Daily Comment (May 9, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a key report on Chinese international trade that points to an early slowdown in the Chinese and global economies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the nomination of left-leaning officials to the Brazilian central bank’s policy board and a discussion of the Federal Reserve’s latest report on financial stability.

China:  The April trade surplus rose to more than $90 billion, but details in the report showed that exports in April were up just 8.5% year-over-year, marking a substantial slowdown from the 14.8% rise in the year to March and adding to concerns that slowing demand around the globe will mean an early demise for China’s post-pandemic economic revival.  Adding to the concerns, imports in April were down 7.9% on the year.  The figures serve as a reminder that world economic growth is already starting to slow.  We continue to believe that the U.S., in particular, is heading for a recession, most likely a bit later in the year.

Canada-China:  The Canadian government designated a diplomat at China’s consulate in Toronto as persona non grata for his effort to gather information about Conservative parliament member Michael Chong and his family in China.  Intelligence officials believe the diplomat’s aim was to “make an example” of Chong and deter other Canadian officials from taking anti-China political positions.  The expulsion will undoubtedly lead to further China-Canada tensions, and, it has already prompted China to expel a Canadian diplomat based in Shanghai.

Pakistan:  Former Prime Minister Imran Khan was arrested this morning on charges of corruption.  The popular conservative politician was ousted by parliament last April amid an economic crisis, prompting months of mass protests by his supporters.  The arrest is widely expected to prolong and deepen Pakistan’s political tensions, making it even harder for the country to overcome its economic challenges.

Eurozone:  As if the European Central Bank didn’t have enough challenges with price inflation and rising wage rates in the bloc, union workers at the ECB have forced the institution to launch a pay review that could lead it to institute semiautomatic wage hikes when prices rise.  The move puts the ECB in an awkward political position after it has spent months trying to convince the bloc’s employers and workers not to push prices or wage rates too high.

Ireland:  With the government awash in corporate tax receipts, Finance Minister McGrath today will formally propose setting up a sovereign wealth fund to channel its bumper surpluses into infrastructure and debt-reduction programs.  The “scoping paper” to be given to the cabinet will examine similar plans in Norway, Japan, and Australia.  It will also set out criteria for the fund, which is to be managed by the National Treasury Management Agency.

Russia-Ukraine War:  Today is Victory Day, when Russians celebrate the surrender of Nazi Germany in World War II.  At the scaled down military parade in Moscow’s Red Square, President Putin used the occasion to bizarrely cast the war in Ukraine as a Western attack on Russia.  Separately, Russian concern over possible Ukrainian attacks prompted the cancellation of the usual parades and other celebrations in at least 20 cities.  Importantly, some observers believe the Ukrainians could launch their counteroffensive today, or at least other major attacks, to spoil the Russians’ big celebration.

Brazil:  Leftist President Luiz Inácio Lula da Silva, who has been attacking the Banco do Brasil (BDORY, $8.67) for its tight monetary policy despite the formal autonomy granted to the central bank in 2021, appointed two allies to the institution’s nine-member monetary policy committee yesterday.  If confirmed by the Senate, Deputy Finance Minister Gabriel Galípolo, a 40-year-old former bank executive, will serve as the central bank’s new monetary policy director, while Ailton Aquino dos Santos, a career central bank employee, will be director of supervision.

  • To bring down inflation, Banco do Brasil is currently holding its benchmark Selic short-term interest rate at a punishing 13.75%. Lula has called for the central bank to cut interest rates to boost economic growth.
  • Lula’s lobbying for lower interest rates has raised concerns that he will push for overly loose economic policies. That prospect has weighed on Brazilian equities and the currency in recent weeks.

Chile:  Voters over the weekend elected conservatives to 33 of the 51 seats in a constituent assembly that will draft a new constitution to be voted on by the end of the year.  The election results mark an about face when compared to the previous 2019 effort to re-write the constitution.  The previous process produced a constituent assembly that was heavily weighted towards liberals and resulted in a draft constitution that was voted down in 2022 for being too leftist.

  • The voting for the new assembly further weakens leftist President Boric and suggests the new constitution will preserve most, if not all, of the current document’s private-property protections, free-market rules, and other conservative measures.
  • The vote is therefore being taken as a positive for the Chilean economy and financial markets, giving a boost to Chilean stocks and the Chilean peso (CLP).

