IGSB - Investment Strategy By Economic Regime

• Today, the US economy can be characterized by late cycle (perhaps even end cycle) with a stagflationary regime.
• A stagflationary regime is one where there is high and rising inflation combined with low or negative growth. Investing during this regime can be difficult.
• Eventually, we believe we will shift from a stagflationary one to a deflationary bust regime. That is most commonly known as a recessionary environment.
• We believe being positioned in long-duration assets, high quality, and commodities will be the best areas of the market for the rest of 2022.
• The best options are investment grade, munis, preferreds, agency MBS, and cash.  In equities, it means commodities and avoiding defensives which are very overvalued.

What the heck is an economic regime?

Generally, the global economy is in one state of four regimes, each of which is a combination of a growth vector and an inflation vector. All that means is a regime assesses what stages of growth an economy is in (high growth vs. low/negative growth) and what stage inflation is in (low inflation vs. high inflation).

Most break down these regimes as follows:

• Inflationary boom: Accelerating growth combined with rising inflation
• Disinflationary boom: Accelerating growth with falling inflation
• Stagflation slowing growth and high/rising inflation
• Deflationary bust: Decelerating or low growth with falling/low inflation.

Here is how those four factors come together to create a matrix:

Modern portfolio theory and asset structure tells us there are specific drivers of returns for each sector, sub-sector, and types of assets to different economic regimes. In other words, sector performance to certain regimes is not random, but a result of logical structure and reactions to economic fundamentals. For example, in inflationary periods, gold tends to rise as do other commodities.

Another example would be equity prices react positively to declining inflation expectations and higher economic growth. This is intuitive since lower inflation often means lower interest rates, which leads to high discounted cash flows from businesses in the future leading to an increase in enterprise value.

The below target matrix, which takes the first image above and transforms it into a more granular (with volatility heat mapping) investment framework. It is also the inspiration behind the Permanent Portfolio .

Established in 1982, in an era of stagnant economic growth and rampant inflation, Permanent Portfolio seeks to provide a sound structure and disciplined approach to asset allocation. The Fund was born in an environment where most investors didn't know where to turn. Harry Browne, one of the founders of the fund stated, "It's easy to think you know what the future holds, but the future invariably contradicts our expectations. Over and over again we are proven wrong when we bet too much on our expectations. Uncertainty is a fact of life." No one can accurately predict the future. Permanent Portfolio recognizes this limitation and seeks to invest a fixed "Target Percentage" of its assets to six carefully chosen, diverse and "non-correlated" investment categories. Such diversification in a single mutual fund seeks to mitigate risk regardless of the economic climate.

Ray Dalio also created the now famous All Weather Risk Parity portfolio out of this concept.

Where Are We Today?

It is highly likely we are approaching a stagflationary environment and perhaps, eventually, a disinflationary bust. Today we have very high inflation (highest since 1981) and very slow growth (it was negative in Q1 and trending close to that for Q2).

Looking at the target matrix, we would clearly be on the left side of the vertical axis. The question becomes, what do we do about inflation. Today, we have high inflation and it has been still rising but we are likely nearing a peak to where that becomes a declining inflationary rate. A recession, by definition, is deflationary.

It may be delayed from the onset of the recession, especially given all the weird structural dynamics at play here since the onset of Covid. For that, we may see inflation rise a bit more even if the economy enters a recession. However, at some point, we are likely to see inflation moderate some from these ultra-high levels.

If we add in the economic cycle, we believe we are late-cycle and perhaps even, end cycle here.

That would imply we should avoid risk as credit spreads are widening and equity prices falling. So far, interest rates have not begun to fall in earnest yet so we don't have that tailwind to duration/high quality. But that will come, likely later this summer and in the fourth quarter.

So How Do We Invest?

Deflationary Bust Scenario: Longer-term (more than one year) it seems most likely that we will enter some kind of slowdown that reduces demand to the point where inflation falls materially. We have been calling for a recession for the last few months and it could be that we are in one currently (we won't know for at least another six months).

In this economic regime, cash and duration reign. That means holding some dry powder for the impending rebound - knowing full well you won't time it perfectly to put that to work at the bottom - as well as high-quality, longer-duration assets. Duration is just the interest rate sensitivity of a bond. Long duration is typically in higher-quality assets

If one were to use simple passive assets, the breakdown of the portfolio would look something like this:

For us, we would want to take a more proactive approach in the majority of cases.

For the stagflationary outcome, which we think will be with us for at least the next six months, we would want to be in cash, inflation-protected areas, EM bond, and energy/commodities.

We've discussed energy and commodities for some time preferring to be in funds like Invesco Small Cap Energy ETF ( PSCE ) , BlackRock Resources & Commodities Strategy Trust (BCX) as well as other areas that would benefit from rising rates. That includes value and cyclical areas of the equity markets. Does that mean you should be up if you invested in value? No, but value has outperformed the market and growth YTD so it is a 'relative winner.'

