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Volume 11, Edition 18 | June 6 – June 10, 2022

A Case for Diversification

Doug Walters, CFA
Market weakness is an opportune time to reflect on the merits of an intelligently diversified portfolio.

Contributed by Doug Walters, Max Berkovich, David Lemire

We are not quite halfway through the year, but it has been an interesting one for portfolios, and we thought it worth taking some time to highlight some takeaways. Few segments of investable markets are not in the red year-to-date, so investors had nowhere to hide (not that they should be hiding). We see this moment as an opportunity to illustrate the merits of discipline with an evidence-based diversified portfolio.

There is no denying it has been a tough year for investors. But some are probably feeling the pain more acute than others. Given the incredible performance of mega-cap tech in recent years, it would have been easy to believe them invincible to any market correction. Yet 2022 has revealed them to be mortal, and we can see it in the performance gap between the Russell 1000 Growth and Value indices.

  • Russell 1000 Growth (IWF): -26.7%
  • Russell 1000 Value (IWD): – 9.3%

Some individual high-profile names have fared even more poorly.

  • Apple (AAPL): -22.6
  • Alphabet (GOOGL): -23.3%
  • Microsoft (MSFT): -24.4%
  • Amazon (AMZN): -34.2%
  • Meta Platforms (META): -47.8%
  • Netflix (NFLX): -69.6%

And those that have been lured into the shiny objects, like cryptocurrencies, are likely experiencing even greater losses. So what is the lesson? Intelligent diversification pays off. Specifically:

  • Owning individual stocks can add unnecessary concentration risk to a portfolio. Even the greatest companies in the world can underperform dramatically.
  • While many bonds are down as well, they have held up better and therefore still provide a useful rebalancing role.
  • Gold (GLDM) has proved once again to be a good store of value in difficult times (up 2.3% in 2022).
  • You need not own the whole market to diversify. Proven, persistent factors (quality, value, momentum, size, minimum volatility) at the core of a portfolio provide diversification and the ability to outperform. Multifactor funds are generally having a good year.

Declining markets are not fun, but if you have an intelligently diversified portfolio, you are well-placed to get through this recent weakness and benefit from the next upswing.

Headline of the Week

Stocks all but gave up the gains of the past two weeks while bond yields rose again. The European Central Bank made some noise on Thursday, announcing the end of quantitative easing in July and a 25bps rate increase. But the inflation number in the US on Friday is our headline of the week.

Stubbornly High

The Consumer Price Index (a measure of inflation) came out on Friday and proved higher than expected.

  • The consensus expected CPI inflation to ease from an annual rate of 8.3% in April to 8.2% in May.
  • Instead, CPI rose to 8.6%.
  • Core CPI (ex-food and energy) of 6.0% was actually down from the previous month’s 6.2% print.

Stubborn inflation means The Fed will need to continue to find ways (primarily through higher rates and asset sales) to take some of the heat out of the price increases. In the short run, that can be a headwind for stocks. But these expectations are priced in, so the trajectory of stocks from here is far from certain (as is always the case).

The Week Ahead

Next week has everyone thinking about interest rates. Not only is the Federal Reserve making a rate decision, but the Bank of England and the Bank of Japan also have rate decisions.

Battle of the Birds

The Federal Open Market Committee meets next week, with a rate decision announcement mid-week.

  • Half a percent hike is all but guaranteed next week, so the excitement will focus on everything else the central bank can do or say.
  • Friday’s hot inflation number may change the calculus over the weekend.
  • Some members like Vice Chair Brainard have hinted they need major deceleration in inflation to deviate from the hawkish path for rates.
  • While others like Atlanta Fed president Bostic are supporting a pause from hikes in September, this he hopes would allow for the rate hikes to work and prevent over-tightening monetary policy.
  • So far, the labor market has not cooled off significantly, but the Federal Reserve has both a stable price and full employment mandate to focus on.
  • The all-important “dot plots” will give markets a view of the path the Federal Reserve is expecting going forward on rates.
  • A reminder there is no meeting of the Fed in August.

Different paths

Neither the Bank of Japan nor the Bank of England is expected to surprise markets, but words, not actions, will matter.

  • The Bank of England is expected to hike rates by ¼ of a percent, which would satisfy the need to do something about multi-decade high inflation without pushing the economy into a recession.
  • Japan is not expected to move rates and will continue to diverge from other major central banks that are raising rates and shrinking balance sheets.
  • Japan needs to keep an eye on exchange rates as the U.S. Dollar/Yen exchange rate is hitting a two-decade high.
  • Another Central Bank with a rate decision next week is The Swiss National Bank, whose current rate is negative.
  • The Swiss are not expected to hike rates right now but may not be able to resist joining the club and try to get to positive rates in short order.

Home Economics

Economic releases mostly come too late to influence what the Federal Reserve will do (or rather say), but Retail Sales, Industrial Production, Producer Price Index, Import Price Index, Mortgage Applications and Housing Starts can all catch headlines.

  • Higher interest rates have started to put a chill on the housing market. The question is, how much?
  • Housing starts are expected to be up in May slightly, while building permits are expected to decline.
  • Retail sales are expected to expand for May, but the rebalancing of what the consumer spends their money on will be important.
  • Import Price Index and Producer Price Index will both provide a read on inflation. However, Friday’s Consumer Price Index stole their thunder.

Google it!

After Amazon.com (AMZN) split its stock 20 for 1 this past week, Google’s parent Alphabet Inc. (GOOG, GOOGL) will do the same on Wednesday.

  • The stock doesn’t get cheaper, more shares are created, but lower stock prices tend to make buying a few shares more affordable for the little guy.

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