Q3 2022 Model Portfolios Update Podcast
- Fed updates impacting the money and bond markets and equity space over the last quarter.
- Macroeconomic recap and outlook for Q4 2022.
- Seeking opportunity during periods of market uncertainty.
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Hi, I'm Joe Tenaglia, Director of Model Portfolios.
And I'm Kevin Flanagan, Head of Fixed Income strategy.
And I am Scott Welch, Chief Investment Officer of Model Portfolios.
And welcome to the Q3 2022 recap podcast where we will review the quarter that was and look ahead to the end of the year of 2022. And we are sitting here today recording this podcast just a few days before we wrap up the third quarter. So we haven't quite closed the books on the markets yet. We don't quite know how things will finish up, but we can say with pretty full certainty that we're starting the fourth quarter with sentiment about as bad as it's been in quite some time. And it's unlikely that the performance of major stock and bond indexes finish with worse performance this quarter than what they had in Q2, which frankly isn't saying much. But it sure does feel like there's a lot more negativity in the markets right now than there was just a few months ago. And really, number of reasons why negativity is kind of everywhere.
But it's fair to say the biggest driver of this is the fed, who just delivered another jumbo sized hike to interest rates in September of 75 basis points. And it seems clear now that the market is taking the fed for their word, that they are going to raise rates until inflation's under control, regardless of the collateral damage that this will cause to the economy and to the job market. And of course the ramifications of this shift has been felt most strongly in the bond market with yield spiking, particularly on the short end. And the majority of the yield curve really inverted pretty deeply at this point in time as we're recording today. So it's not always that the bond market is the place of excitement, but that's certainly been the story of 2022 so far. So Kevin, with that, I want to give you the floor. What is your read with what's going on at the fed, the impact on the economy and then in the bond markets overall?
Come on, Joe. Bond markets are exciting you know that, and we're seeing it this year, but unfortunately the excitement has been all in the wrong direction. And it's really just taken on another leg here. And I think your points are well taken about the fed. If you just look at their latest forecasts that were released after the September fed meeting about a week ago, you see fed funds for this year finishing at 4.4%. The current top end of the range is three and a quarter. So you just do the math. If the fed are going to actually meet their own forecast, which is a whole nother scenario we could talk about and probably spend 30 minutes on a podcast given their track record, which isn't very good at predicting what they themselves will do, I mean that's 115 basis points. So that would mean technically you probably would get another 75 basis point.
I love your term jumbo rate hike at the November 2nd FOMC meeting, which would take us to that 4% threshold. And really that's what we're seeing in the treasury market right now. Echoing your comments there, that if you go from the 12 month bill pretty much all the way out now to the 10 year note, you're seeing four handles on the yield. Now the 10 year treasury as we're recording just a few basis points under, but it looks like that's seems to be where we're headed at this stage of the game. And what's interesting, the difference I think between when we're recording this versus three months ago when we were talking about say, the tenure treasury or the bond market, you were expecting to see maybe a rally because there were concerns that the fed could over tighten, and that we can debate back and forth, are we in a recession? Are we not in a recession?
We all know that the numbers came out two negative quarters of consecutive GDP that were technically in a recession, but nevertheless you could make the case three months ago that there were concerns the fed would over tighten and push us say, deeper into negative territory. Well now you're focusing on rate levels extremely above where the fed was looking at in June. You're talking about almost a full percentage point above where they were expecting the fed funds target to be by the end of this year, and instead of rallying the bond market's actually selling off. So it's quite interesting and I think some of the dynamic as well is playing out what we're seeing overseas. With European bond markets, specifically within the UK where you've seen the gilt-edged bond market really just get tattooed of late. So I think what you're seeing here is this global phenomenon for higher rates where in the past the treasury market had sort of a built in supporting mechanism due to negative rates abroad. That's no longer the case at this stage of the game.
So I think when we're talking about what we should be doing, what we should be looking at with respect to positioning within the fixed income arena, one thing that I think continues to read loud and clear is that we could still overshoot to the upside. So you don't necessarily want to chase duration here, but are we getting closer to that point where maybe we should start looking at if you were say, short duration to the benchmark in a visible way. Do you start to amend that a little bit? So if you look at a barbell strategy, right, do you begin to start to look to add a little bit so your duration short for the benchmark isn't as visible as it was. It's still being visible, but perhaps not as notable or noteworthy as it was up to this point in time. That's where we're getting at, I think in the bond market. That's going to be the big debate I think for the rest of this year and into 2023.
Thanks Kev. That's great backdrop and a perfect transition as well, because we've been talking about positioning particularly on the fixed income side. How are you positioned on a duration element? And I think with that, let's turn it over to Scott. And Scott, we've made some changes in our overall positioning this quarter, both in the fixed income as we just alluded to, as well as on the equity side. So can you talk a little bit about those changes? And then overall how would you describe our positioning at this time?
