What do we at InflectionPoint view as resilient portfolios? They are diversified and robust investments designed to

• Withstand a range of market outcomes.
• Bend without breaking
• Mitigate the impact of possible fat tail risks

To keep things simple, we’ll primarily use Funds. This makes it easy for any investor to implement our strategy effectively. We’ll often use bullet points to distil our key ideas. While this might sacrifice some precision, it allows us to focus on the big picture and avoid getting bogged down in details. Our goal is to provide a clear, high-level overview of how the InflectionPoint Macro team constructs a resilient portfolio for the year ahead, 2025.

“It’s crucial to conduct thorough research and consult with a financial advisor to select funds that align with your specific risk tolerance, financial goals, and tax implications. Please consider your circumstances before making any final investment decisions. This is for exemplification purposes”

InflectionPoint Resilient Fixed-income Portfolio: Year Ahead 2025

Our Key Market Assumptions (KMA)

• Conservative Portfolio Stance: Tight credit spreads and a late-cycle environment necessitate a defensive portfolio positioning. Asset Allocation: 45% risk-off, 30% risk-on.
• US Treasury Core: Remains a premier safe haven, underpinned by a robust growth engine and minimal need for debt-fueled recalibration. Overblown concerns about exploding US deficits further support this stance.
• Yield Curve: Position for a steepening yield curve.
• Credit Exposure: Short-duration high-yield (SJNK), HY with a tail hedge (CDX) or corporate hybrids (EHBD) offers a relatively more conservative approach for the HY sleeve of the portfolio.
• Rates Spread Correlation: While normalizing, rates spread correlation remains elevated relative to the post-GFC to COVID period. This consideration supports an allocation to less rate-sensitive fixed-income sectors.
• Currency (EUR-based Investors): Diversify into USD and CHF as the EUR is expected to underperform.

Upside Risks

• Economic Resilience: A stronger-than-expected economic growth could limit the upside potential of our relatively low exposure to high-beta credit compared to more aggressive portfolios.
• Geopolitical De-escalation: Positive geopolitical developments could lead to a correction in assets with high geopolitical premiums. While this may negatively impact the short-term performance of gold and silver, we believe the long-term fundamentals for these metals remain intact.

Downside Risks

• Second Inflationary Wave: A potential resurgence of inflation could lead to a sell-off in both rates and spreads. Short-duration TIPS and a steepening yield curve strategy could offer protection, especially if central banks are caught off guard and forced to tighten monetary policy.
• Economic Deceleration: A sharp economic downturn could trigger a broad-based risk-off event.
• Potential Capital Repatriation: A significant reversal of foreign investment, particularly from countries like Germany and Japan, could trigger a global risk-off event.
• A “Liz Truss Moment” in some key sovereign bonds markets as investors struggle to absorb excessive fiscal stimulus.

In conclusion, a cautious, defensive approach is warranted given the current market environment. Rather than a high-conviction portfolio, we aim to construct a robust and resilient portfolio that can navigate a range of market outcomes. This involves allocating to a diverse range of assets, even those with lower probability outcomes, to mitigate downside risks and capture potential upside opportunities. By adhering to a disciplined investment strategy, we seek to generate attractive risk-adjusted returns over the cycle.

The Valuation Compass

To assess market valuations, we employ a simple framework that leverages historical data. We utilize metrics like the 10-year CAPE ratio for equity valuations, 10-year real rates for US Treasuries, ICE BofA spreads for high-yield and emerging market debt, and the USD Real Effective Exchange Rate (REER) to gauge the US Dollar’s valuation.

Our analysis, spanning from November 2005, suggests a clear imbalance: risk assets appear richly valued, while rates are trading at historically low levels. While relying solely on a 15-year historical window has limitations, it provides a useful benchmark.

Based on this analysis, we believe that a strategy favouring rates over spreads is prudent. This preference is reflected in our model portfolio. USD is also expensive in this time frame, however, we still like to have a long USD bias in our portfolios, especially for Euro-based investors for diversification purposes.

Now, let’s peel back the layers and examine the core components of our portfolio. We’ll break down each piece, revealing its unique characteristics and how it contributes to our overall strategy.

Inflation Risk-off – Current Allocation: 10%

While there are concerns about persistently sticky inflation above the 2% target, several factors suggest that core inflation may gradually normalise.

