Tactical Income Q3 23 Recap: When Rates Rise…. Something Eventually Breaks

Q323 began right where Q223 left off, the markets had a drastic change in sentiment since the S&P 500 reached a 52-week high on July 31. The last three months morphed into a nerve-wracking quarter as investors grappled with a sharp 73bp rise in 10yr interest rates. The move brought the 10yr yield back to its long-term average for the first time since 2007. The market's heightened sensitivity to escalating rates became glaringly apparent, and as the saying goes, “when rates move significantly higher in a short period of time, something tends to break." The uptrend in rates coupled with stricter lending standards began casting uncertainty on corporations, consumers, and the broader economic landscape. Equity markets didn’t remain immune to these shifts. The revived negative correlation between stocks and bond yields (Figure 1, reminder that bond prices go down as rates go up) resurrected the "no place to hide" narrative, ushering in a risk-averse environment for the concluding two months of the quarter.

Treasury volatility has also been a significant indicator of the equity market’s direction. As rate volatility increases, the equity market is negatively impacted (Figure 2).

While the S&P wrapped up the quarter with a drop of -3.6%, breaking a three-quarter winning streak, the market mood felt more downbeat. The negative sentiment comes from confusion about the sharp rise of the 10yr rate. Is it driven by worries over inflation or strong growth? Looking at the term premium in treasuries or the real rates, it seems the rate hike is less about changes in Fed expectations and more about:

• Potential US sovereign downgrade
• Higher global rates led by Japan exiting YCC (yield curve control)
• Fed QT
• Less demand and foreign ownership—China and Japan
• US budget deficits and resulting increase in supply

The shift in interest rates has also made investing in fixed income more challenging. While most investors welcome the idea of higher yields, the journey to reach those higher rates has been quite painful. If investors didn’t time their purchases well, choose the right duration, or establish a proper ladder of maturities, 2023 has been a rough ride. Losses in the treasury market are rivaling some of the most notorious market meltdowns in history. The current losses in long maturity debt are more than double the previous largest decline in 1981. The losses also surpass the 39% average loss experienced in the 7 US equity bear markets since 1970. Additionally, investors now face increased risks in credit, which has been very stable so far in 2023. Investors are learning many lessons related to fixed income investing during the rising rate environment over the past two years.

Q323 also has brought on a tightening in Financial Conditions, a significant tailwind for risk assets throughout 2023. Easing Financial Conditions were a major catalyst for the markets post the regional bank crisis (Figure 3). As conditions tightened throughout Q3, this put pressure on the equity markets.

As Figure 4 below indicates, the sell-off in Q3 had significant breadth and impacted most sectors. The market pullback weighed on all style and factor boxes, and most sectors. 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.

Tactical Income Strategy Q323 Review

The allocation process of Tactical Income is centered around identifying the current stage of the economic cycle, and channeling risk towards the asset classes, sectors, and individual names poised to thrive from the projected macroeconomic currents. Yet, in the post-Covid landscape, the conventional economic cycle has seen a disruption, necessitating an adaptative stance from the Investment Committee. Additionally, the Federal Reserve's actions are casting a considerable influence on the potential duration and course of the cycle, demanding an elevated level of focus, patience, and versatility in risk positioning within the portfolio. The macro-centric and tactical nature of our strategy continues to be advantageous in this peculiar macroeconomic setting.

The Investment Committee continued to patiently add risk throughout Q3 to take account for the resurgence in some of the economic data. While the average equity exposure increased from 36% to 40%, the beta adjusted weight of the equity exposure was 35%. This lower than neutral equity allocation, along with the focus being on large cap and higher quality names, indicates the defensive nature of our positioning. Within fixed income, the Committee remains focused on increasing yield in a conservative manner, limiting credit exposure and retaining a relatively low duration. The floating rate and low duration of our Bank Loan and Structured Debt positions have served the portfolio well during this market environment.

For Q323, the Hilton Tactical Income Strategy outperformed its benchmark by 55bp gross and 43bp net. As figure 5 illustrates, much of the outperformance occurred in the last month of the quarter, when the markets experienced a selloff in risk assets and a pickup in cross asset volatility. The Investment Committees focus on maintaining a defensive bias in the portfolio helped the strategy outperform during the drawdown in the markets. Key investment decisions throughout the quarter included: lower than neutral beta weighting in equities, maintaining relatively low duration, and limiting credit exposure.

Quick snapshot of Q3 Attribution

• Average Asset Allocation during Q323: 1.8% Cash, 39.8% Equity, 58.4% Fixed Income
• Yield on the portfolio as of 09/29/2023 was 4.6%
• The Hilton Tactical Income Composite Q3 return was -1.26% gross / -1.38% net, which is +55bp and +43bp ahead of the benchmark return of -1.81%*.
• The Q3 outperformance was primarily a result of defensive/higher quality positioning within equities and maintaining a relatively short duration and little credit exposure in fixed income. While the Committee did increase allocation to equities by roughly 5%, the beta adjusted equity weighting remains defensive at 35%.
• The equity sector contribution to return was -1.11% which was +20bp ahead of the benchmark* Sector weightings are fairly balanced with no significant over weights or underweights.
• There were no significant contributors or detractors related to the contribution to return of each sector.
• Fixed Income contributed -22bp which was +28bp ahead of the benchmark*. There were no significant outperformers or detractors within fixed income sectors.
• The average duration of the fixed income portfolio is 3.6 which is roughly in-line with duration of the benchmark. The average credit rating is A+.

Quick rundown of YTD Attribution

• Average Asset Allocation YTD: 2.7% Cash, 36.4% Equity, 60.9% Fixed Income
• Hilton Tactical Income Composite YTD through Q323 return was +1.87% gross / +1.50% net, which is -360bp and 397bp behind the benchmark return of +5.47%*.

2023 has proven to be a challenging year for investors. A cloudy macro backdrop and skepticism around Fed policy decisions has left investors less than confident. This lack of confidence began to show up in late Q3. While we currently remain in what has been described as a “goldilocks” environment—inflation slowing, resilient growth and stable labor market, the marketplace is questioning how long this can last. We have been battling the “soft landing” vs “hard landing” narratives all year, and that continues today. The continued rise in interest rates, at an extremely rapid pace, has added to the de-risking across all asset classes.

The bottom line, the market needs more clarity on Inflation, growth and Fed Policy before you can make any investment decisions with strong conviction. This is why the Hilton Investment Committee remains patient with the allocation of risk. All the different permutations of how this cycle can play out have a different playbook when it comes to positioning and allocation of risk. The data will eventually reveal the path that needs to be taken, but until that occurs, the Tactical Income Strategy will remain defensively positioned, maintaining a relatively low standard deviation, and producing a solid income stream. There are plenty of tail risks related to the economy and the markets, and the Investment Committee remains disciplined as we seek to provide stable returns within an uncertain economic and investment environment. We 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.