Meet a Strategist is a weekly feature where Evan Harp talks to different strategists about how their firms are responding to the current moment. This week, he sat down with Rob Williams, partner and director of research at Sage Advisory.
Evan Harp: What is keeping your clients up at night?
Rob Williams: On the whole, it’s definitely been about rates and the Fed. Clients have not seen this kind of carnage in the bond market unless they’ve been around for a long, long time. They’re not even used to negative returns in fixed income, let alone negative double-digit returns. So that’s definitely been the number one concern.
Also, you’ve had a drawdown in equities, so I think clients have also lost on both sides of their portfolio, and it’s made them lose a little faith in diversification. They’ve seen both their equity and fixed income decline, the media has fanned the flames on inflation, and the Fed is going to keep increasing rates, and some clients have taken the first half of the year and extrapolated out that rates are going to keep going up and we’re going to keep getting deeper and deeper negative returns and fixed income. So, for us, it’s been kind of a calming operation to some extent. This happens a lot when rates go up over a short period in any cycle.
That’s what we’ve been dealing with in the first half. Whenever rates rise quickly, what we tell clients is you’re robbed of one of the most important elements of fixed income returns — and that’s time. You lose out on that time to accrue income. I think the things that we’ve pointed out to help the clients sleep is that our view is more constructive on fixed income. If you look out a bit further over the intermediate term, we know interest rates hikes — there’s more coming. But those hikes are largely priced into rates. We even saw in May and June rates are a little more range-bound. We knew this hiking cycle was going to be frontloaded, but we just think it’s going to be tough for the Fed to go much further than what’s already priced in. There’s a good chance we’re heading toward a recession, and so we tell clients, “Look, you’re getting higher yields. That’s a good thing. You’re going to accrue more income over time.”
It’s going to help us, we’re going to have opportunities for active management. There’s been a lot of volatility, valuations have gotten more attractive on credit. I think what’s really spooked investors is correlations broke down in the first half, right? You got negative fixed income and equity returns at the same time, and we think they’re going to return more to normal in the back half — meaning, when you are in a recession-type of environment on growth, you typically get positive returns in the bond market. I think we’re going to get back to that in the second half. It’s a battle, and we understand why clients are concerned.
Evan Harp: Do you have any recent changes in your allocations?
Rob Williams: Going along with what I just said, regarding rates, we’ve pushed duration a little closer to neutral. Duration is your interest rate sensitivity. So if you’re on top of your benchmark, you’re going to go up and down with interest rates the same as the index. If you’re defensive, you’re shorter, and if you’re aggressive, you’re longer. We were shorter-duration in the first half of the year to be defensive versus rates.
Now, to my comments earlier about maybe a lot of this is already priced in, we were holding a lot of shorter-dated floating-rate exposure, such as bank loans, things that were going to help in the environment we saw in the first half. And we were holding less of things that were going to hurt longer-duration, higher-risk fixed income, like high yield. We’ve tilted a little bit back toward that, saying, “Let’s get a little closer to neutral on duration, let’s get rid of the bank loans,” which did really well, and we extended it back into high yield, things that have a little more duration, and value, where valuations have gotten more attractive.
Now, we’re not ready to be too aggressive, given the slowdown that we’re in the middle of, but over the intermediate term, if you believe rates are close to the peak and spreads are more attractive, you can at least start this process, maybe carefully and gradually.
On the equity side of the of the ledger here, probably the biggest thematic trade we’ve been putting on is decreasing developed international exposure over the last quarter or so, favoring the U.S. more as it has underperformed. Basically, I think the U.S. has taken a lot of its medicine on the policy front. Like I’ve just said, we are hiking rates aggressively, whereas Japan and Europe have not even begun this journey. You throw in the fact that Europe is facing even more inflation pressure due to the war in Ukraine, so we believe regional differences will make a difference in the second half. All things equal, you should have more U.S. than Europe in some of the developed regions, and perhaps more emerging market Asia as China kind of gives a policy thrust to try and help their economy. So, all things equal, it’s been regional tilt and a little bit of extra duration on the fixed income side.
Evan Harp: What do you think of the market right now?
Rob Williams: We have a call every single morning, which gets in the weeds, and then we have our Investment Committee meeting every other week. It’s really easy to focus on the downside, there’s certainly a lot of downside risk. Given that the recession risk is high, the Fed has no choice but to hike aggressively in the next several meetings. We just had a really outsized inflation print, and there’s a lot of uncertainty, such as with Ukraine, and we appear to be entering another COVID wave.
But that said, we have to sketch our outlook out for the rest of the year, and we do see a couple positive elements versus the first half, right, at least sentiment has gotten bad. That doesn’t sound like a positive — saying that sentiment is bad, but expectations have reset, and have gotten very negative. That means there’s going to be fewer negative surprises to absorb. We’re already beaten down pretty good here. We know the odds of recession are high. We know the Fed is going to continue to raise rates, and that’s been priced in; rates and equity valuations have repriced significantly. Rates have priced in the hikes for the rest of the year, most likely. Equities being down 20% in the first half have maybe not priced in all the recession risks, but you can argue that they’ve priced in a portion of it.