First of all, the labour market is showing signs of cooling, with the Beveridge curve indicating a return to pre-pandemic levels.

Second, two concurrent deflationary pressures are emerging: a surge in Chinese exports, defying concerns about supply chain disruptions, and a significant 15% decline in Chinese export prices. These factors are contributing to lower global inflation.

Given these factors, we maintain a relatively low allocation to risk-off inflationary scenarios. Our “inflation-fighter” strategy involves two primary instruments:

1. STIP: a short-duration inflation-linked ETF, offers protection against unexpectedly high inflation.
2. AAA CLO ETF: This ETF invests in the most senior tranche of CLOs. While AAA CLO tranches may exhibit some market volatility, their historical default rates have been negligible, even during periods of significant market stress like the 2008 Global Financial Crisis. AAA CLOs continue to offer attractive spreads of 110-120 basis points over the risk-free rate, which we believe compensates for the liquidity premium.

Inflation Risk-on – Current Allocation: 16%

The narrative here centres around a benign inflation environment and stable growth, which should benefit high-beta credit, equities, and financials.

To navigate this scenario, we’ve implemented a four-pronged strategy:

1. Floating-Rate Loans: We’ve invested in the BKLN ETF, which focuses on floating-rate senior loans. These instruments are well-positioned to withstand rising interest rates.
2. Short-Duration High-Yield: The SJNK ETF offers exposure to short-duration high-yield debt, which is less sensitive to interest rate fluctuations compared to longer-duration bonds.
3. Convertible Bonds: The CWB ETF provides exposure to convertible bonds, which offer a combination of fixed-income and equity characteristics. These instruments typically have low duration and are linked to real assets like stocks, making them relatively resilient to rising interest rates while providing potential upside.
4. Bank Capital: The AT1 ETF offers exposure to bank capital, which can benefit from rising interest rates and improved profitability in a strong economic environment.

We believe this strategy is a valuable addition to a traditional fixed-income portfolio. It offers a combination of income generation, equity upside potential, and relative rate insensitivity, thereby diversifying the portfolio and enhancing its overall risk-return profile.

Inflation Diversifier – Current Allocation: 17%

In a nutshell, this building block includes investing in CAT bonds, which offer floating-rate returns and low correlation to traditional credit spreads, and STIP, a short-duration inflation-linked ETF.

1. CAT Bonds: In particular, CAT bonds offer attractive spreads over risk-free rates (tighter than a few months ago during the hurricane season, but still attractive), as illustrated in the chart provided by Artemis.
2. MINT ETF: This active short-duration income ETF provides diversified exposure to investment-grade corporates and securitized bonds. It offers flexibility and can diversify our exposure to government bonds held in other parts of the portfolio.

Deflation Risk-off – Current Allocation: 25%

Our base case narrative for this scenario envisions a period of lower interest rates, a flight-to-quality towards US Treasuries, and a steepening yield curve. To account for historically high debt-to-GDP ratios for most sovereign debt, we will diversify into global investment-grade credit with a longer duration.

The strategy is then built around 2 key themes:

1. Long Duration 2y leveraged: We employ a long-duration strategy through the TUA ETF. This fund targets the duration of the ICE 7-10 Year US Treasury Index by investing in short-term Treasury futures (2 years). This approach is particularly effective in a risk-off scenario, where the yield curve is likely to steepen.

2. Extend Duration through High-Quality IG Bonds: We implement this theme through two ETFs investing in both US and international investment-grade corporate bonds: LQD and PICB.

Deflation Risk-on – Current Allocation: 12%

Our strategy for this scenario involves a cautious approach to high-yield investing. We prioritize investments with a tail hedge (such as CDX) to mitigate downside risk. Additionally, we prefer investments with subordination risk, as this can protect against weak underlying fundamentals.

• Incorporate a tail hedge (CDX ETF) to mitigate downside risk.
• Allocate to corporate hybrids, which offer subordination risk protection for generally investment-grade companies with solid credit fundamentals.

The narrowing spread between 30-year mortgage rates and 10-year Treasury yields to a historically low level highlights a significant shift in investor sentiment. Investors are increasingly willing to take on credit risk by investing in junk bonds rather than prepayment risk associated with mortgage-backed securities. This trend makes us cautious about the outlook for spread products.