U.S. Fiscal Policy:  President Biden and members of his administration will meet today with House Speaker McCarthy and other congressional leaders to discuss how to raise the federal debt limit.  The meeting is expected to kick off weeks of discussions ahead of June 1, when Treasury Secretary Yellen has warned that the government will no longer be able to pay its bills or make debt service on its debt.  We continue to believe that brinksmanship surrounding the debt ceiling could prompt elevated volatility in the financial market as we approach the deadline.

U.S. Banking Sector:  Yesterday, in its semiannual Financial Stability Report, the Fed said its aggressive interest-rate hikes over the last year have increased risks in the commercial real estate sector.  In particular, the Fed analysts noted the chance that borrowers might have trouble rolling over their mortgage debt, and that property values could fall sharply enough to cause problems for lenders.  The authors asserted that the Fed has responded to the risks by intensifying its monitoring of real estate loan performance and expanding its examination procedures for banks with large commercial real estate exposures.

U.S. Retailing Sector:  While we’ve already written a great deal about the challenges for commercial real estate, especially office buildings and downtown retail stores, new analysis shows that suburban retail stores are benefiting from the work-from-home movement.  Some restaurants and retail businesses that used to focus on bustling urban locations are now moving to the ‘burbs.  With more people spending time closer to home in the suburbs, even regional malls are reporting improved foot traffic.

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Asset Allocation Quarterly (Second Quarter 2023)

by the Asset Allocation Committee | PDF

  • Our forecast includes a normal recession, likely beginning later this year. We also expect a recovery during our three-year forecast period.
  • The path of the Fed’s monetary policy will have an outsized effect on markets. Though market expectations are varied, we expect a measured path for fed funds.
  • Bond exposures are in the short-term segment as our forecast contains a flat yield curve stemming mostly from lower rates in the one-to-three-year segment.
  • Domestic and international developed equity exposures remain elevated across the strategies given our expectations for a recovery and the potential for expansion within our forecast period.
  • In U.S. equities, we lean toward mid-caps as valuations look particularly attractive. We maintain our value bias and cyclical sector overweights and we introduce a quality factor.
  • Gold exposure is maintained for its benefits as a low-correlation asset along with its potential to act as a haven during economic turmoil, hedge against geopolitical risk, strength during periods of U.S. dollar weakness, and reserve asset for global central banks.


The first quarter ended with spiking market volatility caused principally by a banking crisis that included the failure of Silicon Valley Bank, the country’s 16th largest bank. An uneasy calm entered the markets following the swift actions by the Federal Reserve and FDIC to control potential bank runs as well as the contagion fears that surrounded the industry. The Fed’s indication that it will backstop all deposits regardless of size has appeared to resolve problems associated with a bank run. We do not foresee a rapid deterioration of the banking industry or further bank failures, though increased regulation is expected. A near-certain likelihood of recession is discounted into the markets. This combined with the surprising nature of the banking crisis has many investors waiting for potential volatility explosions from other unforeseen sources. Perhaps most importantly, underlying economic fundamentals disagree on whether the Fed has tightened monetary policy to an appropriate level and should pause its rate hikes to maintain a healthy economic environment, as the accompanying chart of the Mankiw Rule indicates.

While the future fed funds rate anticipated by the market is more wide-ranging than usual, we do not expect rapidly changing monetary policy over our three-year forecast period but rather a measured change in the fed funds rate. From an investor perspective, with fixed income yields currently at attractive levels there is little urgency for investors to move into risk assets. However, if the Fed eases in response to the banking crisis and/or a weakening economic climate, fixed income investments will likely no longer earn a relatively attractive yield.

Notable market swings going forward are likely as investors ponder the direction of domestic and overseas monetary policy. The Fed has raised rates to combat inflation, which has slowly come down from its pandemic highs. However, we do not believe that monetary policy alone created inflation and therefore the Fed has limits to its abilities to control it. Rather, the root of inflation lies mainly with deglobalization and changing supply-chain economics, dynamics which have long-cycle effects on the economy. Therefore, we have entered a higher inflation regime than we saw during ZIRP. Inflation will likely continue to moderate from recent highs, as we have seen in recent months, but we expect it to remain toward the higher end of the Fed’s estimated range. Since monetary policy was not the sole cause of inflation, Fed rate changes are not likely to be effective against controlling inflation but may risk damaging economic growth. This is an issue that we are watching closely.


