QUARTERLY UPDATE

The first half of 2020 brought more market activity and angst than many full years or even decades. As we look toward recovery from the coronavirus shock, we see:

Equal reasons for caution and optimism in the US markets.
Hopeful signs for the U.S. economy based on lessons from China.
Attractive opportunity for income in equities, even amid dividend cuts.

Market overview and outlook

The mood, and the market, has evolved at a furious pace since our last quarterly commentary. Morningstar data is telling: The S&P 500 Index notched +/-4% moves in 17 trading days through mid-June of this year versus an annual average of just 3.2 days from 1928-2019. The economic and market metrics are now trending in the right direction. The question is whether the market has moved too far, too fast and priced in all or most of the good news.

Reasons for optimism

Solid economic foundation
The U.S. economy was healthy leading into the COVID-19 crisis. The ensuing recession was caused by an exogenous shock, not a typical end to the business cycle driven by economic overheating. This could hold promise for the recovery.
Credible, coordinated policy response
The global coordination, swiftness and magnitude of the monetary and fiscal policy response is unprecedented and should provide the support needed to bridge the gap toward economic renewal. With an initial injection of $2 trillion, the U.S. fiscal response had already far exceeded that seen in the wake of the 2008-2009 global financial crisis. We are most likely going to see another round of stimulus shortly.
Attractive value vs. bonds
With bond yields down (and prices up), the gap in the value between stocks and bonds, as reflected in the equity risk premium, is wide. This suggests investors can potentially realize greater reward from stocks.

Reasons for caution

Hidden vulnerabilities
The lockdown-driven decline in economic activity and spike in unemployment has left the U.S. economy more exposed to risks. It remains to be seen whether there are any hidden vulnerabilities in the system, including hiccups in reopening progress. Markets do not like uncertainty.
Risk of second wave of infection
COVID-19 is a novel virus, meaning it has no exact precedent. A new round of infection is possible and its burden on the health care system and potential for renewed closures is unknown. The upside is that countries would enter a second wave wiser and more prepared, with availability of greater testing, contact tracing, protective gear and drug interventions.
Heightened geopolitical tensions
The U.S.-China relationship is further strained since the COVID crisis, defined by greater competition and less cooperation. Bouts of market volatility are likely should tensions flare.
Absolute valuations are not cheap
Stock prices are attractive relative to bonds, but by the most common measure of valuation, P/E ratio, they are not cheap. Pandemic-related uncertainty has made the earnings outlook for many companies blurry at best.

Portfolio Changes Since Last Quarter

Overall Asset Allocation

Trade Rationale

Asset Allocation: We continue adding to equities broadly, targeting beaten down value and cyclically oriented exposures and adjusting our regional bets. These moves are complemented with modest increases in duration within our fixed income investments.

US Equities: We maintain but reduce our long-standing overweight to US equities. Some large cap exposures are sold to fund small cap, financial services sector, and value factor purchases. Large cap growth stocks led the market rally in the two months since the March lows, but as markets stabilize and risk appetite recovers, we believe those names most beaten down have relatively more room-to-run in the near-to-intermediate-term.

International Developed Market Equities: Europe has recently moved closer to releasing a much-needed fiscal stimulus package. Consistent with our theme of adding to names that have thus far lagged in the recovery, we add to broad Developed Markets equities, which have a more mid-cap/value tilt than our existing growth-oriented Developed Markets exposure.

Emerging Market (EM) Equities: We reduce Emerging Markets equities to earlier int he year weightings, giving us the budget to fund increases elsewhere in the portfolio.

Fixed Income: We move further underweight bonds relative to stocks, adding to treasuries and extending duration slightly across most risk-profiles.

Portfolio Performance

Easing fears of a potentially unmitigated global health crisis and devastating economic depression served as a springboard for global risk assets in the 2nd Quarter. Economies across the world began to cautiously re-open after months of strict quarantine measures and crippling double-digit unemployment. The US and China delivered several impressive economic data points, fueling further investor optimism of possible V-shaped recoveries in the world’s two largest economies. The S&P 500 rebounded in rip-roaring fashion, delivering the best quarterly performance in over 20 years. Growth outperformed value, small cap outperformed large cap, and technology and consumer discretionary led from a sector perspective. The Federal Reserve continued to play an active role in supporting market liquidity and forecasted interest rates are likely to remain near zero until at least 2022. The US 10-year Treasury traded sideways, closing the quarter at 0.66%.

US large cap, international Developed Markets, and Emerging Markets stocks were the largest contributors to return, followed closely by global technology stocks. Our shifts to ESG-optimized US and Emerging market stocks and Developed Markets growth-oriented stocks continued to deliver outperformance vs their benchmarks. . The largest drivers of performance from a factor perspective were quality and minimum volatility stocks. An overweight allocation to investment grade fixed income was the largest contributor to return within our bond positions, followed by exposure to short-term US high yield bonds. The primary detractors from return were US small cap and financial services stocks, which struggled into the latter half of June.

Asset Class Views

Asset Class	Reviews	Rationale
Asset Allocation
Equities vs. Fixed Income		We are increase our overweight to equities, supported by still attractive equity risk premiums, continued fiscal and monetary stimulus. As restrictions ease and economies across the world begin initial phases of re-opening, we prefer to take risk within equities, particularly within sectors and regions that have thus far lagged in the rally over the past three months. Even with the increase in equities, the quarterly rebalance will most likely result in the selling of some of the equities that have appreciated over the past quarter.
Equity
U.S. Equities		We maintain an overweight to U.S. equities, adding to beaten down cyclicals and value factors, and introducing exposure to the financial services sector, which should benefit from the yield curve steepening, loan originations increasing, and overall economic improvements. Our strategic positions in technology and medical devices remains, which we expect may increasingly serve as relatively defensive plays in a post-Covid-19 world.
Non-U.S. Developed Equities		We continue to be underweight non-U.S. developed market equities, but considerably less so than in the past. An improving outlook due to successful virus abatement efforts and the release of long-delayed fiscal stimulus plans in Europe, make such a significant underweight no longer our strategy. While we continue to prefer to have exposure through our growth- oriented positions for the long-term, we see a tactical opportunity to capitalize on a bounce in the most beaten down names countries and stocks.
Emerging Market Equities		We bring down our Emerging Equities exposure to previous levels. Valuations are still attractive, but want to bring back some of our international exposure to developed markets.
Smart Beta		The potential benefits of smart beta remain tied to their diversification potential, and our tactical view is that the value and minimum volatility factors are better suited for the current regime, with value for upside and minimum volatility for protection. More information on what Smart Beta is – https://bautisfinancial.com/why-we-use-the-factor-investing-strategy-episode-31/
Fixed Income
U.S. Treasuries		We continue to reduce our allocation to treasuries, but continue to hold them as they serve as a source of diversification vs stocks if the re-opening of the economy hits some speed bumps along the way.
U.S. Investment Grade Credit		We are slightly increasing our allocation to investment grade fixed income, however we are keeping the durations short as that is where the Fed is more likely to provide support with their bond buying program.
High Yield Credit		We are overweight high yield bonds with the goal to capture the recovery in speculative grade assets.
Emerging Market Bonds		We maintain a strategic position in fixed-income heavy portfolios.

This document is for informational purposes only. It is not intended to provide financial or tax advice or to address all circumstances that might arise. Individuals and entities using this document are encouraged to consult their own financial advisor.

Quarterly Commentary 2020 3rd Quarter