Portfolio Shield – May 2023

We are pleased to see the equity allocation has been performing extremely well this year and that the changes in the bond allocation are having a positive contribution to the returns.

For the past year, stocks have trended sideways which signifies a lack of market direction and uncertainty. The lack of significant positive or negative catalysts has left investors uneasy as they are unsure if stocks will break higher or lower out of this range.

Investors are now looking to the Federal Reserve where they are hoping the stock market will rally once the Federal Reserve gives a clear indication they have reached terminal rates.

While stocks tend to rally following the Federal Reserve pausing rates, there is no fixed frequency or pattern. Whether stocks rally or not following a decision by the Federal Reserve to pause in a rate-hiking cycle has more to do with investor confidence in the markets and the economy.

For the bond market, it is generally perceived to be bullish for bond prices when the Federal Reserve pauses or reaches the terminal rate. The 2-10s yield curve often predicts the Federal Reserve will soon reach the terminal rate once the yield curve begins to steepen, particularly following an inversion.

While the yield curve does a good job of predicting future growth and inflation expectations, the yield curve does not influence the Federal Reserve’s decision to adjust the policy rate. Instead, the Federal Reserve’s decision to adjust the federal funds rate is based on a range of economic indicators, such as inflation, unemployment, and GDP growth, as well as other factors such as geopolitical events and financial market conditions.

The direction of interest rates after the Federal Reserve pauses rate hikes depends on a range of factors, such as economic growth, inflation, and market conditions. In some cases, interest rates may continue to rise despite the Fed’s decision to pause rate hikes if the economy is growing and inflation is a concern. Conversely, if the economy is weak, and there is little inflationary pressure, interest rates may fall even if the Fed has signaled it will pause rate hikes.

An inverted yield curve does signal the increased risk of an economic downturn in the future, which typically causes investors to seek the safety of government bonds in response to increased uncertainty and market volatility.

Since last month, the 2-10s yield curve has begun to steepen, as two-year Treasury yields are starting to decline at a faster rate than 10-year Treasury yields. This type of yield curve movement is often associated with a bearish outlook on the economy, as investors may be concerned about the potential for slower growth or rising inflation.

Given all of the factors, Jeff and I continue to maintain that stocks and bonds can rally in the near future.

Portfolio Shield™ is currently positioned to take advantage of a rally in both stocks and bonds however, it has decided to reduce its equity exposure by adding long-term bonds to the strategy starting this month.

With the yield curve steepening, as yields decline, the decision by the strategy to hedge enables the opportunity for an upside return should bond prices continue to rally, while attempting to reduce the risk of a decline in stock prices should the equity market break lower out of this one-year range.

Portfolio Shield™ is not a timing strategy due to the look-back period associated with in the construction of its formulas and may not offer any immediate value to the strategy. Over the next several months, Jeff and I believe the addition of the long-term bond hedge will be of benefit to the strategy as declining interest rates as predicted by the steepening yield curve will offer the potential for excess returns over the broad equity market.

Looking forward, our outlook on the global economy:

Recent updates to a broad range of macroeconomic data show the economy still edging closer to the expected recession, though not yet in its final stage where the downside accelerates across a wide front and in almost every category. Consumer spending in the US, for example, is still rising but even in nominal terms the rate of increase has slowed down to minimal levels.

In other places such as Germany, a country further along in the recession process, nominal consumer spending there has been retreating for several months. Retail trade in March, the latest monthly estimate, declined more sharply suggesting the downturn there may have begun to speed up.

German GDP for Q4 2022 showed a sharp decline with no recovery or rebound in Q1 2023. With consumer spending going lower despite increases in consumer as well as commercial confidence, the downward pressures internally combined with worsening conditions externally mean the likeliest outcome continues to be the same one priced into market curves (Germany’s unprecedented inversion).

As is China’s reopening which is proving to be – as expected – a thorough disappointment, coming up short in every aspect. GDP was only 4.5% y/y in Q1, and though widely celebrated in the mainstream as some achievement it was, in fact, insufficiently low. Retail sales went up mainly due to base effects, fixed asset investment actually fell in March, and industrial output was negligible as the global recession continues to produce more of a negative effect than reopening in China contributing positively.

