Q1 Commentary: Staying Level-Headed Through the Madness

By Nick Fisher, Portfolio Manager

As we created our brackets in time for NCAA March Madness, pruned the vineyard and cleaned up our yards after the big windstorm, it was time for our quarterly investment committee meeting.

During this meeting we evaluate the performance of our holdings, have a rigorous discussion of our investment thesis, and decide whether or not anything during the quarter has materially changed that thesis.

Given the high valuations we are currently experiencing in the US stock market, we are particularly interested in evaluating risk scenarios during this process, as they are likely to pose very different outcomes for the investments we own.

Occasionally, as conditions dictate, we make a change. This quarter we have a significant change to report. Although unremarkably sexy, we thought it important to report.

 

Stable or Falling Dollar

What has become more apparent is the idea of increased inflation expectations globally due to: 1) stable commodity prices, 2) a rebound in economic activity (especially in emerging markets), 3) healthy business sentiment (at least for now), and 4) steady wages.

With the likelihood of a recession nowhere in sight (although economic data is mixed), the likelihood of the dollar continuing to rise seems low and therefore any surprise is more likely to the downside.

According to Jeff Gundlach (from Doubleline), the rising dollar trade has become one of the most overcrowded trades out there. At Pilot Wealth, we tend to think a bit contrarian under these conditions, and it causes us to pause.

Indeed, Goldman Sachs’ economist Jeff Prandl recently wrote: “The Trump administration’s preference for a weaker greenback [US dollar], an uptick in global growth -- tempering the outperformance of the U.S. economy -- and the Federal Reserve’s less-hawkish-than-expected posture all suggest the greenback [US dollar] is unlikely to stage an advance anytime soon.”

In walking through the different scenarios we currently see, the dollar no longer offers enough benefit to portfolios in nearly all scenarios. To be clear, this change in stance is not to say that we are excited about the prospects of US stocks.

We are not abandoning our tenet to manage risk when prospective returns are less than satisfactory. We will simply continue the transition that we have discussed over the previous quarters: Transitioning into the areas providing the best prospective returns due to current valuations.

We have telegraphed our intention in this regard to add inflation resistant equities to the portfolio. These include additional exposure to commodity producers and emerging markets. I would add shorter duration investment grade bonds and treasury inflation protected bonds (also known as TIPs) to the mix.

TIPs have become a relatively more attractive opportunity when balanced with a smaller cash position. This will give us dry powder that is easily liquidated, but doesn’t lose purchasing power should the dollar surprise to the downside.

Valuations in the US remain high by historical standards and the risk of significant volatility remains. To reiterate, our strategy is one of balance, taking some risk on one end and very little risk on the other end. We welcome the eventual bumps in volatility, which allows us to take action when appropriate.