How to protect portfolio as debt talks, Fed minutes in focus

Annex Wealth Management Chief Economist and Strategist Brian Jacobsen joins Yahoo Finance Live to discuss how to protect your portfolio amid debt ceiling negotiations, a potential recession, and the market's reaction to debt ceiling talks.

Video transcript

- High inflation, the threat of a debt default, and volatility on Wall Street all adding to growing concerns about a potential recession in the US. So how do you position your portfolio in this environment? Let's discuss with Brian Jacobsen, Annex Wealth Management Chief Economist and Strategist. Brian, good to talk to you today.

Let's start by talking about what we heard from one of the Fed officials today. Fed Governor Christopher Waller saying essentially that he doesn't believe a pause is on the table here until that data shows that there is, in fact, cooling inflation.

He sort of suggested we're talking a few months out from that. And yet the FOMC minutes we got today appears to suggest a pause in place here partly because of debt talks right now, partly because of other economic concerns. What's your base case that you're operating under right now?

BRIAN JACOBSEN: Yeah, thank you for that. I think that, really, what this is highlighting is that there is really a division of opinions on the FOMC. Governor Waller, I respect him deeply. But I do believe that he's actually in the minority with his view that there really shouldn't be a pause. So I would label him as being one of the most hawkish members of the FOMC.

According to the minutes, it seems like there is that consensus that we've done a lot already. And maybe it's prudent just to take a little pause here. Doesn't mean that they have to commit to cutting, but they really don't necessarily need to do a lot more. They can just see how things shake out in the near term.

- Brian, what about what the market is pricing in terms of what we could see the Fed do by the end of the year, even at the beginning of next year when it comes to potential rate cuts. Do you think the market's still being a bit too optimistic about that?

BRIAN JACOBSEN: Yeah, we do. So here at Annex on our investment committee we kind of discuss what's going on with the FOMC, what they're saying, and then also what is the market pricing in. And it seems to us that the market is getting a little ahead of itself being too optimistic that the Fed is going to react very quickly to any sign of weakness in the economic data.

Historically, the Fed has been very fast in responding to crises but very slow in responding to recessionary indicators. And so our base case is that the Fed is going to try to stay on hold probably until at least October, if not until the December meeting. So the market might be a little ahead of itself. And as a result, setting itself up for a little disappointment.

- Yeah, you talk about a potential hold for the Fed. It sounds like you feel like you should be in a holding pattern or investor should be in a holding pattern as well because of the uncertainty around policy right now.

BRIAN JACOBSEN: Yeah. That is really our positioning right now. Is not that we are encouraging people to be out of the market or in the market because that's kind of a fool's errand to try to time that. And really what we're focused more on is the positioning within the market.

If you think about broadly the types of portfolios that do well in different environments, you can have good time portfolios, you can have tough time portfolios, and bad time portfolios. During tough times-- so maybe a short shallow recession, a little bit more volatility-- a tough time portfolio would just be higher quality on the fixed income side, but then also higher quality when it comes to equities.

And we're finding a lot of that as far as what we would call the cash cows. Those companies that have relatively reasonable valuations, but have really a demonstrated ability to generate free cash flow for investors. The areas that we like most are mostly in the small cap value space and outside of the United States.

- Brian, why do you think investors are shrugging off what's happening down in D.C? Because, yes, the Dow fell about 200 points yesterday, off almost 200 points again today. But when you put it in context about what could potentially happen if we do default, they don't seem too concerned.

BRIAN JACOBSEN: Yeah, I think it's because the politicians tend to be almost like the story Chicken Little. Like, kind of running around the sky is falling, the sky is falling, but it doesn't actually fall. And so we've seen this before. Yes, they want to push it to the last minute. And then ultimately they'll come together, everybody will declare victory that they ended up winning.

So, obviously, as we get closer to that deadline, it gets a little bit more stressful to watch that play out. But given the tone out of McCarthy and President Biden, we do think that we're still an incredibly high likelihood that they'll come to a deal probably, let's say, by Sunday, maybe by after the Memorial Day weekend to end up lifting the debt ceiling. But we would still assign an incredibly low, if not vanishingly small probability of the US government actually defaulting on its interest and principal payments.

