InflectionPoint Robust Equity Portfolio

To optimize our portfolio across various market conditions, we employ a regime-based allocation strategy. By identifying four key economic scenarios —’Resilience’, ‘Too Hot’, ‘Crash Landing’, and ‘Immaculate Disinflation’ or Goldilocks— we strategically allocate assets to capitalize on specific market opportunities. As we dynamically adjust our portfolio based on these regimes, we aim to mitigate risks and enhance returns over the long term. While we dynamically adjust our portfolio across different regimes, our strategic asset allocation maintains a broad, scenario-based approach. This ensures we’re well-positioned to navigate various market conditions and capture opportunities across different market cycles.

Translating this into practice, the actual model portfolio takes the following shape:

You may find a quick recap of the ETFs employed in our portfolio construction below:

Our Key Market Assumptions (KMAs)

• Productivity & Technology: The US maintains a strong growth model, underpinned by solid productivity, robust profit margins, and the emerging potential of AI. However, some challenges are on the rise. First, increased global competition, especially from regions like Europe and China, could erode the US’s competitive advantage. Second, a more fragmented regulatory environment could hinder innovation and investment. Third, compared to previous technological advancements like social media and search engines, the complexity of AI implementation could make its widespread adoption slower than expected.
• Earnings Growth: While historical EPS growth has averaged 6.5%, the current macroeconomic landscape poses challenges. Elevated US debt and potential Fed policy constraints could weigh on growth. However, we believe AI-driven productivity gains can offset these macro headwinds, allowing for sustained long-term EPS growth on par with long-term averages.
• Reinvesting dividends and share buybacks: can further enhance returns. Historically, this combination has contributed an average of 4-5% annually. However, given the current high valuations and structurally higher interest rates, we anticipate a more modest contribution in the 3-3.5% area.

• Valuation: With the Buffett Ratio (forward P/S) at a record high of 2.9 and the S&P 500 forward P/E at an elevated 22.0 times, we agree that valuations are stretched by historical standards. The normalization of forward P/E ratios to historical averages of 16-17, from the current level of 22, and a decline in the trailing P/E ratio from 32 to 25 would reduce expected equity returns by approximately 3-3.5% per annum.

• Inflation hedge: While stocks have historically been a better inflation hedge than bonds, the current macroeconomic environment presents some challenges concerning the inflationary regime. Equities, especially those with strong pricing power, can better withstand inflationary pressures than bonds. To build a resilient portfolio, we believe a strategic allocation to equities is quintessential.
• Market Concentration: Goldman Sachs recently issued a cautious outlook for US stocks, projecting a meager 3% real return over the long term. They attribute this low-return expectation to the increasing concentration of the US equity market and elevated valuations. While we remain optimistic about the long-term potential of equities, we share Goldman Sachs’ concerns regarding concentration risk. At InflectionPoint, we advocate for a diversified portfolio that extends beyond a few dominant tech giants. This diversified approach can enhance portfolio resilience and better position it to navigate various market conditions.

We project long-term equity returns near 7%, fueled by 6.5% earnings growth and 3.5% from dividends and buybacks. Nonetheless, valuation normalization could trim this figure by 3-3.5%. Given current equity valuations and the attractive yields offered by bonds, a balanced approach is prudent. We advocate for a diversified portfolio that extends beyond tech mega-caps, incorporating a mix of US and international stocks. Additionally, a 50/50 equity-bond allocation for multi-asset portfolios can provide a more balanced and resilient portfolio, allowing for the potential to increase equity exposure if valuations become more compelling in the year ahead.

Upside Risks

• “Roaring 2020s”: This melt-up scenario, as outlined by Yardeni Research, where productivity growth accelerates, real GDP expands steadily at 3%, and inflation moderates to 2%, could significantly boost corporate earnings and fuel equity market returns. We acknowledge the potential for this scenario to materialize, as it aligns with certain economic outcomes, including ongoing productivity gains, moderating inflation, and prudent fiscal policy.
• Geopolitical De-escalation: While not our central case, a scenario of geopolitical de-escalation, potentially driven by renewed trade negotiations, could lead to a correction in equity sectors with high geopolitical risk premiums. However, this could also boost overall equity markets.

