First quarter 2023 was not an easy ride for investors. Despite very solid returns by the S&P (+7.48%) and the Nasdaq (+17.05%), the first quarter was much more stressful than the index returns would suggest. Headline risk and volatility were a constant and it presented many reversals in investment factors and styles which resulted in clear winners and losers. The year started off like a rocket, market optimism fueled by the notion the Fed was nearly done tightening, mortgage rates were falling, healthy employment and nothing in the economy had “broken”. However, two of the largest bank failures in US history coupled with another rate hike by the Fed disrupted markets and put a “hard landing” scenario back into view. But as the quarter ended, soft-landing hopes seemed to be winning in the tug-of-war versus hard landing fears and the markets experienced a risk on rally.
Despite elevated cross asset volatility throughout the quarter, both the VIX and the MOVE closed -30% from quarter highs, and High Yield spreads closed -12% from their quarterly highs. And a “motionless” S&P continues to trade narrowly between 3,800 and 4,200 with relatively low stock correlations. While there has been tremendous amount of attention given to the impact of economic data and Fed Policy on stock prices, the markets seemed to have been driven mostly by technicals over the past three to six months.
The quarter started with a robust cyclical and low-quality rally which has since reversed sharply. The rally was based more on momentum in the worst performing stock cohort rather than company fundamentals (see Figure 1). This powerful move upward caught many investors by surprise, and the “offsides” positioning and resulting FOMO pushed equities higher.
Figure 1: January “low quality” rally, led by high beta and heavily shorted stocks
SPX (black) v GS Most Shorted (blue) vs S&P High Beta ETF (red)
The equity markets experienced a second “risk-on” trade in early March. The collapse of Silicon Valley Bank and Signature Bank and tightening credit concerns had the markets quickly positioning for slower growth. The result was a massive move lower in interest rates, with 2yr yields collapsing over 100bp in a 5-day period. Lower rates put a strong bid under the large cap tech sector which created strong outperformance by the Nasdaq for the quarter. The breadth of the market gains was very narrow and there were clear Q1 winners: Large Cap over Small Cap; Growth over Value, High Quality over Leverage. From a sector perspective this played out with technology, communications, and discretionary outperforming financials, health care, utilities, and staples.
Figure 2: Q1 Sector Performance for S&P 500
One of the biggest determinants of market direction over the past two years has been the easing or tightening of financial conditions. As the chart below illustrates, as financial conditions ease markets tend to rally. Such easing conditions can help explain the Q322 rally and the rally into the end of Q123.
Figure 3: Easing/Tightening of financial conditions
Tactical Income Strategy Q123 Review
The Hilton Tactical Income Strategy maintained its defensive positioning entering 2023, as the Investment Committee remained cautious on economic growth and concerned with tightening economic conditions. The portfolio remained underweight equity exposure, had limited credit exposure, and focused more on defensive/high quality sectors and names. Anticipating an elevated level of cross asset volatility, the portfolio was structured to seek a low volatility solution within the challenging economic backdrop. The Investment Committee felt very comfortable with their economic outlook and risk allocations within the portfolio. But as with any bear market environment, investors must contend with exaggerated moves in the markets, including many bear market rallies along the way. During these volatile times in the economy and the markets, the Hilton Tactical Income Strategy focuses on the economic data and does not attempt to “trade” short-term moves in the markets.
For Q123, the Hilton Tactical Income Strategy underperformed its benchmark* by 256bp gross and 272bp net. As Figure 4 illustrates, the majority of underperformance occurred during the first month of the quarter, when the equity markets experienced the “low quality” rally illustrated in Figure 1. While the TI portfolio did participate in the market rally, the lag was due to the defensive positioning of the portfolio which has served us well over the past 15 months. While we did add roughly 5% to our equity exposure during the quarter, the portfolio has maintained a defensive tilt. We continue to believe it is prudent to remain patient as the economic data continues to deteriorate on the back of record rate raises which risks ultimately “breaking” something beyond a few regional banks.
Figure 4: Absolute Performance (top panel) & Relative Performance (bottom panel)
Source: Portfolio Analytics Bloomberg
Quick rundown of Q1 Attribution:
- Average Asset Allocation during Q123: 3.5% Cash, 33.7% Equity, 62.8% Fixed Income
- Yield on the portfolio as of 03/31/2023 was 3.7%
- The Hilton Tactical Income Composite Q123 return was +1.81% gross / +1.68% net, which was -256bp and -272bp behind the benchmark return of +4.40%*.
- The Q123 underperformance was primarily a result of the Investment Committee’s decision to remain patient with the more defensive/higher quality positioning and not chase the lower quality equity rally that occurred in first month of the quarter. Underweights in Information Technology, Communication Services and Consumer Discretionary accounted for much of the performance lag for the quarter.
- Equity sector contribution to return was 0.63% which was -234bp behind the benchmark*.
- The biggest sector outperformers were Financials (+13bp) and Health Care (+10bp). The biggest sector underperformers were Information Technology (-114bp), Communication Services (-60bp) and Consumer Discretionary (-53bp). As discussed, it was these sectors that led most of the “low quality” rally and the tech rally towards the end of the quarter. And many of the top performing names were companies without dividend yields, preventing TI from allocating to them.
- Fixed Income contributed +119bp which was -21bp behind the benchmark*. Most of the lag was a result of slightly shorter duration in both Corporate Debt and Government Debt.
- The average duration of the fixed income portfolio as of 3/31 is 3.5 which is roughly .3 shorter than the benchmark*. Average credit rating is A+.
2023 has proven to be a challenging year for investors. While robust Q1 equity performance has masked many of the struggles, we are far from an all-clear sign needed to justify adding significant risk to the portfolio. We feel slower growth and stubborn inflation will remain major themes in the coming quarters, and this creates a challenging backdrop for revenue growth and corporate margins. We anticipate an elevated level of volatility which can drive both drawdowns and bear market rallies. The Tactical Income Strategy will continue to maintain a defensive and high-quality bias and seek to provide stable returns within an uncertain economic and investment environment. The Investment Committee will continue to watch the economic data and the Fed closely, looking for signs of a true pivot in the economic cycle. Such a change would prove more durable and would spur significant changes in the portfolio. Until then we remain patient, and as always, vigilant.