A recession is well-anticipated by market participants and therefore also generally discounted into current pricing. Despite the U.S. economy entering a higher inflation regime, domestic large cap stocks have continued appreciating since last autumn. Concentration remains high in the S&P 500 Index, with five names delivering most of the price appreciation year-to-date. These stocks are in the Technology sector, whose companies tend to be more cyclical and have historically underperformed in a higher inflation environment. The S&P 500 has also maintained a premium relative to lower capitalization U.S. stocks as well as international stocks despite economic worries and concentration risk. For these reasons, we view domestic large cap stocks as less attractive compared to lower-capitalization stocks. We reduced the overall large cap exposure, while maintaining the Aerospace & Defense position and cyclical sector overweights. Deglobalization and re-militarization of foreign countries is a sustainable long-term trend likely to continue for years. We maintain our sector overweights to Mining, Energy, and Industrials in most strategies. Mining and Energy sectors are likely to benefit from electrification/green energy policies as electrification is metals-heavy.

Mid-cap equities, specifically, are at historically wide valuation discounts to large cap stocks, which we find attractive. Lower current valuations provide a measure of protection against volatility that might occur during economic weakness and potential Fed actions. The underlying fundamentals are supportive of mid-cap equity earnings during the forecast period. We introduced a quality factor in our mid-cap exposure, which mirrors the investment structure on the large cap side. The quality factor screens for profitability, leverage, and cash flows, which should support the group through economic volatility.

We continue leaning into a value bias across all market capitalizations. We view the sustainability of earnings growth as more attractive in equities categorized as value and the fundamental multiples of P/E, P/B, and P/CF are modest compared to historical data. In addition, value style has a lower exposure to sectors that we view as overpriced. Although the total return for value has vastly outdistanced growth over the past year, outperformance cycles tend to be multi-year events and, consequently, we anticipate that we are in the early stages of a value outperformance cycle.

We retain an overweight in international equities due to favorable relative valuations of international developed stocks versus U.S. counterparts, constructive policies from most developed market central banks, and the prospect of a weakening U.S. dollar. Though we also expect positive returns on emerging market stocks over the forecast period, its exposure is limited to only the most risk-accepting strategy, Aggressive Growth, given the potential geopolitical risks from China and its heavy weight, in excess of one-third, in the emerging markets indexes.


While a recession is in our forecast, we are not expecting the Fed to react as aggressively as it has in prior recessions during this century, where it reduced fed funds to the zero bound. Rather, while it is a near certainty that the Fed would curtail its current QT balance sheet reduction of $95 billion per month, it is more likely that the Fed would initiate targeted programs, much as it did in March 2020. Our base case is that the Fed reduces fed funds in small increments when faced with a recession as long as policymakers believe that inflation has the potential to be rekindled. Over our three-year forecast period, we anticipate the U.S. Treasury yield curve will transform from its current steep inversion to a more traditional slope, albeit relatively flat. It has become popular for managers to extend duration when the yield curve inverts, and this has mostly worked in the secular bull market for bonds that has existed since 1984. However, we are not of the opinion that this type of bond market environment will exist over our forecast period, which leads to four words in our industry that induce fear: “this time is different.” Accordingly, the cyclical positioning of bonds in the strategies is all loaded in the short-end of the curve, with the exception being the strategy designed for Income, which still incorporates an unchanged 10-year laddered maturity structure, yet incorporates a tilt to one-to-three-year Treasuries.

Among investment-grade corporate bonds, we expect only modest widening of spreads over the forecast period as the past few years have not led to excessive accumulations of debt. Nevertheless, we acknowledge the sizable increase over the past year in the cost of capital for companies that are issuing debt, either for new projects or for refinancing. This naturally leads to the expectation that these firms will experience pressure on earnings and their ability to support bond covenants, particularly for companies that are rated B or lower.


Although REITs have suffered dramatic erosion in prices over the past year relative to the broad equity market, they remain excluded from the strategies. The avoidance of the sector over the near-term was encouraged by negative pressures on demand for office and retail space, compounded by the difficulty in arranging financing through regional banks stemming from deposit outflows. In contrast, broad-based commodities have produced outsized returns over the past two years as a result of healthy demand which led to inflated prices. We removed the broad-based commodity exposure due to the recession in our forecast beginning later this year. However, we retained the allocation to gold across the strategies due to our belief that it can act as a haven during economic contractions, hedge against geopolitical risk, strength during periods of U.S. dollar weakness, and reserve asset for global central banks.

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Asset Allocation Performance