Photo credit: The New York Times

INVESTMENT ENVIRONMENT¹

The beginning of the Federal Reserve (Fed) rate cutting cycle made for a cracker of a quarter for most investment classes. Global equities markets (MSCI ACWI IMI)^^d turned in a total return of 6.8%. As in the second quarter, emerging markets (MSCI EM)^c once again had the strongest performance among equity regions, up 8.7% on the back of major fiscal and monetary announcements by the Chinese government. Fixed income also performed well—US bonds (Bloomberg US Aggregate Index)^e were up an impressive 5.2%.

12-month total returns from both equities and fixed income were also spectacular. Global equities were up 31%, led by US equities (S&P 500),^a while the US bond market pushed into double digits, +11.6%.

With both the jobs picture and inflation softening, the Fed chose begin lowering its key overnight borrowing rate with a 50 basis point cut, bringing the new target range to 4.75%-5%. Rates fell throughout the yield curve, especially at the shorter end. The yield curve, as measured by the 2- and 10-year Treasuries, is no longer inverted as it had been for the previous 26 months. As we have mentioned in the past, inverted yield curves had been a reliable indicator of past recessions, as shown in the chart above where the yield curve is inverted when the plot goes negative, and periods of recession are shown by the shaded areas. It should be noted that most recessions have not begun until after the yield curve returns positive, so it should be interesting to see if this time will prove to be the exception to the rule as stock market valuations seem to imply.

However, right now the US economy continues to show few signs of a coming recession. September’s job report surprised strongly to the upside with 254k new jobs created, 114k more than expected by economists.

The unemployment rate fell to 4.1% and average hourly earnings rose 4.0% year-on-year, well ahead of inflation. And speaking of inflation, it continues to tick down, however slowly. September’s core consumer price index (CPI, excluding food & energy prices) was 3.3% (see chart to right). The Fed is trying to get inflation down to 2%, but this is for core personal consumption expenditures (PCE). The most recent core PCE reading was 2.7% in August, so still running hot. Given the rosy employment picture and recent sticky inflation readings, we think that the Fed rate-cutting cycle may be shallower than many investors had initially hoped for in when the Fed made its large 50 basis point rate cut mid-September.

In China, the government finally responded to the deterioration of its economy caused by a real estate crisis and a hangover from its aggressive Covid containment strategy. Government pledged more fiscal and monetary support for the economy and more action to stabilize the property sector. This triggering a 21% increase in its equity market in the third quarter, as measured by the iShares MSCI China (MCHI) exchange traded fund.²

The situation in the Middle East deteriorated during and after the third quarter. Israel escalated the conflict by assassinating Ismail Haniyeh, Hama’s Qatar-based political leader, while in Tehran to attend the inauguration ceremony of Iranian President Masoud Pezeshkian in late July. Three weeks later Israel detonated pagers and walkie-talkies of Hezbollah members in Lebanon, killing dozens and wounding thousands. Days later, Israel launched a series of air strikes against Hezbollah leadership, killing its long-time leader Hassan Nasrallah and several of his successors, and sending ground troops into southern Lebanon.

Iran responded to these attacks against its proxies by firing approximately 180 ballistic missiles at Israel on 1 October, some of which got past Israeli and US defenses to strike Israel military installations. Israel is currently planning a retaliatory strike against Iran, which US officials believe will include strikes against Iranian military and energy infrastructure. Iran has threatened to strike any Arab states that aid Israel in its retaliatory strike, including allowing Israeli warplanes to fly over its airspace. With fears growing over the possible reduction in energy supplies coming out of the Middle East and rising optimism that an improving Chinese economy will increase energy demand, the price of West Texas Intermediate (WTI) crude increased about 12% between 26 September and the time of this writing (11 October).

PERFORMANCE DISCUSSION

Third Quarter
AlphaGlider strategies closely tracked the strong performance of their respective benchmarks during the third quarter—with our more aggressive strategies doing slightly better than their benchmarks and our less aggressive strategies doing slightly worse. Our overall positioning within equities helped our relative performance, while the makeup of our fixed income investments served as a relative drag.

Our strategies were well positioned to take advantage of the strength from foreign equity markets during the quarter, particularly those in China, and “China-adjacent” markets like Singapore. And while the US equity market lagged overseas markets during the quarter, the bulk of our US equities performed inline with overseas markets thanks to our preference for value, quality, and smaller capitalization companies. We also benefited from a large exposure to US utilities which enjoyed the tailwinds of lower interest rates and rising electricity demand from data centers.

On the other hand, our preference for shorter duration fixed income investments (4.5-5 years vs our benchmark’s 6 years) was not well suited to the new environment of Fed rate cuts. But one bright spot among our fixed income positions was our emerging market sovereign bonds which nearly matched the return of our strongly performing emerging market equities.

Our ESG strategies outperformed their respective Core strategies as fossil fuel companies struggled during the quarter. Our more aggressive ESG strategies also benefited from their position in clean energy companies which rebounded in the third quarter after a difficult stretch of performance.

One notable fact is that all 28 funds² used by our Core and ESG strategies were in positive performance territory during the third quarter.

Last 12 Months
AlphaGlider strategies performed well in absolute terms over the trailing 12 month period, but lagged their respective benchmarks by approximately 15%.

Unlike with the third quarter, our strategies’ overweighting of overseas equities and US value, quality, and small cap equities, and underweighting of US growth and technology equities hurt relative performance over the last year. Another drag on our strategies’ 12-month relative performance was the short overall duration in our fixed income investments, as was the case in the third quarter.

AlphaGlider strategies benefited from that their large exposure to US utilities, and from non-consensus holdings such as emerging market sovereign bonds and market neutral equities.³

AlphaGlider’s ESG strategies outperformed their respective Core strategies over the last 12 month due to their inherent underweight exposure to fossil fuel and overweight exposure to US technology. Unlike in the third quarter, the clean energy equities held by our more aggressive ESG strategies hurt their relative performance.

LOOKING FORWARD

We made several changes to AlphaGlider strategies since our last CIO Commentary. The first change was to cut some of our alternative investments³ in exchange for more exposure to non-large cap US equities. We had originally crowded into the alternatives space when bond yields had crashed, leaving fixed income unattractive. When bond yields began to rebound in 2023, we started shifting back into fixed income—but had not yet trimmed our oversized alternatives holdings until this past quarter.

The first alternative investment we trimmed was our market neutral equity fund,² taking it down to a 1.5% position across all of our strategies. This fund has matching long and short positions within all sectors and market cap sizes of the US market, leaving it with zero net exposure to the overall equity market, individual industries, and market cap sizes. As such, we saw this fund as an attractive alternative to cash when cash and short-term bonds were paying close to nothing. Now that rates are higher, the opportunity costs of being out of cash and short-term bonds to fund this position have risen substantially. The fund increased about 16% on a total return basis since we added it in early 2022, well ahead of cash.

We also trimmed our international commercial real estate fund to a 1% position across all strategies, except for our Conservative (AG-C) strategy in which it went to zero. The fund had suffered mightily from the Covid-induced work-from-home trend as well as from the strong dollar. We are concerned that the US dollar may continue to remain strong, or strengthen further, especially if Trump wins in November and implements his campaign pledge to aggressively raise tariffs and reduce immigration.

We put the proceeds of these two sales into a mid-cap US fund. This reduced the underweighting we have to US equities to around 30%, and further diversifies our US equity exposure away from large cap growth companies that we still find expensive.

A more recent change we made to AlphaGlider strategies was to increase the resilience of our strategies to the possibility of higher than expected inflation over the coming years. Exiting the quarter, the bond market was pricing in only 2.1% average annual inflation over the next five years, a number we find to be low given the current environment.

First off, 2.1% annual inflation is a relatively low bar. Over at the last 40 years, a period in which global inflation was pressured downward by the end of the Cold War and China becoming the factory of the world, US inflation ran below 2.1% for only one-third of the time. This is shown in the chart on the following page.

