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Joe Tenaglia:

Hi, I'm Joe Tenaglia, Director of Model Portfolios.

Kevin Flanagan:

And I'm Kevin Flanagan, Head of Fixed Income strategy.

Scott Welch:

And this is Scott Welch, Chief Investment Officer of Model Portfolios.

Joe Tenaglia:

Welcome to the 2022 second quarter WisdomTree Model Portfolio Recap Podcast where we'll review the first quarter and the first half of 2022, as well as look ahead to the second half of the year. And if you are a long-only investor, there's really only one feeling to describe what we just experienced in the second quarter, and that feeling is pain. And really June was a terrible month that capped off a terrible quarter that was the exclamation point on a terrible first half of the year. And really nothing was fair. Stocks around the entire globe got absolutely rocked.

The All Country World Index was down about 15% in the quarter alone. The S&P 500 was down about 16%, which brought the overall first half loss to 20%, which is the worst start to a year for the S&P in over 50 years. From a factor standpoint, value outperformed growth, but that didn't really mean much on an absolute basis as most value indexes were still down about double digits for the quarter. Internationally, equity markets did slightly better than the United States with really an emphasis there on slightly. In these regions, there's been a big focus on the continued strength in the U.S. dollar, which has certainly eaten into investor returns if those positions were not hedged back to the dollar.

Making things worse is that fixed income once again did not act as the balance of a balanced portfolio. The Agg index was down almost 5% on the quarter and now year to date losses through the first half of the year now exceeding really an unthinkable -10%. Towards the end of the quarter, you saw credit spreads begin to widen relatively sharply, both in investment grade and in high yield. Moving out to commodities, they had been really the only bright spot for multi-asset portfolios, really just up until May. Even those closed down pretty sharply to end the second quarter and the Bloomberg Commodity Index was down about 6% in the second quarter overall.

So really just across the board, not great. And according to Bank of America Merrill Lynch, this was the worst first half of the year for a 60/40 portfolio since 1932. Wow. So this market really kind of to me is reminiscent of what we saw in 2018 when just about every single asset class was down. But this time, it sure feels like everything is down even more. And really the big market driver continues to be the broadening out of inflation and the Fed's reaction function to that. We saw a 50 basis point hike as well as a massive 75 basis point hike in the second quarter.

The first hike of that size dating back to 1994, as the Fed really tries to play catch up to the runaway inflation numbers and get overall positioning to neutral or maybe even to a restrictive policy stance as soon as they possibly can. So with that, Kevin, I think now is a good time to bring you in. What is your read on what we're seeing from the Fed and is there any way that they can pull off a soft landing without driving us into a recession?

Kevin Flanagan:

Well, thanks, Joe. I'm glad to follow that nice optimistic assessment for what occurred in the markets over the last quarter and year.

Joe Tenaglia:

You're the bond guy. You should love negativity like this.

Kevin Flanagan:

Yeah, I mean, being the bond guy, I guess the bond market needs to take a lot of the responsibility there for what we've seen with respect to interest rates and how much they've risen so far this year. To your point, really across the board, there's been no place to run, no place to hide, whether it's treasuries, agency securities, mortgage-backed securities, corporate bonds, emerging markets. It was really across the board. And for the most part, unless you're in a treasury floating rate strategy, if you're clipping a coupon, you were going to get hit on the duration side as well.

I mean short duration, once again to your point, Joe, really not providing perhaps some of the mitigation against interest rate risk that we've seen in the past and a lot of that has to do with your question, what the Fed has been up to. I mean, it's fascinating to think that the Fed has actually only raised rates three times so far this year. But to your point, 25, 50 and now 75 basis points. And it looks as if you take Chairman Powell at his word, which I think the markets need to do at this stage of the game, the Fed has only really just begun that there's more to come with this.

And I'll talk about this in a second with respect to what the markets are looking for on the recession side of the equation. But when you look at the comments from the Fed chairman of late, whether it was in Congress or in Portugal at the ECB Conference, he's pretty much driving home the same message, and that is their number one priority is to bring inflation down. And even to the point of quote, "Except the higher recession risk" that comes with the territory. And certainly what you're appearing to see now in the bond market is a lack of, shall we say, credibility that the Fed will actually follow through on what has in fact been a Fed funds target getting up to maybe three and a half percent at one time starting to move towards the 4% threshold.

And here we are just a couple of weeks after the June FOMC meeting, as we record this podcast, the change in market sentiment in the money in bond markets has been truly astounding. And I think it's important because going forward as we look into the second half of this year, that this volatility, this fluid kind of Fed policy outlook, it's going to stay with us. It's going to be part of the investment landscape for at least the next six months and arguably into the first portions of 2023. So just dialing it back a little bit, just looking at the 10 year treasury yield as they are proxy for the bond market to provide some of that volatility.