- So no need to hedge against a potential default. You think the moves that we have seen in the market are pretty justified given the reality in DC?

BRIAN JACOBSEN: We do, yeah. And if you really think about it, some of the moves on the optimism and the pessimism around the debt ceiling, it's really meant plus or -1% on the S&P 500 because the bigger story is really about the roving recession that the economy has been going through. The fact that S&P 500 earnings fell about 26% from the fourth quarter in 2021 to the fourth quarter of 2022. So we've already had a profits recession. The market has responded to that.

Now, how much more is left? And I think that's really the bigger question for investors. And that's where we think that positioning within those higher quality names can really be beneficial to help you ride through any type of volatility that we'll experience.

- Brian, one of the areas that you are looking at here is international and emerging markets. More specifically, where are you seeing that buying opportunity?

BRIAN JACOBSEN: Yeah, so Japan is a good example of something that we were noticing for a while, as far as from a valuation perspective fundamentals because of the weak currency, also highly levered to the China reopening story. Now it seems like things are getting a little bit better in Japan as well from an economic perspective.

And so that area has already run. It probably still has more room to run. But other areas is just kind of broadly with, say, European equities. A lot of people are still worried about what's going to happen now this upcoming winter since the troubles in Ukraine between Russia and Ukraine.

If that's going to continue, what does that mean for natural gas storage for the upcoming year? It's almost like there's this perpetual belief that they're going to be falling into a recession. But the reality is they've been defying those expectations.

So European equities broadly, it's got more of a value tilt to it which we actually like here. And it is likely to benefit from a weaker dollar over the long-term. We don't think the dollar is going to be collapsing under its own weight here. But a little bit of weakness on the margin would actually likely be beneficial for international as opposed to US investments.

- What about emerging markets? I mean, you talk about a weaker currency. Certainly the concern around EEMs has been the dollar denominated debt. But also, you talked about the China reopening play. Is there money to be put aside there?

BRIAN JACOBSEN: You know, so we like to be a little bit more selective when it comes to EEM. It's a number of different emerging markets so it's always a plural and not a singular. And if you actually look at the Chinese market, it almost did around trip this year. So it had a really good start, to now it's given back all of its 2023 gains because the reopening hasn't been quite as strong and vigorous as what people were originally expecting.

And so where we're seeing, actually, more opportunities when we talk to the individual managers that we allocated to would be areas like, let's say, India, much more favorable demographics. They also have some reforms that are continuing to go through. Probably going to weather any type of international volatility on a geopolitical front better than what China might. There's still that tension between the US and China. India might be a beneficiary of that.

But you can also look at other countries to even say in South America. Obviously, lots of political issues pop up all the time in emerging markets. It's one of the reasons why they typically trade at a discount, to developed markets. But the fundamentals, actually, seem like they're in a pretty solid space-- place for some areas like, let's say, Brazilian exposure or even in Mexico.

- Brian, bringing it back here to the US, certainly what has been driving the market here has been the techs performance and what we've seen from a number of the larger cap tech companies. Why do you think that momentum? Or do you think that momentum is going to fade?

BRIAN JACOBSEN: Yeah, we're not really all that optimistic about that momentum continuing. One of the problems with momentum is it can actually reverse rather quickly. That's one of the problems with chasing winners. You do want to let your winners run, but sometimes they can then run into a wall when things, actually, end up reversing.

We think that a lot of the resiliency and strength within tech very concentrated in, actually, companies that are very good cash flow generating companies. We have to remember that in 2022, that was a rather tough period of time for some of the big tech. So you had a decent rebound, they prove that they have resilient profit margins, that was the formula. People were caught a little bit offsides on that trade, and so you probably saw a little bit of overshooting in terms of how those stocks have done.

That's what the reason why we're actually more biased towards if you have to think about it more simplistically. Instead of thinking about a market cap weighted portfolio for your exposure, think about maybe more of an equally weighted exposure. There's all sorts of ETFs and mutual funds that you can get exposure using that type of strategy.

- Yeah, it feels like that's increasingly a theme that we are hearing over and over. Brian Jacobsen with Annex Wealth Management. Good to talk to you today. I appreciate the time.