Portfolio Update: Reducing Risk

Summary

• The Gardner Group is reducing equity and credit risk across our balanced portfolios and moving back into core fixed income
• Macroeconomic risks have increased, and we don’t believe stocks are adequately discounting the risk of an earnings recession
• At the same time, core bond yields have risen materially this year – offering more attractive potential returns and increased downside protection
• These trades will be implemented across The Gardner Group’s Growth, Growth With Income, and Capital Preservation portfolios.

Trade Details

From a macroeconomic perspective, U.S. core inflation remains stubbornly high. In response, the Federal Reserve continues to implement aggressive monetary policy tightening and is unlikely to stop until there is clear and consistent evidence that inflation is falling towards their 2% target. This will take a while and there is a good chance the Fed will tighten too much.

As such, we see an increasingly high risk of an economic and earnings recession over a shorter-term (12-month) horizon. This is now our shorter-term base case expectation.

While equity markets have sold off over the past several weeks, we believe there is additional downside risk. At current levels, our analysis indicates that stocks have not adequately discounted the risk of a potential macroeconomic and earnings recession. In the meantime, core bond yields have risen materially this year (the Agg Bond Index is yielding above 4%), to the point where equities are no longer relatively cheap versus bonds.

When we weigh the shorter-term equity market downside risks and our medium-term (five-year) return expectations across the wide range of scenarios we believe are reasonably probable, we think it makes sense to tactically reduce equity and credit risk and increase the defensiveness of our portfolios.

Therefore, we are reducing global stocks by anywhere from 2% to 5% across the balanced portfolios. We are also eliminating the tactical overweight to floating-rate loans. The proceeds will be reallocated into core investment grade bonds to increase the recessionary ballast of the portfolios and provide additional downside protection.

The timing of our decision to sell loans is driven primarily by portfolio-construction considerations. Loans have been one of the best-performing fixed-income asset classes this year and we believe the floating-rate loan space is generally healthy. However, considering the improved yields for core bonds and additional downside protection during a recession, we don’t think we’re giving up too much upside rotating out of loans into core bonds.

More details will be available in The Gardner Group’s Third-Quarter Investment Thoughts coming out in October.