lower in the face of strong economic growth, the bond market appears to be discounting a longer-term view that the acceleration in the rates of inflation is a short-term phenomenon. We expect the event that could send U.S. rates higher will be the eventual slowdown in the Fed\u2019s bond purchase program.<\/p>\n\n\n\n

Global Equity: Expect global growth to increase in 2021.<\/strong>
Europe has begun to adopt a viable vaccination program, and as a result, the country is experiencing a broader economic expansion, which has led to European stocks outperforming U.S. equities for the first time in more than five years. However, as we look at the prospects of sustained future growth, the narrative has not changed much for the Eurozone. Structural and demographic headwinds will be a natural impediment to sustainable growth across Europe. We continue to favor China over much of the developed international equity investment universe. While growth in China is slowing, we anticipate 2021 GDP will be above 8% as China continues to build its competitive position.<\/p>\n\n\n\n

Alternatives: Increasing exposure to multi-strategy funds.<\/strong>
We are increasing our allocation to long\/short equity, multi-strategy, and real asset funds as performance expectations for risk assets continue to decline. We believe returns of a traditional 60\/40 portfolio will be challenged over the next three years as fixed income struggles to post positive returns and equity earnings growth slows. Diversifying the portfolio and reducing correlated volatility is critical to managing through a low return environment. In general, publicly traded liquid alternative funds have had a difficult time replicating hedge fund returns over the past several years.<\/p>\n\n\n\n

ASSET ALLOCATION & PORTFOLIO STRUCTURE<\/h4>\n\n\n\n

The S&P 500 is currently trading over 24.5 times next year\u2019s earnings. This is high by any historical measure. While we agree that a low interest rate environment and stimulus can justify higher multiples than the historic norm, at some point, valuation matters. We are maintaining the current allocation to equities overall, but we continue to have a more defensive tilt across our asset allocations and choose minimum volatility strategies and equal weight ETFs. We believe this will reduce the overall volatility of portfolios due to macro shocks and idiosyncratic risks.<\/p>\n\n\n\n

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We are maintaining our fixed income allocation, despite historically low interest rates and tight spreads. However, we are changing the mix of underlying fixed income strategies to reduce overall exposure to credit. Fixed income still remains the asset class with the lowest correlation to equities. There is an increased desire for some protection in a portfolio as stocks trade at excessive valuations and economic uncertainty persists due to a reduction in further stimulus and the spread of the Covid variant increases. We are currently using fixed income as a defensive asset with an emphasis on the actual income component. With the risk of rising interest rates, we continue to position the fixed income allocation with a short duration bias. This decreases the portfolios sensitivity to interest rate volatility without giving up meaningful expected return.<\/p>\n\n\n\n

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Source: Bloomberg, Barclays
*Tactical Weight Based on moderate U.S. Client Allocations (low tax sensitivity)
** US Large Cap Growth = Russel 1000 Growth TR, US Large Cap Value = Russell 1000 Value TR, US Small Cap Growth = Russell 2000 Growth TR, US Small Cap Value = Russell 2000 Value TR, International Developed = MSCI World ex USA NR, Emerging Markets = MSCI EM NR, Governments = Bloomberg Barclays Government Related, Mortgages = Bloomberg Barclays U.S. MBS, Corporates = Bloomberg Barclays U.S. Credit, High Yield = Bloomberg U.S. Corporate High Yield, International Fixed Income = Bloomberg Barclays Emerging Market Fixed Income, Cash = Bloomberg Barclays U.S. Treasury<\/p>\n<\/div><\/div>\n\n\n\n

DOMESTIC EQUITY ALLOCATION<\/h4>\n\n\n\n

Supported by strong earnings and fiscal and monetary stimulus, the equity market measured by the S&P 500 is up over 13% year-to-date. Similar performance across domestic midcap and small cap helped to lift overall portfolio performance. Equity performance in the first half of the year was marked by a rotation out of technology stocks, which benefited from the stay-at-home work environment, and into recovery stocks such as travel, leisure and entertainment.<\/p>\n\n\n\n

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While we expect to see strong economic growth in the second half of the year, our base case outlook for domestic equity performance is that most of the recovery from a reopening economy has been priced into the market. Technology stocks led performance equity returns in the last year, while small cap stocks have been the bright spot in 2021. This has driven up valuations to historically elevated levels. In the absence of more stimulus, investors should expect lower returns over the near term. A lower workforce participation rate will eventually increase wage pressures, which in turn, will put pressure on operating margins as companies are forced to increase wages. This will ultimately begin to eat away at earnings.<\/p>\n\n\n\n

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Over a rolling three-year period, performance of the S&P 500 should be positive as long as interest rates remain near zero. However, any effort by the Fed to push interest rates higher will likely have a lagging negative impact on equity returns. \u2003<\/p>\n\n\n\n

