Confluence Investment Management: Asset Allocation Q2 2024

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HFA Staff
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The Confluence asset allocation process is centered upon risk management. Our asset allocation strategies offer a broad spectrum of risk profiles, ranging from a relatively conservative posture in Income (purple) to a risk-accepting profile in Aggressive Growth (orange). The volatilities of the primary asset classes of cash, bonds, and stocks are illustrated by the black bars for reference in the accompanying chart.

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Over market and economic cycles, the level of risk among asset classes naturally changes. As the cycles and risks unfold, we aim to guide each strategy within its respective volatility ceiling. Our evaluation of the economy, monetary and fiscal policies, interest rates, regulation, valuations, and other investment variables in a forward-looking context informs our asset allocation through adaptive diversification. Although we seek return opportunities, we do so within risk constraints scaled for each strategy.

The Confluence Asset Allocation strategies are structured to offer differing risk profiles. The more conservative portfolios take on less volatility in exchange for more muted, though typically steadier, returns. The more aggressive portfolios accept higher volatility in pursuit of potentially higher returns.

The variance of returns among asset classes from quarter-to-quarter can change significantly, as the table below indicates. Over the past three years, we have experienced a highly volatile stock market, with several quarters registering sizable gains and others with dramatic declines. Historically, stocks and bonds tend to be negatively correlated; however, correlations have been positive more recently across the asset classes. Last quarter saw a return of somewhat more traditional correlations between asset classes, with performance of longer-duration bonds and stocks diverging. We expect volatility to remain elevated due to various factors.

Portfolio and Asset Class Commentary

The volatilities and returns of 12 sub-asset classes over the past three years are illustrated on the above chart as are the volatilities and returns for each of the five Confluence Asset Allocation strategies represented by the colored vertical bars. Note that the Confluence strategies exhibit a range of returns that denote gross-of-fee returns on the top end of each bar with the bottom of the bar representing net returns which assume an industry-designated maximum fee of 3%.

Over the past three years, in general, risk assets have delivered the highest returns, although they have also delivered the most substantial levels of volatility. This period has been characterized by several prevailing market themes, including the fluctuation of inflation, shifts in monetary policy (both expansionary and restrictive), a trend toward deglobalization, mounting global geopolitical tensions, and instances of banking system failures, among others. Commodities have delivered the highest return for this three-year period, but they have also exhibited a high level of volatility. REITs have experienced the most volatility, yet with a meager return profile. During this time frame, an intriguing development has been the notable shift in correlations between bonds and equities, with these two major asset classes displaying a more positively correlated relationship. This shift has diminished the diversification advantages traditionally associated with holding both types of assets. While bonds typically act as stabilizing forces in turbulent markets for risk assets, this scenario has not held true in an environment marked by elevated inflation levels, as evidenced by the heightened market volatility and negative returns for investment-grade bonds.

The Confluence Asset Allocation strategies depicted by the colored bars have generally generated positive returns over the past three years, both in terms of gross- and net-of-fees. The exception is the Income strategy, which had positive gross-offees returns, but generated negative net-of-fees returns when the maximum 3% fee is applied. This can be explained by the high bond allocation, which is appropriate for the strategy, given the negative returns of investment-grade bonds. In general, the strategies with greater exposures to stocks and commodities produced higher volatility and returns. The single exception has been the lower relative returns of Aggressive Growth, in which the detractor has been its exposure to emerging markets.

When we construct the Asset Allocation strategies, each strategy is held to a distinct and unchanging volatility governor. Thus, bonds are used more broadly than stocks in strategies with lower volatility ceilings, such as Income, as compared to the highest volatility ceiling of Aggressive Growth. While this may seem intuitive, it also explains the different exposures to sub-asset classes for each strategy. Sub-asset classes with greater volatility are more likely to be employed in strategies with higher volatility ceilings. One example is small cap stocks, which are more liberally employed in Growth and Aggressive Growth. Though lower market capitalizations have the potential to offer higher returns, they carry elevated levels of risk.

Anticipating a generally good, but volatile, economic environment, we are balancing equity exposure with bond allocations in the risk-constrained portfolios. We regularly assess and review a wide array of data affecting the macroeconomic environment including inflation pressures, sentiment, growth prospects, valuations, credit, and exchange rates, among other elements. As conditions change, we will adjust the exposures in each strategy to remain within the designated risk parameters.

Economic Viewpoints

The US presidential election season is starting to take over the airwaves and usually brings concern over the general direction of politics and the economy. Given that this important part of the democratic process involves intense emotions among voters, one might expect the election’s outcome to significantly influence market sentiment and performance. Yet, historical data contradicts this statement. Instead, markets have typically shown a tendency to remain flat in the first half of the election year and rally in the months just before the election. Importantly, markets are good at discounting expected outcomes, but they do not handle uncertainty and rapid change well. Congress is expected to remain divided with slim margins, thus major changes in overall legislative action is unlikely.

We will focus more on the election in the coming quarters, but for now, we continue to closely watch inflation, labor markets, and fundamental valuations of each asset class. Inflation remains front of mind as the Federal Reserve’s communication moves from “transitory” to “speed bump” inflation. As we’ve written before, we see structural forces positioned to keep inflation higher than pre-pandemic levels. Factors contributing to higher inflation include supply chain rearrangement with reshoring and friend-shoring of industrial capacity, elevated geopolitical tensions, and developed world aging demographics.

Labor markets have remained surprisingly strong with the unemployment rate currently at 3.8%. While wage growth rate has slowed, the most recent median wage level grew 4.7% year-over-year. Technological advancements, most notably AI, could change labor’s significance, but we believe there will be minimal impact during our forecast period. On the other hand, the aging workforce and uncertainty of immigration numbers will have more impact on whether the labor markets remain tight.

Inflation, labor markets, and economic growth are important indicators in their own right, but their combined effect is amplified by the monetary policy response. As higher-thanexpected inflation and the strong labor market continues, our expectation is for the fed funds rate to stay higher for longer. While our forecast does not include policy tightening, we believe that the easing timeline and magnitude have been delayed. We don’t expect the FOMC to lower rates to the levels seen in recent easing cycles. We also expect the Fed to hold policy steady through the election cycle.

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The post above is drafted by the collaboration of the Hedge Fund Alpha Team.