Q2 2021 Rebalancing and Themes

Overall, the last quarter has been a bit up and down. I want to take a stock of where we are, what are the key themes and then identify asset allocations going forward.

Current State as of July 2, 2021

S&P and Equity markets have continued their move forward, although there have been a couple of dips (which have been bought). However, as I see it there is a little bit of bump ahead in the road. Market appears to be precariously placed as it freaked out about possible increases in the interest rates. At such low rates, markets are very sensitive to interest rate surprises. Nasdaq has moved even higher due to some movement back from value to growth.

Commodities have plunged (and are trying to get back). I think it really depends on the outlook of industrial activities and growth prospects. Both these items appear to be weakening. Similarly, dollar increases may have caused a bit of a decline in the commodities pricing.

Dollar index has spiked up and dollar seems to be in a strong movement up. This will impact returns for all commodities, foreign market and precious metals trends.

Crude Oil futures have continued to grow upwards. Some of the demand is still locked up (e.g., India and Europe), and even the dollar spike up hasn’t been able to impact the price negatively.

Treasury yields for both 30 year and 10 years have dipped, although they are starting to tick back up

Outlook and Asset Allocation

In order to figure out the asset allocation, I believe the short term and the long term are getting bifurcated to some extent. In terms of longer term scenario, I want to write another blog on the various paths an “endgame” scenario can take – but that might take some time.

Short term is getting driven primarily by a few things – expected dollar strengthening, possibly inflation being transitory (as suggested by Fed), and growth rates slowing down in the near term. Right now none of these things are a certainty, but the expectation is what is driving the short term in this blog.

Dollar direction is probably the most important driver. Dollar appears to be strengthening to a large extent (while something like Euro appears to be in a declining pattern). If Dollar continues its way up, the reflation trade fades in the short term. Inflation trade still remains an important trend in the longer term. Reflation trade fading would mean commodities, and gold declining. The yields for 10 and 30 years might be declining as well implying some short term improvements in bond prices as well as movement back from value to growth in the short term. We will explore all this in the tables below.

US Equities: 25% Allocation

Asset ClassesNear Term Outlook
(Rest of 2021)
Longer Term Outlook (2022+)
US Equities – Broad Based Large Cap (e.g., SPY, IVV)15%
Starting to see some slowdown (e.g., ECRI weekly leading index which is a 2-3 quarters leading indicator for equities). Some non-zero probability of Delta variant.
However, interest rates on the long end going down may prop it up. Earnings jumps are expected. Employment picture is improving. Dollar going higher may improve the returns as well. Nobody can predict what can happen – as the increase in prices of growth stocks might drive the volatility indicator higher, leading to “machines” going in risk-off mode driving it down 🙂
13%
Some headwinds (e.g., High oil prices which impact equity prices negatively 1 year indicator, prospects of capital gains taxes, etc.) System appears fragile, however, with high sensitivity to interest rate changes. P/E are still elevated and even if they if they only partially revert to mean multiples – that might drive prices a bit lower. While there is some reduction in allocation – it is more than being offset by increase in the value portion of the portfolio.
US Equities – Value (E.g., SDY, Include Financials, but not energy, which is treated separately below) 5%, underweight in the short term – although it may become a good point for starting to allocate for future
While the sector has been high performing over the past 2 quarter, it has underperformed in June – primarily due to drop in rates causing a bit of a sector rotation back from value to growth. My outlook is that the rates will continue to drop in the short term as inflation and growth will disappoint in the short term.
10%, Overweight in the long term

The value sector has still been trading at 50% discount vs. longer term historically. There divergence in correlation between growth which may make value a good hedge.

Value also has a lower duration than growth, making it a better hedge against interest rate increases.
USD Exposed Growth Stocks (QQQ) 5%
Interest rates on the long end going down may prop the growth sector a bit. Some upside may also be expected from dollar pop up.
2%
Over the past decade the valuations have gone too high and covid has pulled forward a lot of earnings. We have a bit of exposure in the US tech from the SPY above. It appears that growth to value rotation has started. I do think
Overall Traditional Equity (Sum of above) 25%
Overall positive on equities. However, needs to price in a few issues – Delta variants, taxes, and continued inflation increases
25%
Similar Equity allocation as shorter term. However this has a higher value allocation vs. short term.