The ongoing banking shock, another prediction baked into curve inversions, is almost certainly to speed up the downturn and push the recession into its fullest phase. The Federal Reserve hiked rates likely for the last time and market bets have grown for rate cuts to begin by July and maybe even at the next meeting in June. This is not just from the bank crisis, though that is certainly one key factor, but also the very likely fallout from it as credit (and money) availability dries up, pushing the economy headlong into the expected deflationary condition.

Market curves have consistently priced an eventual rapid reduction in worldwide interest rates due to severe monetary, financial, and economic difficulties. Everything that has happened in recent months has been entirely consistent with those projections. The pace of deflationary money and financial turmoil has already materially picked up. As those continue, the same is in store for the global economy.

Portfolio Shield™ reduced its position in SPY & QQQ and added a position in TLT across all models for May.

Portfolio Shield™ met both of its criteria to initiate the hedging of the equity positions by reducing its equity exposure to add a position in long-term bonds. In addition to the original criteria triggering, the 2-10s yield curve also has to be rising or steepening to initiate the bond hedge. While the 2-10s yield curve is potentially at the beginning of a steepening phase, it is still rising.

Looking ahead, the strategy will likely remain hedged with long-term bonds for June, July, and August based on current market conditions.

Please be aware that the rebalancing software is unable to bring smaller balance accounts in line with the model and may not have the the same or any of the long-term bond positions as larger balance accounts.

We are considering adding additional equity funds to the allocation using the same one-month momentum screen from Momentum Timer Pro™ as we have done with the bond allocation where the funds are only added for the month when their one-month momentum screen is positive.

One of the challenges money managers face is trying to find funds that are not highly correlated with the major equity indices. We have identified three ETFs that are suitable for consideration as they also have enough liquidity, in terms of trading volume, for the strategy.

The three equity funds we are considering, which have a low or negative correlation to the S&P 500 and Nasdaq-100, and each other, are iShares MSCI Emerging Markets ETF (EEM), VanEck Gold Miners ETF (GDX), and Energy Select Sector SPDR® ETF (XLE).

These funds may be added at any future rebalance.

Research continues as we look to determine the best way to add these funds to the models.

These changes we are considering to the equity allocation will move Portfolio Shield™ more towards a true monthly rotational momentum strategy.

The Growth, Balanced, Income, and Conservative models have removed AGG from the models and increased its position in HYG and IEF for the bond allocation for May.

Based on the current one-month momentum screen applied to the bond allocation, the strategy recommends holding HYG and IEF for the month.

Overall, we are pleased to see the implementation of the one-month momentum screen to the bond allocation had a positive impact on the returns and risk of the bond allocation.

Based on last month’s performance and the greater return potential from the combination of HYG and IEF, we have removed AGG from the strategy.

If the one-month momentum screen for both HYG and IEF is negative, the bond allocation will add SHY iShares 1-3 year Treasury Bond ETF in an attempt to control downside risk from declining bond prices.

We will continue to run the additional one-month momentum screen, from the Momentum Timer Pro™ report for HYG and IEF and make adjustments to the bond allocation each month for the Growth, Balanced, Income, and Conservative models based on its recommendations.

As a reminder, all strategies are rebalanced on the first trading day of each month and at that time, any new monies are invested according to the model strategy you are in.

For those who want to change between strategies, changes will occur at the next rebalance.

Zero balance accounts that have had a zero balance for six months or more will be closed and where applicable, the advisory agreement terminated. There is only a 0.3% allocation to cash in each model. Due to a misreporting between Morningstar® and the ETF providers, the Asset Allocation box on the fact sheets may show a higher cash position than is actually in the model.

If you have any questions or would like to change which Portfolio Shield™ strategy you are invested in, please let me know.

The latest Morningstar® Investment Detail Reports for the Portfolio Shield™ family are available on the Portfolio Shield™ website.

Thank you for your continued trust in allowing us to manage your money with Portfolio Shield™.

Thank you,

Steven Van Metre, CFP®