Downside Risks

• Second Inflationary Wave: A potential resurgence of inflation could lead to a sell-off in both rates and equity. This is a worst-case scenario for balanced portfolios, where certain tail hedges like precious metals, defensive stocks with strong pricing power, and real assets may be crucial.
• Economic Deceleration: A sharp economic downturn could trigger a broad-based risk-off event. In such a scenario, low-volatility equity strategies and ETFs, as well as undervalued sectors, could provide some dampening of volatility and mitigate drawdowns.
• Potential Capital Repatriation: A significant reversal of foreign investment, particularly from countries like Germany and Japan, could trigger a global risk-off event. Moreover, escalating geopolitical tensions and trade wars could lead to increased regulatory fragmentation and protectionist measures, particularly in the technology sector. Given the US’s reliance on free capital flows, such a scenario could pose significant challenges to U.S. equity valuations.
• A “Liz Truss Moment”: could occur in some key sovereign bond markets as investors struggle to absorb excessive fiscal stimulus. While this scenario is less likely in the US, given the recent political appointments (Bessent and the D.O.G.E. Department, if both are confirmed), it remains a potential tail risk for high-debt developed economies. To mitigate this risk, careful portfolio construction and diversification are essential.

US Exceptionalism: Drivers of US Equity Outperformance

We are coming off a decade of extraordinary US equity outperformance. A $1 investment in the S&P 500 in 2010 has grown to over $6 today, significantly outpacing global markets. This dominance is reflected in the S&P 500’s share of global market capitalization, exceeding 70%, and its relative size to US GDP, which has grown from around 100% to over 160% since the 2000s period.

To understand the drivers behind this outperformance and set the stage for future expectations, let’s delve into the key factors.

US equity outperformance has been driven by a combination of factors: 1) faster revenue growth, 2) margin expansion, 3) rising P/E multiples, and 4) the strength of the US dollar (for unhedged global investors).

As this performance attribution analysis by Bridgewater reveals, US equity outperformance has been driven by a combination of factors: faster revenue growth, stronger margin expansion, and P/E multiples expanding more rapidly than those of other developed markets. These drivers have contributed roughly equally to the overall outperformance.

While the technology sector has had a significant impact, US outperformance has been broad-based across sectors. Even excluding the Technology sector, the US still outperforms the rest of the developed world in terms of the three dimensions: revenue growth, margin expansion, and P/E multiple expansion.

US companies have historically demonstrated superior capital allocation efficiency (see chart below). This is evident in their ability to generate higher returns on invested capital (ROIC) compared to their global peers. Since the 1990s, US companies have consistently maintained ROICs above 15%, while most other developed markets have struggled to achieve single-digit returns.

US companies were also able to grow their sales at a faster pace and saw better margin outcomes.

Can the US Equity Magic Trick Continue?

As we discussed, the past decade has been a remarkable period for US equities. But can this extraordinary performance persist? The answer hinges on the ability of US companies to maintain their competitive edge, particularly in technology, and the broader macroeconomic environment.

While AI holds the promise of boosting productivity, its widespread implementation remains a challenge. Additionally, the US faces a more complex macroeconomic landscape. Firstly, limited fiscal space could constrain future stimulus measures. Secondly, the Federal Reserve’s challenge of balancing inflation and growth could limit its ability to support the economy. Lastly, the increasing complexity of AI implementation, compared to previous technological advancements, could hinder its widespread adoption.

Given these challenges, while we maintain a strong tilt towards US equities, we recognize the importance of diversification. Investing in a broader range of US stocks, beyond the dominant technology giants, and allocating a portion of the portfolio to other developed markets will be key to portfolio resilience.

Valuations for: the US, Europe, Switzerland, Japan & China

While we advocate for the continued outperformance of US equities, we are also convinced that a degree of geographic diversification into markets like Europe, Japan, and Switzerland can enhance portfolio resilience. However, given its strong fundamentals and growth prospects, we maintain a tilt towards the US. We would opt for country ETFs for Japan and Switzerland, while for Europe, we would select specific stocks.

Defying the Odds: Building a Robust Equity Portfolio for 2025!

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 “Too Hot” – Allocation 10%

This scenario hinges on a backdrop of increasing geopolitical tensions and trade protectionism, which could exacerbate inflationary pressures and economic slowdown. Persistent high real rates and a slowing economy could lead to a downward repricing of equities (see chart below).

To capitalize on this potential market dynamic, we are investing in a portfolio of four ETFs.

• SPYV (SPDR Portfolio S&P 500 Value): 2% Focuses on value stocks from the S&P 500 Index.
• XLE (Energy Select Sector SPDR): 4% Invests in U.S. energy companies across various segments like oil and gas exploration and production, refining, and marketing.
• PPA (Invesco Aerospace & Defense): 2% Concentrates on companies involved in aerospace and defence industries.
• IS3S (iShares Edge MSCI World Value Factor): 2% This ETF invests in value stocks globally.

Inflation Risk-on “Resilience” – Allocation 16%

Central Narrative: A combination of fiscal stimulus, tax cuts, and protectionist policies could supercharge economic growth, leading to elevated inflation levels above 3%. To capitalize on this scenario, we would focus on sectors that typically benefit from economic expansion and inflationary environments.

• iShares MSCI USA Quality Factor ETF (QUAL): 6.5% This ETF focuses on companies with strong financial health, stable earnings, and sustainable growth potential. It’s a defensive play, often outperforming during market downturns.
• iShares Dow Jones Global Titans 50 ETF (EX12): 2% invests in stocks with strong recent price momentum. It’s a more aggressive strategy that can generate significant returns in bull markets but may underperform during bear markets.
• iShares Edge MSCI USA Momentum Factor ETF (QDVA): 2% focuses on undervalued stocks with high dividend yields. It’s a more conservative approach that can provide steady income and capital appreciation over the long term.
• Global Titans (EX12): 5.5% This ETF invests in a select group of large-cap global companies with strong brand recognition and competitive advantages. It offers exposure to global growth opportunities.

Deflation Risk-off “Crash Landing” – Allocation 20%

Here is a breakdown of the portfolio:

• SPLV (Invesco S&P 500® Low Volatility ETF): 10%This ETF invests in a portfolio of low-volatility stocks from the S&P 500 Index, aiming to provide a smoother ride and lower risk compared to the broader market.
• ACWV (iShares MSCI Global Min Vol Factor): 10%This ETF invests in a diversified portfolio of global stocks with historically low volatility, aiming to provide a smoother ride and lower risk than the overall market.
• XLP (Consumer Staples Select Sector SPDR Fund): 0% This ETF tracks the performance of a market-cap-weighted index of companies in the consumer staples sector, including food, beverages, tobacco, household products, and personal care products.
• XLU (Utilities Select Sector SPDR Fund): 0%This ETF tracks the performance of a market-cap-weighted index of companies in the utilities sector, including electric utilities, gas utilities, and water utilities.

We believe the current allocation to SPLV and ACWV is sufficient to navigate potential market volatility. While we may tactically use XLP and XLU during heightened uncertainty or a strong risk-off view, our current focus is on balanced and diversified solutions.

Deflation Risk-on “Immaculate” – Allocation 35%

Central Narrative: With only 30% of US stocks outperforming the market, a potential rate cut could shift the market dynamics, favouring a broader range of stocks. To capitalize on this opportunity, we are overweighting the S&P 500 Equal Weight Index (represented by the RSP ETF), and the Russell 2000 Index (represented by the IWM ETF), and investing in a classic growth long-duration equity theme (Nasdaq 100).

Our selected products:

• InflectionPoint Growth/Income (WF000IPGGI): 10%A US-tilted GARP fund aiming to generate long-term capital. outperforming the MSCI World.
• iShares S&P 500 Equal Weight (EWSP): 10% This ETF tracks the S&P 500 Index but with an equal-weighting approach. Unlike traditional market-cap-weighted indexes, which allocate more weight to larger companies, this ETF allocates equal weight to each constituent stock. This approach provides exposure to a broader range of companies within the S&P 500, potentially reducing concentration risk and offering diversification benefits. By periodically rebalancing the weights of the constituent stocks, the ETF incorporates a mean-reversion strategy. This means that it sells off overperforming stocks and buys underperforming ones, potentially leading to better long-term performance.
• iShares Nasdaq 100 (CSNDX): 10%This ETF tracks the Nasdaq-100 Index, which comprises 100 of the largest non-financial companies listed on the Nasdaq Stock Market.
• iShares Russell 2000 (IWM): 5% This ETF tracks the Russell 2000 Index, which represents the bottom 2,000 stocks of the Russell 3000 Index. It provides exposure to small-cap companies, which often have higher growth potential but also higher volatility.

Portfolio Diversifiers – Allocation of 19% Equity ETFs and 15% USD & CHF

In a nutshell, the highlights are the following:

• Commodity exposure: DBC provides exposure to commodities, which can be a hedge against inflation. We like a small pure commodity exposure to hedge inflationary and geopolitical risks.
• InflectionPoint Italian Equities: WF00IPITEQ offers a high-conviction exposure to Italian stocks as selected by Giorgio Vintani.
• Core US equity exposure: Similarly to QDVA provides exposure to the momentum factor but for the broad global market.
• International diversification: EWL, IEFA, and GMF offer exposure to Swiss, developed international, and Asian equities, respectively, providing geographic diversification.

For Eur-based investors, we think diversification into USD and CHF make sense and we advocate a 10% and 5% allocation respectively. The implementation can be done by selecting USD or CHF-denominated share classes for the ETFs discussed.

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 24.9% 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 29.5% 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.