Quad 2 to Quad 4 Portfolio Adjustments – New 401k Portfolio Allocation
What is it?
We value the insight we get from Hedgeye. Hedgeye is a research company we use to get a perspective about macroeconomic developments. To simplify their process, they assign a Quad number to current and anticipated changes in the economy.
A Quad 2 environment states that growth and inflation are rising while Quad 4 states that they are falling on a year over year basis. Based on those assumptions, we then set new targets for our investment allocations by tilting towards asset classes that may be favored in this new environment.
In their view the economy is moving from a QUAD 2 to a QUAD 4 environment in the first quarter of 2022.*
Why does it matter?
Volatility has been rising over the last few weeks. Some of the sectors that have been doing well over the last couple of years, like technology and consumer discretionary, have been the most largely hit.
As we are studying market movement, we will be shifting some of our allocation in equity to defensive sectors that may be less susceptible to a slowing economy (QUAD 4), like consumer staples, utilities, and healthcare. We also plan on adding to defensive diversifiers like treasuries and gold.
Furthermore, we are changing the 401k Portfolio Allocation from 2 to 3 as seen below.
Did the Inflation Balloon Pop?
What is it?
“Even as the government reported the fastest economic growth in nearly 40 years, the air that inflated the economy in 2020 and 2021 is escaping . . . The income support given to workers, businesses, and local governments has been withdrawn.”**
“You want a car but you can’t get one because Taiwan can’t make or deliver enough computer chips to satisfy the demand. It’s going to take time to build the capacity and reknit the supply chains, but delayed gratification is a lost art. We’ve become accustomed to getting anything we want at that exact instant we desire it. So we pay whatever it costs to get it now.”**
“Incomes are now dropping like a stone. Most of the support Congress provided last year and the year before has been withdrawn. Real disposable incomes (adjusted for purchasing power) fell at a 5.8% annual pace in the fourth quarter . . .”**
Why does it matter?
Economic conditions are changing, and looking at the variables above there is less optimism now than when investors sent stocks to record highs not long ago.
“Where does that leave the economy? Powell says that the economy is strong and that everyone can tolerate the Fed’s anti-inflation medicine. But I think that’s bluster. Underneath the surface, the foundation looks weak. “**
In our opinion, we believe that the Federal Reserve is late to attempt to control inflation. Not so long ago the Feds message was that inflation was transitory as the supply chain issue was worsening. Here’s a link to an article written in August about the Fed’s position at the time.***
We are concerned that a now eager Jerome Powell may hike interest rates too late and too high which may push the economy into a recession.
Flattening Yield Curve
What is it?
“The flat yield curve is a yield curve in which there is little difference between short-term and long-term rates for bonds of the same credit quality.”****
A normal yield curve shows that the interest rate market should value the short-term yield lower than the long-term yield. This is due to the fact that there are increasing risks when purchasing longer-term bonds as more things can go wrong in a longer period of time. Normally, it looks something like this:*****
Why does it matter?
As the Federal Reserve prepares to raise the Fed Fund rate, which is a 3-month interest rate, it affects short-term Treasury rates that fluctuate on the bond market as it follows the Fed Funds rate. Furthermore, if the bond market is expecting lower economic growth, it may force long-term yields to fall. A combination of those two phenomena may cause a flattening yield curve.
As the yield curve flattens, it is possible that it inverts which means that short-term interest rates become higher than long-term interest rates.
The chart below displays the difference between the 10-year Treasury yield and the 2-year Treasury yield. A downward sloping line shows a flattening curve.
Moreover, an inverted yield curve occurs when short-term interest rates are higher than long-term interest rates. This is displayed in the chart above by the blue crossing below the black line.
Historically, an inverted yield curve has been an accurate warning sign that the economy may face a recession. Everytime over the last 36 years the yield curve inverted, a recession shortly followed (gray shaded area) including the short-period the yield curve inverted in 2019.
Therefore, we think it is important to follow how the Federal Reserve acts in their attempt to control inflation and how the yield curve evolves during that time as we manage downside risk within our clients’ portfolios.
Other articles I found interesting this week:
Current 401(k) portfolio
Our last portfolio reallocation: 1/31/2022.
Want more information?
The weekly market update provides a window into the process we use in our investment management process. At Breakaway, we believe markets are always changing and require a nimble yet data-oriented approach.
Our process attempts to identify trends and momentum in the financial markets. With that information, we align our clients’ portfolio accordingly in the hope to help our clients accomplish their life goals while attempting to lower the risk of a large drop in their portfolio.
*Hedgeye: “McCullough: Powell has to walk back hike expectations” 1/25/2022 https://app.hedgeye.com/insights/111074-mccullough-powell-has-to-walk-back-hike-expectations?type=macro%2Chedgeye-tv
**Rex Nutting. “Opinion: Hidden in the GDP report is proof that the air is already coming out of the economy”. 1/27/2022. https://www.marketwatch.com/story/hidden-in-the-gdp-report-is-proof-that-the-air-is-already-coming-out-of-the-economy-11643310318
***Ann Saphir: “Why Fed’s Powell Still Thinks High Inflation is “Temporary”. https://www.reuters.com/business/why-fed-chair-powell-still-thinks-high-inflation-is-temporary-2021-08-27/
****James Chen: “Flat Yield Curve” 3/23/2020 Investopedia https://www.investopedia.com/terms/f/flatyieldcurve.asp
*****Adam Hayes: “Yield Curve” 1/13/2022 Investopedia https://www.investopedia.com/terms/y/yieldcurve.asp#:~:text=A%20yield%20curve%20is%20a,rate%20changes%20and%20economic%20activity.
***** * FRED Economic Data: “10-year Treasury Constant Maturity Minus 2-year Treasury Constant Maturity. https://fred.stlouisfed.org/series/T10Y2Y#0
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