Deflation Diversifier – Current Allocation: 8%

To stabilize the portfolio, we will consider two strategies:

1. US 2-10 Year Steepening ETF: This ETF can hedge various rate scenarios, including a classic recessionary steepening and a scenario where a fiscal stimulus-response is poorly received by the market.
2. EM Corporate Bonds (CEMB): While EM debt can be a strategic diversifier in a multipolar world, current tight spreads limit its appeal for a significant allocation. We will consider a tactical approach to EM corporate bonds, adjusting our exposure based on market conditions.

While US 2-10 steepening trade may be crowded, we believe an allocation provides some benefits. This strategy can perform well in a range of scenarios, including a sharp recession or a “Liz Truss Moment” sudden rise in long-term interest rates.

The Currency Overlay

With regards to currencies, we find the table below (JPM Research) very helpful in synthesizing our view. In a nutshell, the willingness and ability of policymakers to employ monetary and fiscal policy tools, coupled with relative valuations, are key determinants of currency trajectories.

• The Euro. Given the potential for increased geopolitical tensions and the limited fiscal flexibility of many European countries, the Euro (EUR) is likely to bear the brunt of any adverse shocks. As a result, the European Central Bank (ECB) may be forced to ease monetary policy further, potentially weakening the currency (–). Additionally, the EUR’s relative valuation (REER) appears expensive, suggesting further room for downside.
• The Swiss Franc (CHF) presents an intriguing opportunity. While the Swiss National Bank (SNB) may be compelled to cut interest rates in response to a flight-to-quality demand, this is likely to occur concurrently with ECB rate cuts. This narrowing yield differential could exert upward pressure on the CHF, making it a valuable addition to a diversified portfolio. In valuation terms (REER) which takes into account inflation differentials, CHF is marginally cheap relative to the Euro.
• The US Dollar (USD) offers a compelling mix of carry trade potential and geopolitical hedging. Despite its relative strength, the USD benefits from a yield advantage over the EUR and can serve as a hedge against a range of geopolitical outcomes.
• The Yen (JPY). While the USD and CHF offer compelling opportunities, the Japanese Yen (JPY) presents a unique and potentially lucrative investment thesis. The JPY’s historically cheap valuation, coupled with the Bank of Japan’s (BoJ) relatively hawkish stance, makes it an intriguing countercyclical play. A potential scenario involves the unwinding of the yen carry trade, which could drive significant appreciation in the JPY.

More broadly EM FX does not seem compelling yet:

When people tell us that US tariffs are priced in, We show them this chart (see above). The Mexican Peso (top middle) is significantly stronger than it was in 2016 after the election. The chart compares the FX reaction to Trump’s election in 2016 and now Markets haven’t fully priced in the impact of tariffs. There’s still a lot of complacency out there. In response to this, we keep our EM local currency exposure very limited to 2% in our model portfolio.

Preview Part II

In our next post, we’ll delve into the equity component of our multi-asset strategy. Stay tuned to discover how we’re positioning our equity sleeve.

Actual Portfolios on Wikifolio

Finally, I want to introduce three portfolios Giorgio and I published on Wikifolio. Tom’s a multi-asset portfolio, and Giorgio manages a global growth-income equity portfolio with a heavy US tilt. The third one is on Italian Equities. Check them out!

https://www.wikifolio.com/en/int/w/wf00inf8ig

Our Multi-Asset Portfolio is up 23.9% in little more than a year, with a notable Sharpe Ratio of 2.8

https://www.wikifolio.com/en/int/w/wf000ipggi

Our Global Income and Growth Portfolio is up 27.5% in little more than a year, with a Sharpe Ratio of 1.9

https://www.wikifolio.com/en/int/w/wf00ipiteq

The Italian Equities Portfolio is up 5.4% since late February and has outperformed the FTSE MIB Index by 260bp in this timeframe

Happy trading and see you next week!

InflectionPoint

Disclaimer

All views expressed on this site are my own and do not represent the opinions of any entity with which I have been, am now, or will be affiliated. I assume no responsibility for any errors or omissions in the content of this site and there is no guarantee for completeness or accuracy. The content is food for thought and it is not meant to be a solicitation to trade or invest. Readers should perform their investment analysis and research and/or seek the advice of a licensed professional with direct knowledge of the reader’s specific risk profile characteristics.