Let's Prep Your Portfolio for 2020

Last week I asked the question Is a trade truce enough? I believed it was and it seems the market has agreed with me. For one of the few times in recent memory there is no wall of worry to climb. Most fears have been resolved for now. Next week I will examine what fears may emerge, but for now let's review what I think you should have been doing in your portfolio and what to do in the coming days and weeks as year-end offers some interesting opportunities. I've been recommending a few key themes: Higher bond yields. The 10-year Treasury went from 1.78% at the start of the month to 1.92% as of last Friday, which has caused popular ETFs such as the iShares 20+ Year Treasury Bond ETF to lose 2.5% in the past month. The iShares iBoxx $ Investment Grade Corporate Bond ETF , an investment-grade ETF, had gains of only 0.7% because the move in interest rates offset much of the credit spread tightening. The long-dated bond market continues to get inflows, but I expect losses and underperformance to continue (Canada has seen signs of inflation, Germany is likely to capitulate on some form of Green-based fiscal stimulus, and it remains a crowded trade). OK credit and equity markets, with big rotations driving returns. Because my background is credit, I'll start there. The Bloomberg Corporate Bond Index average spread dropped from 105 basis points at the start of the month to 95 basis points on Friday. That's the tightest spread since early 2018. The infamous credit default swap (CDS) indices dropped to 45 basis points, again their tightest since early 2018. The high-yield market has also performed extremely well -- indeed, better than the investment-grade market -- because CCC credits, the weakest credits, did very well, providing ample evidence of short squeezes. Plus, the high yield market isn't as tied to interest rates. Based on my current view, I'd be selling high yield (short squeezes tend to end in January) and I'd be neutral on investment grade (spreads will have trouble tightening further and I'm bearish on interest rates). If anything, I'd add leveraged loan exposure; yes, that is in the face of negative story after negative story, which are more than priced in. I'm not sure I'm ready to add to closed-end funds that invest in leveraged loans or business development companies (BDCs), but it is too early to take profits here (the VanEck Vectors BDC Income ETF has returned 32% to investors this year -- which includes a healthy 9.3% distribution yield -- and is up 4.1% in the past month). Suggesting you hold these asset classes makes me very nervous, because the easy answer is to take profits, but the easy answer seems wrong for now. On the equity side, I think the rotation continues. Low volatility funds, such as the Invesco S&P 500 Low Volatility ETF , which is up 1.5% this month, will lag in this market. I prefer to avoid the bond proxies and I like things such as financials (the Financial Select Sector SPDR Fund is up 3.7% in the past month) and cyclicals (the Energy Select Sector SPDR is up 4.9% and the SPDR S&P Oil & Gas Exploration & Production ETF is up a whopping 12.7%). This rotation out of safety into risk should continue into the start of the year; many managers in stocks and bonds will be reluctant to show large exposures to some areas, such as energy, that struggled all year, but will correct that allocation at the start of the year. Emerging markets and Europe. I expect Europe and emerging markets to outperform the U.S. for different reasons. In Europe, it is based largely on a belief that we will see fiscal stimulus focused on green projects. That will allow bond yields to rise and yield curves to steepen. That combination of growth, which tends to spur transactional activity at banks, and higher yields (net interest margin is a more important metric for most European banks than U.S. banks) will help banks rally. Banks make up disproportionately more of European indices than they do U.S. indices, so outperformance should occur. Emerging markets should benefit from the cyclical rotation, though on a country level, I'm concerned about the direction Turkey is taking and I fear that Brazil benefited from trade tensions between China and the U.S. and may not prosper as much next year. However, as a whole emerging markets should do well.

Let's Prep Your Portfolio for 2020

From bonds to energy to emerging markets, an examination of what might be hot and what might not.

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