As the Federal Reserve raised interest rates to combat inflation, NorthCoast Asset Management found opportunity in bond ETFs during the third quarter.
And although the firm remained cautious on stocks, it redeployed some of its cash positions in ETFs investing in equities. It favored ETFs buying and holding value stocks.
"The opportunity cost of being in cash and not in bonds has started to become more expensive," said Patrick Jamin, chief investment officer for NorthCoast. "We believe the Fed will continue to stay the course in tackling inflation regardless of decelerating growth, and we expect the yield curve to flatten further."
Here are some highlights from the quarter.
Bond ETFs Provide Fixed-Income Opportunities
NorthCoast put cash to work in its Tactical Income portfolio with new stakes in bond ETFs. This portfolio is typically comprised of ETFs invested in corporate and/or government bonds and ETFs invested in dividend-paying stocks
Jamin opened a position in the iShares 1-3 Year Treasury Bond ETF in the third quarter. "There is no default risk, low duration risk and the yield is 3.5%," he said. According to iShares, this bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with short maturities of one to three years.
NorthCoast also bought the iShares Preferred and Income Securities ETF during the quarter. The fund provides access to preferred stocks that pay a fixed dividend.
"Banks are posting strong capital ratios, so the bank preferred market looks historically attractive," Jamin said. "PFF is a good diversifier because PFF has a relatively lower correlation with the overall stock market and Treasuries."
Jamin closed out of the SPDR Blackstone Senior Loan ETF and bought the Invesco Senior Loan ETF. "This holding is attractive in a rising-rate environment, since it tracks floating-rate, high-yield senior debt issued by banks to companies, and thus offers less interest-rate risk," he said of BKLN. "We are contemplating increased recession risk and default risk of certain corporate bonds and bank loans, so we have been focusing more on quality. BKLN has moderately better credit ratings."
Spotlight On Fundamentals
The iShares Core S&P 500 ETF, Invesco S&P 500 Equal Weight and iShares Core S&P Mid-Cap remained top positions in NorthCoast's ETF portfolios. "We have been cautious on equities since the beginning of 2022, even though valuations are now more reasonable," Jamin said.
He added: "We believe inflation pressure, aggressive monetary tightening and slowing growth remain a dominant global macro theme for the U.S. equity markets."
"The consumer price index was higher in August than consensus, despite a sharp drop in gasoline prices. We also believe the downside risk to corporate earnings poses risk to equities with higher valuations," Jamin said.
Value Over Growth
Beyond bond ETFs, Jamin expects to see value stocks outperforming growth stocks. He bought shares of the Schwab Fundamental U.S. Large Company Index ETF during the third quarter. "FNDX has P/E ratio of 14.1 versus the S&P 500 which is around 19," Jamin said. "FNDX weights its holdings based on fundamental metrics rather than market capitalization."
What's the result? "You end up having a higher-quality portfolio and avoid overweighting overvalued companies and underweighting undervalued companies," said Jamin. "FNDX is doing the opposite of traditional market-cap-weighted indexes. Thus, FNDX tends to be overweight financials and energy stocks and underweight on technology stocks."
NorthCoast exited its position in the iShares Core MSCI Emerging Markets ETF.
"Overall, we see that there's a bit of a synchronized global growth slowdown, with most central banks raising interest rates at the same time," Jamin said. This causes "a difficult backdrop for emerging-market equities and capital flows."
For example, "China's PMI was below the neutral 50 threshold in five out of the last six months," said Jamin. "China has had a zero-Covid policy and a property market that is correcting," with both factors "hurting domestic demand."
The iShares MSCI Canada ETF is a recent addition for the NorthCoast ETF portfolios. The dividend growth rate and sector allocation of the fund appeal to Jamin. "There is about 37% of EWC in financials and about 20% in energy," said Jamin. "We believe those two areas will perform well in the current environment."