Most importantly, we do see some signs that inflation will improve in the coming months. That sounds like a crazy statement when we just got that CPI, and it was higher than expected. But again, you’ve got to look forward. Here’s some things that we’re seeing on the inflation front that don’t make the media as prominently: high inventories among the big retailers like Target and Costco means that price pressures are going to start easing. You’re starting to see at least the first indication of a housing market slowdown. We’re seeing increased layoffs, so that’s going to start trickling through to wage pressure. And finally, we all know commodity prices, energy prices, have sold off over the last month. If you take that diversified commodity index is down about 12% since early June, I think all these factors will start feeding into inflation numbers in the coming months and that will hopefully give the Fed latitude to tone down the aggressiveness later in the year, which would help both equity and fixed income. The tricky part is that we have a lot of shipping issues still, and if there’s more shutdowns in China, price pressures can be sticky and stick around for a little while.
So we’re not saying that we’ve reached the peak, but we can at least see the pieces coming together for inflation to start showing some more positive signs a little later in the year. As an active manager, that makes us think that there’s going to be some opportunities in the second half to make some pivots. So it’s a very uncertain, difficult environment, but we think will there’ll be some opportunities.
Evan Harp: Are there any ETFs you want to highlight?
Rob Williams: I’ll give you one on the income side. We look at ETFs as a vehicle to express our view. But ETF markets have gotten a little more complex, and you’ve been able to do more finite type of trades and more specific things in ETF markets, which is a good thing.
Probably our most popular strategy the last couple of years is our multi-asset income. This is going to be a more conservative balance that has a lot of equities, but its goal is generating attractive income, keeping volatility closer to fixed income than equities, more like high yield-ish type of volatility rather than full-on equity. This is probably our widest opportunity set as a product on the ETF side, so we use a combination of core fixed income, Treasuries, mortgages, corporates, and non-core fixed income — like high yield, hybrids, and alternatives, like preferred stocks and MLPs. Finally, we can put up to 30% in equities. So equities is where we found the challenge this year.
We found some success with a particular ETF on the equity side of our multi-asset income strategy. We started using the JPMorgan Equity Premium Income ETF (JEPI ). So it’s a long-only, low-vol equity index, but it has a sensible option overlay to generate extra income. This satisfied exactly what we wanted to do this year — and that is to have equities to diversify, but be defensive, so then you don’t have the duration risk and you get some attractive income. This ETF worked really well in that slot because its beta is nowhere near the S&P; it’s a low-vol. It’s more like a 0.6 beta, 60% of the volatility of the S&P 500, which was around high yield or less, but it out-yielded a good deal. So, the first half, for example, it was down 8%, S&P is down 20%. Its yield was, most of the first half, more than 9%. So it just fit that slice in the portfolio, maybe not where we’d want to put it everywhere across our ETF complex, but for a multi-asset income, where you’re going to have equities and some higher-octane fixed income — perfect vehicle. And I think it also highlights the evolution of the ETF market. This is something that just didn’t exist several years ago.
Evan Harp: What’s one thing that sets your firm apart?
Rob Williams: You always want to list all your attributes, but if I had to try and boil it down to something that permeates through a lot of things, it’s probably the background of the firm. We’re an institutional-oriented firm. I think that makes us a little bit different, especially from some of the other ETF-based strategists that have grown up in more of the high-net-worth retail world.
We manage over $17 billion, and about 70% of that is institutional. So when we got into ETFs as a vehicle, we were really already managing a top-down-oriented process, and we just took on ETFs as a perfect vehicle for executing our view. So we evolved into this not to glom onto ETFs because they were a hot product, but just to take what we already did well and use technology, a better technology, which is ETFs.
I think clients appreciate that, advisors certainly appreciate our mindset. As an institutional shop, you’re very much about customization. You’re more about goal rather than benchmark orientation for institutional clients; a lot of them have very specific goals, and they’re not so tied down to a benchmark. So we think this thinking is appreciated by advisors and clients. It goes through to how we give access to our team and our service model. I think there’s some practical advantages to it, right? If you hired us for a 60/40 portfolio and 40% of it is in fixed income, it’s good to know that we’re institutional shop on the fixed income, and we cover it from the top down and the bottom up. We’ve been trading ETFs for 20 years, but we’ve also been trading individual bonds for 25 years. So if we’re allocating to preferred stocks or credit, we have a good view of the ETF and the macro picture. But we also have a good bottom-up view from our traders on the desk that have traded that every day for the last 20 years.
Then finally, I’ll say clients and advisors appreciate our diverse knowledge base. If you operate in the institutional space, you have to have a wide knowledge of a lot of different types of clients. We do liability-driven investing, we do insurance, corporate cash, retirement plans. High-net-worth advisors don’t always come across these opportunities, but when they do, they know they can pick up the phone and call Sage, and we’ll probably have had experience in that type of opportunity. And we’re always happy to help and lend whatever we know about a space to an advisor. So that’s how I would boil it down: Our institutional orientation has been very well received.
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