DIVYS Q3 23 Recap: Duration Risk Everywhere

The beginning of Q3 2023 kicked off on a high note with the S&P touching a 52-week high on July 31. Yet, the financial climate has shifted since then. The optimistic sentiment that fueled the market's rise over the first seven months of 2023 dissipated quite swiftly. Investors found themselves facing a notable 73 basis points increase in 10-year interest rates, a change that, coupled with tighter lending standards, hinted at challenging times ahead. Meeting corporate debt obligations now seems more daunting with rising borrowing costs; consumers' previously ample savings are dwindling, oil prices are on an upward trend, and the economy, which has held up stronger than expected so far, is showing signs of slowing down.

Equity markets responded, with the S&P breaking its three-quarter winning streak. For the first time this year, the Magnificent 7 showed signs of cracking, selling off -10% from its July high to August low. The revived negative correlation between stocks and bond yields (Figure 1) resurrected the "no place to hide" narrative, ushering in a risk-averse environment for the concluding two months of the quarter.  

The S&P ended the quarter down -3.6%, and yet the market mood felt much worse than a minor, low-single-digit summer shower. The market was forced to grapple with the source of the rise of the 10yr rate, accepting “Higher for longer” as the new regime, and the market was forced to reshape its investment decisions to better fit it, a rather unpleasant activity.

While we often discuss the “why”, the implications of “higher for longer” are more important to make informed weather forecasts, none of which look pleasant either. 

As Figure 2 below indicates, the sell-off in Q3 had significant breadth and impacted most sectors (9 of 11), it worsened sequentially with the month of September negative for 10 of 11 sectors.  The market pullback weighed on all style and factor boxes.  Concerns about the health of the US consumer and increasing risks of a recession created a risk off environment.  After being a bottom-performing sector in the first two quarters, Energy was the top performer in Q3 fueled by a nearly 30% rise in oil prices, which combined with rising rates can only be perceived as negative for the consumer.

Dividend and Yield Strategy Q323 Review

The rising rate environment obviously creates some unique challenges for dividend strategies, particularly among higher-yielding defensives.  In general, the lower yields and longer duration of equities offer no place to hide when the entire yield curve rises in such an extreme manner.  

The rapid ascension of rates also forces us to revisit fundamental equity valuation truths; chiefly among them, are we being compensated properly for the risks we are taking? After 3 straight quarters of P/E expansion, the equity market seemed to agree, as the S&P saw multiple compression of 1.3x during the quarter as investors reduced equity exposures on the back of a cloudy macro picture (Figure 4). 

The Hilton Dividend and Yield Strategy kept a defensive selection bias given the uncertain macro backdrop and expected volatility across all asset classes. This translated into a focus on higher quality names with limited levels of leverage and less exposure to higher rates. Broad exposure to growth and value has enabled the strategy to participate in market rallies while limiting downside during drawdowns. This is particularly evident in the positive relative contributions from two sub sectors: interactive media (represented by the XLC in the portfolio, dominated by growth names like META and GOOGL) and asset managers (ARES, ARCC, largely value-oriented). DIVYS kept a limited exposure to rate-driven sectors such as Real Estate, while increasing allocation to other high-yielding areas such as Financials to keep exposure to both dividend growers and payers

For Q323, DIVYS underperformed its benchmark* by 59bp gross and 72bp net.  As Figure 6 illustrates, the Dividend and Yield strategy outperformed during the last two months of the quarter when equities markets sold off and equity volatility increased.

Quick snapshot of Q3 Attribution:

• Average allocation to cash decreased to 2.3% (3.4% in Q223) as cash was deployed into various new positions.
• Yield on the portfolio as of 09/29/2023 was 2.16% and the beta was .89.
• The Dividend and Yields Strategy returned -4.42% gross /-4.55% net, which was -59bp and -72bp behind the benchmark* return of -3.83%.
• Relative to the Nasdaq US Broad Dividend Achievers (DAATR), DIVYS was overweight communication services, technology, healthcare and underweight staples, financials and industrials.
• There were no significant sector outperformers or underperformers during the quarter.
• Top single-name contributors included XOM, CVX, ADP, and NOVO.
• Top single-name detractors included AAPL, MSFT, ZBH and NEE.
• Relative to the S&P500, DIVYS remained defensive: overweight staples, healthcare, utilities, and industrials. DIVYS remains underweight technology, financials, consumer discretionary, and communication services. But the over and underweights were reduced to reflect the lack of clarity in the macroeconomic landscape. 
• New positions added during the quarter:  CBU, GS, AVB, APO
• Positions sold during the quarter:  VZ, CCI, LVMH

Quick rundown of YTD Attribution:

• The Hilton Dividend and Yield Strategy YTD return through Q323 was +1.64% gross / +1.24% net, which is -26bp and -38bp behind benchmark return of +1.90*.
• DIVYS relative underperformance in Q3 was driven by the same sectors that it benefitted from during the first half of the year. After being top contributors to relative return during 1H23, Financials and Healthcare flipped from top positive contributors to leading Q3 detractors. Specifically, banks and healthcare devices performed poorly during the quarter, due to worsening financial conditions and concerns about GLP-1s (new weight loss drugs) , respectively.
• The DIVYS strategy continues to maintain a lower standard deviation vs benchmark*—one-year standard deviation of 13.0% vs benchmark* of 14.2%.  The standard deviation has contracted meaningfully due to the lack of equity volatility through Q323.

2023 has been a tough year for investors. The unclear macroeconomic landscape and doubts surrounding the Fed's policy moves have left investors feeling uneasy. Even though the current “goldilocks” situation looks good—with slowing inflation, solid growth, and a steady job market, there is a growing concern in the market about how long this can last and what the upcoming challenges might look like.

In a nutshell: we need more insight into inflation, growth, and the Fed's plans. The Hilton Investment Committee is staying patient, keeping a close eye on the economic data and the Fed's actions, waiting for clear signs of a major turn in the economic cycle. Such a shift would call for significant adjustments in the portfolio. Until that point, we are staying patient and, as always, keeping a sharp lookout.