So thank you, Joe, and I'm going to steal from Kevin because he didn't say it out loud. There's income back in fixed income again. And so much to his delight and our colleague Rick Harper's delight, we are actually spending a lot of time talking about fixed income, which we haven't done for the last several years. As Kevin alluded to, we are discussing maybe increasing our duration a little bit. We are still underweight the ag, we're still overweight credit, we still like that positioning, but we're talking about much more than we have been for a long time. On the equity side, we believe we're one of the few firms that actually has an explicit allocation of small cap stocks outside the US both in EVA and EM markets. We still like those trades.
They're not really working right now, but historically they added significant value. And if you know Wisdom Tree, you know that we're factor oriented. So we like small caps, we like value, we like quality, we like dividends. So from the equity side, those trades have all worked out very well for us. You can't get completely out of the way of a tsunami market movement, but the things that we tend to allocate to have done better. We can just leave it there. And in light of that, we actually increased our exposure, our explicit exposure to U.S. Small caps over the last couple months because the valuation delta between large caps and small caps is just, it is as wide and as high as it's ever been.
And so if you have a little bit of patience and we're not tactical allocators, if you have a little bit of patience, we think that that small cap tray is going to work out really well for us. So fixed income, there's a lot of things to talk about on the equity side, we like how we're positioned and Joe, you can chime in on that. And the last thing that I'll say is a lot of our incoming calls from advisors these days is, "Hey, what else do you have besides stocks and bonds?" So we're seeing a lot of interest in real assets, in alternatives and those sorts of things that frankly were very much out of favor for a long time but now appear to be coming back into favor.
Yeah. I think that's a great summary. And just hitting on that point of we increased our exposure to U.S. small caps over the course of the third quarter. And I think we get questions about, well what if we're entering a recession? Wouldn't you want to be out of small caps because those are more risky? And I keep alluding back to the tech bubble where you had valuations at such compelling levels in the small cap space that even though you had a downturn in the economy and in the stock market. Small caps and small cap value were actually positive as the NASDAQ was cratering 70 plus percent, because the valuation opportunity really prices in a lot of the negativity beforehand.
And I think you're seeing a lot of that play out again today in the small cap space where you're basically at recessionary levels in small caps and then on a relative basis you're at 20 year discounts of small caps relative to large caps. But of course everything that we do, particularly in the small cap space, has a quality filter on it. So we aren't looking at something like the Russell 2000, which tends to be much more lower quality, but something that we have a lot of conviction in because of the profitability of the names that we have that we're exposed to. So I think that's an important point that I wanted to make on that front. Kevin, anything that you'd add on the duration side?
No, I don't think so. I just think it's an important distinction to make that not still chasing duration, but getting to that point as I mentioned, that maybe you can come in a little bit and reduce some of that short versus the benchmark. The question is, if you look at technical analysis, which is really difficult at this stage of the game because we're at some of the highest levels we've seen in yields for quite some-
Just say it. Just say, Fibonacci.
Yeah, okay. Fibonacci. If you look back and the all time high was right around 5.3% and the next level on that analysis is 414. So that's the concern. Do you overshoot the 4% level here? But it seems as if you believe we're not headed back towards that 530 level, which I really don't think is the expectation at this stage of the game. You're getting closer perhaps to the end than where we were before. But if the bond market has taught us anything this year, it's that you need to be very mindful that you don't want to be a bond market timer here. That you want to be methodical in your approach and look at things from that vantage point rather than trying to jump on the train and take advantage of valuations. Because volatility is still going to be the watchword.
Joe, let me just add, I know we're running up on time here, but let me just add, one of the things that Kevin has talked about a lot is the volatility of the bond market over the past six, seven, eight, nine months. And that's the last thing that people want in their portfolio is volatility in their bond portfolio. So I think prudence, caution, patience are the names, are the words for that aspect.
Exactly. I think we're dipping our toes back into the duration pool, but we're certainly not going off the diving board at this point in time. So thank you both for your comments. And that will do it for this quarter's edition of the Wisdom Tree Model Portfolio update podcast. As always, we highly recommend you check out the Wisdom Tree Model Adoption Center for updates, resources, client tools, et cetera, et cetera, at wisdomtree.com/mac. Thanks again and we'll speak with you next time.
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Nasdaq: A global electronic marketplace for buying and selling securities.
Russell 200: Measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
Fibonacci retracement: A technical analysis tool displaying percentage lines which look at support and resistance levels, potentially signaling short-term price/yield reversals. The concept of retracement suggests that after a period of market movement, prices/yields can retrace a portion of their prior pattern before returning to their original trend.