In early May, it got up to about 3.2%, then it fell 50 basis points, a half a point to 2.7%. Then it moves up to almost three and a half percent and then back down again to about two and three quarters percent as we record this podcast. That's an incredible amount of volatility in the bond market. One you see very, very infrequently. Obviously, doing this for a long time, that type of movement in just a two month period, you could make the case it's unprecedented. I'd have to go to the videotape to take a look at that, but it's something very unusual.

So where do we go from here? Well, I think the Fed does make fighting inflation, their primary mission, that you do get to a Fed funds rate somewhere, let's call it, between three and three and a half percent. Remember we're at 175 as we moved after the second quarter. So, that's still a lot of rate hiking to do from the Fed response. The question is, what are the economic numbers going to look like going forward? Are they going to provide the Fed with that continued, let's call it, comfort level to raise rates to that three to 3.5% threshold?

That's going to be very important and it's not just jobs numbers. We're going to need to see consumer spending, manufacturing activity, housing activity. There's no mistaking the fact Powell wants to reduce demand. He's actually said a lot of the issues of inflation were supply oriented. Fed can't do much about supply, but the monetary policy that they can implement has to come in on the demand side and that's what they're going for. So housing would be one of the first, one of the first areas or sectors of the economy you would expect to see the chinks in the armor beginning to form.

But when you look at a variety of economic reports, we're seeing a lot of chinks in the armor right now. So, we're moving from what was good growth, solid growth to end 2021 where we had a negative GDP in the first quarter. And it doesn't look like based upon the numbers we have now, you're really going to get much in the way of a positive showing in the second quarter, not expecting a negative handle as we've seen from the Atlanta Fed's GDP now, but a modest gain. So that it's very likely the first half of 2022, if you didn't average, may actually have a minus sign to it.

So that is important for the Fed because monetary policy acts with a lag. So the numbers they're getting are not necessarily real time with what's going on with the economy. Markets right now are in the process of taking you to that three, three and a half percent kind of range, this is Fed funds futures, and then actually showing the Fed cutting rates in the back end of 2023. So once again, volatility, a lot of fluid movement in the markets, I think that's what should be expected going forward in the bond market.

And from our vantage point from an asset allocation process, what we were looking to do in fixed income is continuing our mantra of being shorter duration versus the benchmark, but also looking at some of those other sectors, such as emerging market debt, where there could be some continued challenges moving forward as global central banks tight, not just the Fed. Remember the ECB, Bank of England and others are all joining the party as well, tightening monetary policy and reducing some allocation to that space, moving into, say, an area like agency mortgage-backed securities, which have seen some cheapening up or weakening in recent months as a lot of bad news had been priced in.

So those are the kind of moves, complimentary moves that we're looking to do and obviously implemented here in the second quarter for fixed income. But hang on, because it's going to be, I think, a very choppy second half of 2022, specifically in the bond market.

Joe Tenaglia:

Thanks, Kev. And I think if you're looking for a silver lining, you might have just touched on two of them. One is that sentiment really can't get much worse than it possibly is, which as we all know, it tends to be a much more bullish contrarian indicator than anything else. But two is that if that terminal rate that we're getting to by the end of 2022 is somewhere between three and three and a half percent, markets already priced that in and the dots are already there already. So, there's not a ton of room for many more hawkish surprises, but I feel like I've been saying that and thinking that for most of 2022 in general.

So, hopefully, there's not much more room to be surprised on the upside, at least in terms of hawkishness there. So thanks for that, Kev, makes a lot of sense. Scott, let's turn to you.

Scott Welch:

Sure.

Joe Tenaglia:

With everything going on in the equity markets and really kind of all capital markets to begin with, within the WisdomTree Models, we really haven't made a lot of changes specifically within our equity positioning. How would you describe our overall positioning and why do you think we've kind of been staying the course?

Scott Welch:

Thanks, Joe. That's a good question. And first of all, I just wanted to say I really appreciated Kevin's comments. We were talking a little bit beforehand. This is an interesting time. Well, to me, it's sort of a back to the future. Because when I got into this business a long time ago, the bond market dictated what happened, The bond market told us what was going to happen and there's the expression of the bond vigilantes and things like that are very out of vogue today and I think they may come back. And so I'm glad that Kevin went into the depth that he did because I really think that the bond market is the place to be focused on right now.

The summertime is on us. We just finished the Independence Day long weekend. I always remind investors to be a little bit wary about putting too much emphasis on what happens on a daily market movement during the summer months because people are out and trading volume is lighter and sort of things tend to get amplified more than perhaps they might. But let's talk about the markets specifically. Joe, you summarized very well, I thought, the horridness of the first half of this year. But if you think about what Wisdom Tree is as a firm, we make our bones, our sandbox, if you will, is in non-beta cap weighted products.

