Updated November 10, 2023
AJ Giannone, CFA
After last week’s Fed decision to keep rates unchanged alongside the weaker-than-expected Friday jobs report, investor sentiment took a sharp turn positive as long-term yields fell and equities rallied.
The Fed highlighted that financial conditions had become increasingly tight due to market-driven selling pressure at the long end of the curve, which had rapidly pushed rates and spreads higher. While our leading economic indicators continue to offer a mixed outlook overall, the heavy selling of equities and fixed income in October set the stage for a potential year-end rally in risk assets. We are therefore increasing our risk exposure in the portfolios as follows:
QQQ (Nasdaq 100) - With a heavy focus on Technology and Innovation, QQQ is unique in that its portfolio has a greater sensitivity to changes in interest rates relative to more traditional large-cap equity funds like SPY. Additionally, strong forward earnings prospects and positive seasonality metrics make this a great addition to diversify risk.
NVDA (NVIDIA) - NVIDIA has made headlines this year as the main beneficiary of the recent advances in Artificial Intelligence. As demand for its AI-focused products (specifically chips) soared, so did NVDA’s stock price. However, since July, it has traded sideways as investors have adopted a 'wait and see' approach, evaluating how likely NVDA is to exceed the already lofty expectations that the market has for its future growth prospects. Interestingly enough, NVDA now trades with a forward P/E ratio of 27.4 which would otherwise be considered elevated if not for the expectation of massive 78% annualized earnings growth over the next 5 years according to analyst estimates. We’re looking for NVDA to continue to execute in the AI market and benefit from a strong risk-on impulse into year end.
AMZN (Amazon) - Amazon has a diversified business model that includes e-commerce, cloud computing (AWS), advertising, and a growing presence in areas like streaming, Artificial Intelligence, and healthcare. Amazon’s unique combination of diverse revenue streams, strong branding, market leadership status, and heavy focus on innovation make for a compelling investment story. We’re looking for AMZN to continue to execute on its AWS growth strategy and e-commerce/advertising margins, as well as benefit from the heavy increase in AI-related R&D spend on compute resources. AWS should also stand to benefit from decline in long term rates as its future cash flows become relatively more valuable.
MSFT (Microsoft) - With its early 2023 investment of $13 billion in OpenAI, the maker of ChatGPT, Microsoft has positioned itself at the forefront of the Artificial Intelligence market. Subsequently, the field of AI has exploded with activity across the whole continuum of hardware and software solutions. Microsoft has been a huge beneficiary of this growth as many of its core Azure clients have demonstrated a willingness to invest heavily in the platform to roll out their own AI tools, both internally and externally. We view this as the early stages, and although we expect significant volatility in the short term, MSFT is increasingly well-positioned to capitalize on these opportunities over the long term. MSFT should also benefit from the recent decline in the long end of the yield curve.
FXI (China Large Cap Equity) - Chinese equities have had a rough 2023, down over 19% on a total return basis YTD as of this writing. Selling pressure has increased and remained elevated, especially over the past few months as demand for exports declined. YoY, Chinese exports have declined by 6.4% as of October. Additionally, stress in the Chinese credit markets had radiated outward from its construction and development sectors that turned out to be precariously overleveraged. All of this negative sentiment, combined with investors collectively “throwing in the towel” has pushed the valuation metrics on FXI down to relatively attractive levels for an entry point. We’re looking for an inflection in the news flow to move from “terrible” to “relatively less bad” which should provide an opportunity for a meaningful move higher in the medium term.
HYG (High Yield Corporate Bonds) - Boasting an SEC yield of 8.54%, this high-yield bond ETF provides the portfolio with an expected real yield well in excess of anything that had been available to investors since the great financial crisis. With an effective duration of just 3.61, it has a limited sensitivity to shifts in the yield curve. While defaults are trending up, they are coming off of historic lows, so we view the option-adjusted-spread (OAS) of 371 bps as a healthy level of spread relative to our view on the trend in defaults.
EDV (Extended Duration Treasuries) - In October, long-duration treasuries further extended their record drawdown as yields at the long end of the curve continued their rise from the historic lows of 2020. Consequently, EDV now offers a 4.98% SEC yield and asymmetric exposure to yield curve movements, which can mitigate the impact of rising yields and benefit from their decline.
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