Second, the geopolitical situation may be in its worst state since the Cold War, and has the potential to trigger new bouts of inflation. We saw global energy prices spike when Europe was forced to wean itself off Russian oil and gas after Russia invaded Ukraine in 2022. Now we are seeing energy prices spike again this month with the escalation in the conflict between Israel and Iran. Israel has vowed to retaliate against Iran for firing approximately 180 ballistic missiles at it on 1 October—with Iran’s oil infrastructure being a potential target as we mentioned early. But more consequential than energy price spikes is the rise in protectionism and isolationism globally—threatening to raise prices by lowering competition. The clearest near-term threat to global trade comes from the US where Former President Donald Trump is running for president on an economic platform of 60% tariffs on Chinese imports and 10-20% tariffs on all other imports. If enacted, these tariffs would undoubtedly trigger retaliatory tariffs on most US exports.

Third, regardless of which US presidential candidate is victorious in November, the next US administration appears poised to push inflationary policies. Vice President Kamala Harris is campaigning on creating an “opportunity economy”—expansive fiscal policies only partially funded by increased taxes on corporations (from 21% to 28%) and high earners (39.6% top tax bracket from 37%, and a lower income threshold). These policies include extending the 2017 Trump tax cuts (TCJA) to households making less than $400k/yr, expanding the child tax credit and early child education, giving $25k grants to first-time home buyers (surely to put upward pressure on home prices), rolling long-term home care into Medicare, extending and expanding Obamacare subsidies, and increasing the allowable tax deduction on small business startup expenses tenfold (from $5k to $50k). The nonpartisan Committee for a Responsible Federal Budget (CRFB) estimates that Harris’s plan would increase the US debt (currently at $35.7 trillion) by $3.5 trillion above levels projected under current law over the next 10 years in a central case scenario, and $8.1 trillion in a worst case scenario.

However, Trump’s campaign platform contains significantly more fiscal stimulus and fewer clawbacks than Harris’s plan, and thus would likely to be more inflationary. In addition to the previously mentioned plan to slap tariffs on anything foreign, Trump promises to restrict immigration and deport one million undocumented migrants, actions that would likely spur inflation by removing workers in an already tight labor market. And then there are his long list of tax cuts, including permanently extending all expiring TCJA tax cuts, reducing US manufacturer corporate tax rates from 21% to 15%, eliminating taxes on tips, overtime, social security benefits, and US citizens living abroad, lifting the $10k cap on state and local tax deductions, and making car loans tax deductible. Using the same methodology that it used in the analysis of Harris’s economic plan, the CRFB forecasts that Trump’s plan would increase the US debt by $7.5 trillion above levels projected under current law over the next 10 years in a central case scenario, and $15.2 trillion in a worst case scenario — about double that of Harris’s plan.

The chances that the winner’s campaign pledges will be fulfilled are heavily dependent on if the House and Senate are also controlled by their party, allowing for easier passage of presidential-led legislation. As of the time of this writing (11 October), the betting site Polymarket is putting a 57% chance on the US having single party control over the presidency and Congress next year — with a 39% chance of a Republican sweep and an 18% chance of a Democratic sweep.

So with all of this in mind about the current environment and the market’s modest inflation expectations, we felt it necessary to increase the resilience of our AlphaGlider strategies to higher than expected inflation over the coming years—think of it as additional insurance against the possibility of a single party sweep of the presidency and Congress. We did this by taking up the portion of Treasury Inflation-Protected Securities (TIPS) within our strategies' fixed income sleeves to between 25 and 30%. As you most likely know, TIPS are a type of Treasury bond that are indexed to an inflationary gauge. If inflation turns out to be higher than expected, one will receive a higher return with a TIPS than with a plain vanilla Treasury of the same duration — and visa versa. Our fixed income benchmark, the Bloomberg US Aggregate Index, does not include any TIPS investments, thus making this an outsized bet on inflation exceeding 2.1% on average over the next five years.

No doubt you have seen pictures and videos of the death and destruction inflicted by hurricanes Helene and Milton over the last couple of weeks. I was surprised and saddened to learn that only about 2% of residences in the 100 counties hit hardest by Helene-related power outages were protected by flood insurance. In Buncombe County, where Asheville, NC is located, that figure was just 0.7%. Nationwide, about 4% of households in the US have flood insurance according to the Federal Emergency Management Agency (FEMA). While not every house needs flood insurance, it would seem that the most prudent level is well north of 4%. Again according to FEMA, 99% of US counties have been impacted by flooding events since 1996, and one-third of flood insurance claims are from low- or moderate-risk flood areas. Although I am far from being an insurance specialist, I think we all need to ask these basic questions of ourself: Do I have flood insurance? If not, was my decision based on an educated analysis of my home’s flood risk, or have I not given it enough thought? I know my clients in Houston have gone through this exercise, but the rest of us may not have.