International Equities: 15% Allocation

Asset ClassesNear Term Outlook
(Rest of 2021)
Longer Term Outlook (2022+)
International Equities – China

(MCHI(2%), FXI(2%), BABA (0.5%), PDD (0.5%). Other to be considered – JD, BIDU, NIO, EDU, GDS, TAL, YUMC, BILI)
5% Hold
China appears to be bouncing back from its credit cycle. The way that I have implemented Some of the Chinese equities also support the growth portfolio (but not exposed to USD).
5% Hold
China is still underrepresented in the overall institutional investors portfolio and a fair value allocation should improve the multiples (in addition to other secular drivers). China also benefits from having not accrued too much debt for Covid response. Ideally China allocation will be higher – however, political risks keep the allocations down for me.
Only counter to keeping the same allocation would be if there are any early indication on deteriorating conditions with US (and then it might already be too late).
International Equities – Emerging

VWO, EEM, IEMG form the core positions while it may be possible to create a tilt by region:
Russia (RSX), India(EPI, INDA), Brazil(EWZ, ILF), Japan (VPL, EWJ), and other south east Asia (ASEA) in the short list to buy separately

5% Hold
While, Emerging markets are in a good place to outperform with declining rates as their duration is longer (promise to pay later). Many of these also have a good value (e.g., Japan) or commodity tilt (e.g., Brazil and Russia). More positive on growth oriented vs. value oriented emerging markets in the short term.
5% Hold
Longer term emerging markets reflect good opportunities. They have underperformed in the past decade. However, their growth along with the potential for the dollar to devalue may provide upside. Many of the countries still have a low Debt to GDP ratio. Additionally, the low(er) correlation with US equities may represent a good diversification asset.
International Developed:
VEA (2%), EFA (2%), IEFA, VXUS (1%), EWJ
5% Low Conviction Hold
Europe allocation is a bit more of a diversification play. However, no real conviction in Europe. Germany obviously offers a value play.
5% Low Conviction Hold
Developed markets may not itself represent a dollar hedge as their currencies might actually be disadvantaged vs. USD. Some risk may actually be inherent in this system as more of “Brexits” emerge. But that is the reason why Europe has a lower valuation and needs a bot of allocation into the portfolio
Total International 15%
15%

Precious Metals and Commodities: 15-20% Allocation

Asset ClassesNear Term Outlook
(Rest of 2021)
Longer Term Outlook (2022+)
Energy / Oil (XOM, Chevron, Hess, Lukoil, TOT, RDS) 3%
Significant portion of the world’s economy is still under lockdown. Air travel is not back up. Oil price is still low vs. historical (and haven’t met the Goldman targets). However, OPEC is sitting on a large supply (as is China which has been purchasing since when the price has been very low) – As a result the price upside may be capped. Downside could be additional lockdowns, or OPEC releasing more supplies.
2%
Assuming Oil can hit $100, it may make sense to take some gains off – however, clearly one would need to consider momentum indicators. Broadly, I would still maintain a core energy position. In the longer term aspiration may be to get rid of oil – that may not happen for at least this decade. The move towards ESG has resulted in a significant declines in capex allocated to Oil sector. For me Oil may still represent a positive story.
If we start to see Baker Hughes Rig counts starting to go back up then we may have to reconsider this thesis.
Other Commodities (VAW, Vale, FCX, X, COPX. Could Look at GUNR, RIO, CNQ, NTR. Shortlist COPX for when the market is at right price.)2% Underweight
Dollar spike has hurt Commodities in the short term. Growth appears to be slowing – slowdown of global industrial leading indicator from ECRI. There may be continued pull-back in Economic growth dependent
3%
Commodities have been very cheap for a long time. As we enter the next phase of world growth / infrastructure spend there may be some upside in this new “supercycle”. ESG cannot be achieved without Lithium, heavy metals, and copper – if the world does decide to go for Oil independence, there is upside here. If the thesis of higher inflation in the longer term persists it might drive commodities higher. As I will explain in the “endgame”, if the fiscal spending drive inflation waves, it may lead to overall price rises, even though the inflation might go up and down.
Gold and Silver
(Gold – IAU, GLD, PHYS, Silver – SLV, SIVR
; Gold Miners – GOLD, NEM, RGLD, SAND, BTG, ). Could also allocate a little to Platinum (PPLT)
10% Hold
There does not appear to be a strong catalyst for gold in the short term.
Dollar is stronger so gold price is declining. Gold prices increase in terms of real yields declining – so its a little confusing for me right now. Rate of change of balance sheet for central bank is also slowing. Gold positioning is a bit painful currently – but given the longer term trends I am using this to build up a bit more towards the longer term target, which is…
15%
Gold price increases in inflation. Especially in the later stages. Will need to maintain this defensive position to ensure catch the upside.
After inflation of 70s, Warren Buffet wrote that Berkshire stock had done well, but it still bought same amount of gold as it did 15 years back. I agree gold is a bit of a “faith and belief trade”, but for now I am sticking with it 🙂
Overall Commodities 15%
Interest rates lower and Dollar higher will impact the commodity prices in the short term as the inflation trade rewinds in the short term.