GLOBAL EQUITY ALLOCATION<\/h4>\n\n\n\n

We are maintaining our international allocation on the back of outperformance over the near term. We believe the growth cycle across Europe will stall faster than in the U.S. Europe is still facing many structural issues: High debt loads, a shrinking industrial segment, and Brexit are challenges that did not go away because of the pandemic. If anything, these issues have worsened and will likely escalate in the intermediate future. Japan has continued to have a difficult time emerging from the pandemic. They are likely to slip back into a recession in 2021, and given their demographic and cultural issues, it is unlikely that they will be able to shift toward a meaningful growth cycle anytime soon.<\/p>\n\n\n\n

Looking further across the globe, China and Southeast Asia continue to be the most promising markets. Their economic expansion continues to grow as they increase their competitive footprint. While increased regulation across China has hurt some of their largest stocks, we see this as a short-term buying opportunity as the growth prospects for these companies have not diminished.<\/p>\n\n\n\n

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In spite of the breakdown in trade negotiations, we are still anticipating the resolution of Phase One of the U.S.-China trade dispute. China\u2019s economy has slowed from 7.0% in 2015 to 5.5% today. Clearly, the road to a trade treaty is bumpier than investors initially believed. However, with traction from the recent stimulus added to China\u2019s economy last year to support the housing sector and an increase in bank lending, we are more optimistic about the potential for an increase in China stocks. We have added a small position of China ETFs to our models.<\/p>\n\n\n\n

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SECTOR ALLOCATION<\/h4>\n\n\n\n

Performance of Technology, Industrial, and Communications sectors has been strong through the first two quarters of the year.<\/p>\n\n\n\n

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We remain overweight in Technology in most of our Portfolio Models. We are still in the early stages of Cloud growth and 5G, and believe that both are catalysts for continued growth.<\/p>\n\n\n\n

We have moved toward an underweight position in Utilities and Real Estate. While we generally like the real estate segment, a rising rate environment is a negative driver of both utilities and REITs.<\/p>\n\n\n\n

We are neutral on the Consumer and Financials sectors. The Consumer sector benefited from government stimulus checks, but the likelihood of this continuing is low now that the economy is opening and inflation has begun to accelerate. Financials have also benefited from accelerating inflation, as it has driven a steepening of the yield curve and increased net interest margins. We believe this trade has generally run its course and is fully priced into Financials stocks.<\/p>\n\n\n\n

FIXED INCOME<\/h4>\n\n\n\n

The fixed income asset class has struggled to perform in 2021, coming out of an above-average year of returns last year. Interest rates are broadly higher than they were this time last year. The rate on the 10-year U.S. Treasury is up 30 bps year-over-year, which has put pressure on returns across credit, despite significantly tighter credit spreads. High yield fixed income has been the top-performing sector. Much like small cap stocks, high yield bonds were slow to recover from the COVID-19 pandemic fallout. As investors chase returns and yield, they have chosen to move out the risk curve and buy below investment grade credit as a way to boost income. Government stimulus and bailouts have aided in stabilizing lower credit quality companies.<\/p>\n\n\n\n

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Across our fixed income allocation, we have been increasing the quality of the longer duration allocation, while generally maintaining a short overall duration tilt. Returns across fixed income have become increasingly asymmetric and low. We believe the expected return across fixed income will be 1-3% over the next three years. Conversely, the downside risk is somewhat asymmetric as any significant rise in rates or widening of spreads could result in losses beyond 10%. Having a shorter duration fixed income allocation will reduce the overall volatility within the fixed income allocation.<\/p>\n\n\n\n

Within our below investment grade allocation, which includes high yield bonds, levered loans, and preferreds, we are broadly becoming more cautious as spreads and yields touch historically low levels. The high yield index now only yields a meager 3%, which is causing investors to move out the risk curve and often to assets not within their typical investment strategy. This is a red flag. If this pattern continues on for some time, valuations will eventually be stretchedand a skewed risk to reward can lead to large market dislocations when things unwind. We are maintaining our allocation to high yield debt with a maturity inside of five years and to levered loans, given their floating coupons. We are, however, reducing our allocation to preferreds. Preferreds have had a nice run, up more than 10% over the past 12 months. The annualized return of preferreds over many market cycles is approximately 5%, given this is generally the average coupon of the securities. We believe the asset class is currently overvalued and will revert toward a 5% annualized return.<\/p>\n\n\n\n

ALTERNATIVES<\/h4>\n\n\n\n

We view Alternative assets as an important part of a diversified portfolio. In general, our Alternatives sector considers Private Equity, Hedge Funds, Real Estate, Private Investments, Business Development Companies, and Liquid Alternatives.<\/p>\n\n\n\n