So, we would continue to add duration in chunks as we progress through the summer and as a recession appears more and more likely (meaning should a recession look like it would be avoided we would stop adding duration). Stay centered in high quality. That means avoiding:

• High yield
• Loans
• Convertibles
• Limited duration
• Global Income
• EM Equity

Be invested heavily in:

• Cash
• Long duration treasuries
• Investment grade / long duration quality
• Munis
• Agency MBS / mortgages
• Preferreds

What can we invest in within each of those bullet points:

***yields are 30-day SEC yields***

Cash: I like to use include PIMCO Enhanced Short Maturity Active ETF ( MINT )(2.01%), JPMorgan Ultra-Short Income ETF ( JPST )(1.77%), iShares 1-3 Year Treasury Bond ( SHY )(2.71%), iShares Ultra Short-Term Bond ( ICSH )(1.61%), iShares 1-5 Year Investment Grade Corporate Bond ( IGSB )(3.98%), and iShares Short Maturity Bond ETF ( NEAR )(2.13%).

Most of my capital today is in a combination of IGSB and SHY. SHY should benefit from when the Fed re-pivots back to being doves sending the 2-year treasury back down towards zero.

Long-Duration Treasuries: There are a ton of options here. In fact, just iShares alone has a dozen or so options. Top picks would be iShares 10-20 Year Treasury Bond ETF ( TLH )(3.26%), iShares MBS ETF ( MBB )(2.13%), JH Mortgage-Backed Securities (JHMB). If you want super-juiced duration there's iShares 25+ Year Treasury STRIPS Bond ETF ( GOVZ )(2.97%).

In CEFs, we would check out:

• BlackRock Income ( BKT ), yield 7.93%, discount -7.1%
• First Trust Mortgage ( FMY ), yield 5.67%, discount -7.8%
• Western Asset Inflation Linked Opps & Inc ( WIW ), yield 6.5%, discount -14.5%.

Investment Grade / Long Duration Quality: Again, lots of options and here we would focus on ETFs over mutual funds as well as looking at the CEFs available with large discounts. Top picks would be iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD )(4.86%), iShares 10+ Year Investment Grade Corp Bond ( IGLB )(5.19%), iShares Aaa- A Rated Corp Bond ETF ( QLTA )(4.31%).

In CEFs, we would check out:

• BlackRock Core Bond ( BHK ), yield 8.21%, discount -8.02%
• Angel Oak Dynamic Financial Strategies Income Term Trust ( DYFN ), yield 9.14%, discount -15.1%
• BlackRock Credit Allocation ( BTZ ), yield 9.52%, discount -9.65%
• Putnam Premier Inc ( PPT ), yield 8.25%, discount -8.25%
• Invesco Bond ( VBF ), yield 4.55%, discount -8.55%

Municipal Bonds: We prefer these from the CEF side but we tend to augment those positions with open-end and ETF positions. I prefer active management over passive in munis so we have mostly mutual funds for this exposure outside of the CEFs below. Top picks would be IQ Mackay Muni Inter ETF ( MMIT ), Thornburg Intermediate Muni ( THMIX ), Vanguard Long-Term Tax-Exempt ( VWLUX ), Eaton Vance National Muni Income I ( EIHMX ) [Please note institutional class listed. For individual investors, use the retail share but DO NOT pay a load].

In CEFs, we would check out our Muni Core tab but as of this writing like best:

• BlackRock MuniVest ( MVF ), yield 5.58%, discount -8.6%
• BNY Mellon Strategic Muni ( LEO ), yield 5.67%, discount -5.7%
• Nuveen Muni Credit Income ( NZF ), yield 5.76%, discount -9.9%
• AB National Muni Inc ( AFB ), yield 4.90%, discount -11.2%

Agency MBS / Mortgages: We covered this a bit in the long-duration treasuries category as agency MBS, or mortgage-backed securities backed by the government, are quasi-treasuries (don't @ me). I would add some actively-managed versions like JanusHenderson Mortgage Backed Securities ETF ( JMBS )(2.05%), and SPDR Portfolio Mortgage Backed Bond ETF ( SPMB )(3.89%).

In CEFs, we would check out:

• DoubleLine Opp Credit ( DBL ), yield 8.49%, discount -3.42%
• Angel Oak Dynamic Financial ST Inc ( DYFN ), yield 9.14%, discount -15.1%
• BlackRock Income ( BKT ), yield 7.93%, discount -7.1%

Preferreds: This is the riskiest area of the list we have created but if you stay in the highest quality/IG from the big banks, most of the risk is duration. Many of these preferreds have perpetual maturities so their duration can be very long. Top picks would be Cohen and Steers Select Pref & Inc ( PISHX ), Destra Flaherty & Crumrine Pref & Inc ( DPIIX ), and JP Morgan Preferred and Inc Sec ( JPDIX ).

In CEFs, we would check out:

• First Trust Inter Duration Pref & Income ( FPF ), yield 8.64%, discount -10.1%
• Cohen & Steers Tax-Adv Pref Sec & Inc ( PTA ), yield 8.60%, discount -13.5%

Concluding Thoughts

Knowing which economic regime we reside, or are heading into, can help prevent portfolio blow-ups and position you for the greatest probability of success. Today, we are clearly in a 'stagflationary' period of high and rising inflation as well as low and slowing growth.

We do believe that is changing and think investors should start positioning - as the summer progresses - into areas of the market that work in a 'deflationary bust' environment. That is one that is most characterized by a recession. However, even if a technical definition of a recession is not achieved, we still believe we will eventually see that kind of investment strategy work as the effects of a near-recessionary environment lower inflation.

For further details see: