Monroe Wealth Management Portfolio Allocations & Insights 10/24/22

Key Takeaways:

• Keep stock/bond split close to benchmark and continue to slash active risk under the hood: outsized Fed influence, recession risk, and inflation uncertainty vastly widens the range of outcomes, in our view, and diminishes our risk-taking appetite

• Bring longstanding value tilt and underweight to growth closer to neutral, buying back into technology stocks after avoiding much of the devastating year-to-date selloff

• Remain overweight US stocks with a preference for inflation-sensitive Developed Market stocks and low volatility Emerging Market stocks, as international economic and inflation outlooks and central bank policy initiatives diverge from the US

• Maintain a modest duration underweight position, selling longer-term nominal and inflation-linked US treasuries in favor of exposure to shorter-term credit and currently higher-yielding, attractively priced mortgage-backed securities

Trade Rationale:

• We have been strategically cutting risk and pruning active bets (exposures that deviate from the benchmark) across our models since the middle of last year, citing heightened market risks as the Fed commenced its tightening campaign. These proactive moves have generally served the models well amidst one of the most challenging periods for investors in modern history, with both stocks and bonds concurrently falling into bear markets. Consistent with the trajectory of our last several rebalances, we are again shrinking exposure to overall risk and pulling back on existing active views, inching closer to benchmark in almost all respects.
• We are not seeing much signal in current market action, economic data, or Fed guidance. We avoided falling prey to the numerous head-fake bear market rallies this year and the overly optimistic narratives that sparked them. Recent ‘Fed-pivot’ dreamers suffered a rude awakening, falling victim to yet another short-term bounce and instead instigating a more forcefully hawkish posture from the Fed.
• While we still think inflation should moderate into next year, price pressures in shelter and services have remained stubbornly sticky. Signs of demand destruction in the economy are becoming visible, but the jobs market continues to demonstrate impressive resiliency and household and corporate balance sheets remain well insulated. In our view, this persistent strength likely emboldens the Fed to get more aggressive in its mission to quell demand and vanquish inflation at a faster pace. But given the long and variable lags in the transmission of monetary policy, inflation could very well already be slowing quite meaningfully by the time the negative effects of tightening impact the economy. For these reasons, we believe the odds of a Fed-policy-induced recession appear to have increased.
• A further cautionary tale, in our view, comes from current earnings expectations, which remain unjustifiably elevated and may need to be revised notably lower. A wave of downgrades from analysts in 2023 could put even more downward pressure on stocks, particularly if a recession does materialize. However, if incoming inflation data improves in conjunction with slowing money supply growth (which we already see evidence of), our research suggests that could potentially be a powerful bullish catalyst. So, we aren’t outright bearish and intend to remain patient given the mixed evidence available, waiting for stronger signals to emerge before re-risking.