Monroe Wealth Management Portfolio Allocations & Insights 5/18/22

Key Takeaways:

• Trim equity overweight but maintain a preference for stocks over bonds, with a focus on adding portfolio resilience as inflation potentially apexes but recession odds tick higher.

• Reduce overall sensitivity to growth and volatility, cutting net exposure to technology, small caps, and credit, while locking-in gains on commodities and energy stocks after handsome

• Introduce exposure to US infrastructure and dividend-focused stocks, which have historically delivered attractive relative returns during periods of tightened financial conditions

• Increase exposure to inflation-protected US Treasuries (“TIPS”), which potentially provide less downside if long nominal rates rise further while tactically hedging against any further
  potential upside surprises in inflation expectations

• Remain underweight emerging market stocks, and further aim to de-risk by rotating into names that have historically exhibited lower volatility characteristics

Trade Rationale:

• While the synchronized drawdown in stocks and bonds has been unnerving, we expected an increase in volatility as the Fed’s hiking cycle commenced – consistent with historical norms. However, so long as inflation is far above the Fed’s comfort zone of 2-3%, it is unlikely to provide support for markets, acting in disciplined fashion to normalize rates, reduce excess demand and bring the labor market into better balance. But since the speedy and sustained selloff has directly contributed to the Fed’s objective of tightening financial conditions (stock volatility is up, credit spreads have widened, short- and long-interest rates have risen), the market has already provided substantial tightening to cool the economy.
• While we expect the annual real GDP growth rate to slow to a below trend pace by the end of this year, we don’t expect that rate to dip below zero, given the economy’s strong current expansionary readings, and seeing that U.S. consumer balance sheets remain in unusually strong condition. That said, the potential for a recession has indeed increased. As the Fed flirts with this tipping-point amidst its efforts to corral inflation, we think volatility could remain elevated and growth-oriented assets could underperform.
• Further complicating the Fed’s balancing act, we believe a ‘peak inflation’ narrative may begin to take hold over the summer months as incoming year-over-year inflation prints reflect last year’s Mt. Everest-like base effects. Recent data shows excess inventories piling up across industries, and decelerating momentum in wage growth, auto prices, and freight activity further support the idea that inflationary pressures will ebb lower. In our view, a material repricing of the consensus inflation trade would take pressure off the Fed, potentially lowering the number of hikes needed and leading markets to lower US Treasury bond term premiums, lower mortgage rates and raise stock prices. Yet, risks to undermining this lower inflation thesis are out there (think further escalations in Eastern Europe or more lockdowns in China), so we are hanging onto several inflation-focused hedges across the portfolio.
• Regionally, we continue to prefer US stocks for their historical relative resilience to a broad range of economic scenarios and as a proxy for quality – but modestly reduced our long-standing overweight to further mitigate exposure to growth and adjust overall risk closer to the benchmark. Within US equities, we are re-positioning into potentially lower risk exposures, moving closer to neutral on the value/growth style trade, hardening the portfolio for whatever may come. While, as we highlighted in March, a recession in Europe has become increasingly possible, we now believe the European Central Bank will shift policy to be relatively less antagonistic to risk assets and only slowly normalize policy, which makes international developed market stocks marginally more attractive, particularly after such a vicious selloff.