With the climate changing, it can be difficult to access the true flood risk to your home going forward. The Flood Insurance Rate Maps used by FEMA are notoriously inaccurate, and not in a good, conservative way. Just because your area has not flooded in the last 100 years and is not in a designated flood zone, it does not mean your home is safe from flooding going forward. With that caveat, here are a few resources found that you can look up your home’s flood risk, and perhaps more importantly, your area’s flood risk.

Government flood maps: Let’s start with FEMA’s Flood Insurance Rate Maps, which frequently underestimate future flooding risk. If these maps show moderate or higher risk of flooding, you are best to get flood insurance. But if they show little to no flood risk for your address, I recommend looking to see if any nearby properties are at risk. Even if they are in the clear too, you should also check the following resources.

Online listings: You can look up your address on Realtor.com or Redfin, for instance, to view environmental risks, including flooding, that impact your property.

First Street: The data on Realtor.com and Redfin comes from First Street. You can look up your address on their website to discover more conservative and detailed climate risk data for your property. Below is a graphic from the Washington Post showing First Street’s map for Swannanoa, a town in hard hit Buncombe County, shows a much larger area of flood risk than the FEMA map does.

Note that flood insurance from FEMA’s National Flood Insurance Program (NFIP) is far from a perfect instrument to protect yourself from a hurricane like the ones we have seen recently. First, it only covers $250,000 in flood damage to your building and it does not include outside items like swimming pools and hot tubs, landscaping, fences, wells, septic systems, patios, etc. Second, it does not cover damage to your contents — for that you need separate NFIP contents insurance which is capped at $100,000 coverage, and does not include anything in your basement or your car (although your auto policy likely covers the latter).

If you need more coverage than what the NFIP provides, know that private insurance companies are increasingly offering flood insurance plans, both primary and supplemental to NFIP coverage. And for those of you who rent your home, know that your renter’s insurance policy likely does not cover your contents for flood damage. However, you can buy flood contents coverage from NFIP or perhaps with an additional flood plan from your renter’s insurance company.

I would encourage you to seek out an independent insurance specialist if you have any questions about appropriate insurance coverage.

NOTES & DISCLOSURES

¹This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete, and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
²Mutual funds, exchange-traded funds and exchange-traded notes are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
³Alternative investments, including hedge funds, commodities and managed futures involve a high degree of risk, often engage in leveraging and other speculative investments practices that may increase risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are subject to the same regulatory requirements as mutual funds, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. The performance of alternative investments including hedge funds and managed futures can be volatile. Often, hedge funds or managed futures account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, including hedge funds and managed futures and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products including hedge funds and managed futures often execute a substantial portion of their trades on non-US exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in the US markets. Additionally, alternative investments including hedge funds and managed futures often entail commodity trading which can involve substantial risk of loss.
⁴Rebalancing can entail transaction costs and tax consequences that should be considered when determining a rebalancing strategy.
^Indices are unmanaged and investors cannot invest directly in an index. The performance of indices do not account for any fees, commissions or other expenses that would be incurred.
^aThe Standard & Poor's 500 (S&P 500) Index is a free float-adjusted market capitalization weighted index that is designed to measure large cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization in the US equity markets.
^bMSCI Europe, Australasia and Far East (EAFE) Index is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of developed market equities outside of the US.
^cMSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization weighted index that is designed to measure large and mid-cap equity market performance in the global Emerging Markets.
^dMSCI All-Country World (ACWI) Investable Market Index (IMI) is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of global equity markets.
^eThe Bloomberg Barclays US Aggregate Bond Index is a market capitalization weighted index that is designed to track most investment grade bonds traded in the United States. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds and a small amount of foreign bonds traded in the United States. Municipal bonds and Treasury Inflation-Protected Securities (TIPS) are excluded due to tax treatment issues.


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