So almost everything that we offer at the product level has some kind of factor tilt built into it and the things that we tend to focus on are quality, value, size, dividends, and varying combinations depending on the product. And so, even though we are open architecture and all of our model portfolios include both WisdomTree and third party products, that's one of our characteristics, we're going to have a bent, if you will, toward value and quality and dividends and size. And if you think about the first half of this year, as both you and Kevin pointed out, bonds did not do what they historically have done, which is provide a hedge to the equity beta risk within a traditional, call it, a 60/40, or 80/20 portfolio.

It was bad for everybody. But the things that worked better within your equity portfolio were value and dividends. And Joe, you referenced the discrepancy or the dispersion between value and growth in the first half of the year. It was as high as it's ever been, I think, historically. And so, the WisdomTree portfolios were already tilted that way just because we're WisdomTree. And so we haven't made a lot of changes in our equity allocations because we were tilted towards the things that are working better now. We were tilted toward them beforehand.

And so, basically for the past 10 years sailing into a very heavy headwind where large cap growth was the only thing that, well, not the only thing, but it was the thing that dominated market performance, now, all of a sudden, if you will, the wind is at our backs because value is working better. Dividends are working better. Quality is working better. Size has been less of an issue. It hasn't really come to fruition, if you will, but we think it might, or as we move forward into the second half of the year. So, we haven't made a lot of changes, but it's because we were already tilted and allocated toward the things that currently are working the best.

One of the last comments that I want to make is I've written some blogs recently. We've published some stuff, some content recently that talks about the endowment model. Now, we don't need to dive into the weeds on that, but essentially all it means is having allocations to real assets and alternative investments. Let's call them non-traditional strategies or lower correlated strategies to equities and bonds. I think people should be really looking at that. Certainly, a lot of the inbound inquiry that we get these days is, hey, what else do you got besides stocks and bonds that I might put into my portfolio?

And for a long time, those strategies were not really particularly helpful, but right now they are. So in the models that we run that have allocations to commodities or real assets and alternative investments, and we typically start with managed futures, those things are helping. And they may not be overly positive on the year depending on the strategy, but they are certainly not down as much as the broader equity markets. And that is what the endowment model is intended to do, it's to not lose as much in down markets so that you don't have to gain as much in up markets to end up ahead.

So, I actually like the way that our portfolios are positioned right now. We just had our most recent investment committee meeting a few days ago. We made a few small changes around the fixed income allocations and some of our models. Kevin addressed that. We have not made a ton of changes on the equity side because we like the way that we're positioned right now and we think that, as both Joe and Kevin have referenced, there's going to be a lot of volatility, rising interest rate environment. All eyes should be on the Fed and the bond market right now because that is going to tell us what is going to happen.

And we're paying attention, but we're comfortable with where we're at. So I'll stop there, Joe, and see if you have any follow up questions or you want to go someplace else.

Joe Tenaglia:

No, that's fantastic. I think I always find people interested in kind of our factor tilts, and I think you could really kind of boil it down to two primary ones in quality and value. And given what we're talking about of more choppiness in the market and given what we're talking about of persistently higher inflation, I mean, quality and value have been the anchor positions for a long, long period of time. And we think that those really kind of are the two that are best suited for the current environment, like you had just alluded to there.

Scott Welch:

Yep.

Joe Tenaglia:

Great intel there, Scott. So thank you all and that'll really cover it for this quarter's edition of the Wisdom Tree Model Portfolio Update Podcast. As always, we highly encourage you to check out the Wisdom Tree Models Adoption Center for updates, resources, client tools, and everything under the sun at WisdomTree.com/mac. Thanks again. We'll speak with you next time.

All data as of 6/30/22 unless otherwise noted. 

Definitions:

Basis Points: 1/100th of 1 percent.

Bloomberg Commodity Index: A broadly diversified commodity price index distributed by Bloomberg Indexes that tracks prices of futures contracts on physical commodities on the commodity markets.

Bloomberg US Aggregate Bond Index (the Agg): is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. 

Fed Funds Futures: derivatives based on the federal funds rate, the U.S. overnight interbank lending rate on reserves deposited with the Fed.

Federal Open Market Committee (FOMC): The branch of the Federal Reserve Board that determines the direction of monetary policy.

Federal Reserve (Fed): The Federal Reserve System is the central banking system of the United States.

Gross Domestic Product (GDP): The sum total of all goods and services produced across an economy.

MSCI ACWI Index: A free-float adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets.

S&P 500 Index: Market capitalization-weighted benchmark of 500 stocks selected by the Standard and Poor’s Index Committee designed to represent the performance of the leading industries in the United States economy.

Treasury Floating Rate Security: A debt instrument with a variable interest rate usually tied to a benchmark rate such as the US Treasury Bill Rate