20%
Tailwinds include dollar devaluation, inflation. Typically inflation after fiscal stimulus comes in waves and would expect to keep setting higher benchmarks for commodity prices. Gold and silver appear to grow in the later part of the inflation cycle – so positioning it for that time may be appropriate

Cryptocurrencies: 2-5%

Asset ClassesNear Term Outlook
(Rest of 2021)
Longer Term Outlook (2022+)
Cryptocurrencies (Bitcoin, Ethereum through Coinbase) 2% Underweight in the near term until it reaches some support levels
Mining shutdown and restrictions in China appears be be causing selling. Technical pattern (for my untrained eye) appears to still look ominous (with a clear head and shoulders pattern).
If there is a decline in the market, the liquidity pressure almost always lead to a corresponding decline in Bitcoin as well.
There may be some pressure from GBTC unlocking period.

Both of these factors suggest that there may be another 10-20% downside coming (from current $35K). I will likely start buying if it declines below $28K.
5%
Overall, Bitcoin has dropped to a level that the regulatory risk has reduced.
I still think that in the longer term the log price relationship may be the right way to think about it. Thus my framework would be positive on BTC until it starts to hit >$60K or so.

Ethereum appears to continue getting traction. I have moved from being at 85% Bitcoin to being 85% Ethereum, but I will be looking to increase my Bitcoin proportion within the allocation.

Bonds and “Bond Like”: 10%

Bonds have been a strong outperformer over the past 40 years. However, as I have said in my earlier blogs, given low yield and prospects of increasing yields bonds are pretty much a speculative investment. This leaves a huge gap in the portfolio – Bonds were an effective hedge against drop in Equity prices, but the correlation may be increasing. This results in me looking for some “bond like” instruments. For me, Telecom Infrastructure appears to be close to bonds – it has steady “coupon” payments from highly rated top-3 wireless companies. Contracts are long term in nature and churn is lower. Growth in bandwidth requirements is an ever present theme and has been acclerated by Covid. As a result, while it is very much an equity, I am including telecom infrastructure as a “bond” position.

Asset ClassesNear Term Outlook
(Rest of 2021)
Longer Term Outlook (2022+)
Telecom Infrastructure (5G Plays)
CCI, CLNY, SBAC
3% Hold
Overall potential for 5G services is immense. At the bottom of the 5G stack lies the telecom infrastructure which is something that is generally attractive to me as an income and growth play. Combination of Fiber, Towers, Data Centers and Small Cells may provide the right growth and dividend play.
3% Hold
An additional advantage for this asset class is that it provides a “bond replacement” type asset. As the portfolio needs to move towards a lower duration portfolio, these assets through their coupon like payments have a lower duration.
Long Term Treasury Bonds (TLT) and Short Term Treasury Bonds (IEF) 4% Hold
In the near term this is a very interesting situation. Inflation readings were high – but the long end of yield curves is declining. Fed has said that they might raise rates in two years. However, long term rates are decreasing, which is super confusing. If the next inflation readings are lower, could there be additional QEs? Keep Calm and Carry on having some allocations in Bonds
4% Hold
There is some non-zero possibility that US can start to see negative rates. In UK it has happened for the first time in 300 years (so have I heard). There is some possibility that the yields can go down further (both in the short and the long end). However, everything considered, Bonds just have a lower upside potential. The bond year bull market is as old as I am and appears to be in the last innings. The yields are super low, and the coupons are low as well – it appears to be a speculative thesis, and sizing should be based on a speculative positioning as well
Volatility Hedge (IVOL)3%
<More on this later – still trying to understand this instrument>
3%
<More on this later – still trying to understand this instrument>
Total Bonds and Bond Like7-10% 7-10%

Overall Picture

Asset ClassesNear Term Outlook
(Rest of 2021)
Longer Term Outlook (2022+)
Traditional Equity – USD Exposed 25%25%
International Equity 15% 15%
Precious Metals and Commodities 15% 20%
Cryptocurrencies 2% 5%
Total Bonds and “Bond Like”10% 10%
Real Estate20% 20%
Cash13% 5%

Overall Thoughts

The overall themes for me remain the same as in previous blog posts. Bond yields in the longer duration have confused me a little bit. The updated asset allocation aligns the portfolio a bit better with the picture that the 10/30 year yield curve may be telling us. The cash in the short term allocation appears to be a bit excessive. I understand Ray Dalio’s argument around “Cash is Trash”. But I think we need to be positioned for any big market shocks – both to manage the draw down and also to be positioned for opportunities. The other pointer will be to really keep one eye on the longer term allocation, and start to position for that as the opportunities present.

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