View From The Top: The waiting game

View from the very top: We may be due a pause. Equity markets have enjoyed a robust ride year-to-date, even when consensus opinion remains highly cautious. To ignore the known unknowns would be foolish. Uncertainty over the health of the economy and the direction of monetary policy remain top of mind. At the same time, US banks are still failing and the debate over the debt ceiling is not fully over. We believe that there is little to be gained from the Federal Reserve cutting rates too early. This, however, is to miss the point. Markets are highly anticipatory. We also had a major valuation reset last year, in both equities and fixed income. While a combination of still-high inflation and low real GDP growth is neither desirable nor sustainable longer-term, even with a pause in the very near-term, the path of least resistance for markets may be up. We caution against complacency, argue for a balanced and pragmatic approach to asset allocation and believe that staying nimble and opportunistic is absolutely crucial.

Asset Allocation:

• Equities: The rally in equities has been highly polarising year-to-date. The two standard deviation outperformance of the US tech sector is the largest seen since 2010 (per Bank of America Merrill Lynch) and has had the effect of driving both the NASDAQ and S&P 500 Indexes higher. Correspondingly, on all headline valuation metrics, neither Index looks cheap relative to 30-year historic averages (per Bloomberg). While the most recent earnings season was generally better than feared, forward estimates assume just a 2% decline in earnings for the S&P 500 Index over the remainder of 2023 (per Factset), which seems optimistic to us. All the above suggests that a judicious approach to stock picking is necessary. We favour a balance across styles: growth and value, cyclical and defensive.
• Fixed Income/Credit: Our stance on this broad asset class has become increasingly positive. We see fixed income as being a currently valid alternative to equities given both the yield and the carry that is available. Further, peak inflation logically means peak bond yields, in our view. At the same time, we do recognise that in the extreme event of a US debt default, even US Treasuries would not represent a safe place to hide, given their use as collateral elsewhere in the financial system. The case for corporate credit is less compelling, given the risks of further bankruptcies and defaults.
• Currencies: The US Dollar has enjoyed a rally in the last month, but is still down significantly from its October 2022 peak. For context, last year’s level marked the highest relative move for the currency in 20 years. Our sense is that currencies tend towards mean reversion. A weaker Dollar is generally positive for emerging markets (and vice versa).
• Gold: There remains a logical place for gold in portfolios, in our view. We see it as a valid hedge against geopolitical uncertainty and have not been surprised to see Central Banks increasing their exposure to the asset class amidst a context of heightened geopolitical tensions. Gold is also negatively correlated with real bond yields.
• Cash: Money market funds have been an inevitable beneficiary of financial uncertainty in the US, with inflows at an all-time high (per Bloomberg). We recognise that cash comprises a bona fide asset class for the first time in decades but also see a continued case for tactical and unemotional deployment into other undervalued areas of the market.
• Alternative Assets: It is important to be selective in this broad and diverse area. We are attracted to business models with good visibility, typically in the form of strong balance sheets and collateral-backed cashflows, but recommend thorough due diligence. The lagged impact of higher interest rates may impact certain areas (especially commercial real estate).

Everyone’s waiting for something. Top of most lists might be the direction of monetary policy from Central Banks, potential recessionary evidence and a definitive resolution to the US debt ceiling debate. At the same time, summer vacation time is getting ever closer. Many are already looking forward to this. Given both the magnitude of uncertainties ahead and the healthy rally that certain asset classes (especially growth equities) have enjoyed year-to-date, we believe a near-term pause may be possible. None of this, of course, changes our longer-term view that within six-twelve months, inflation should be lower and longer duration assets hence higher.

These are interesting times for sure. When questioned, investors remain highly cautious. Global Fund Managers are the most pessimistic they have been all year, with 65% now expecting a weaker economy over the next 12 months. Bond allocations are apparently at their highest since 2009 (data per Bank of America Merrill Lynch). However, the numbers do not support such caution. The NASDAQ Index has risen ~30% since 1 January with the NYSE FANG+ Index now ~60% higher than at the start of the year. Even European equities are almost 10% above where they ended 2022. At the same time, 10-year US Treasuries are yielding an almost identical amount relative to the start of the year.

The only explanation we can see is that the more the market rises, the less investors seem to trust or believe in its durability. This dynamic is also compounded by the relative lack of breadth within the market. Strip out the performance of NVIDIA, Microsoft, Apple et al and the 2023 returns of US equities looks markedly less impressive. Few would also dispute the notion that current valuation levels can be described as cheap. Take NVIDIA, the perceived poster child for all things AI-related. It trades on a multiple of ~25x 2023 sales. Its earnings ratio for the same period is ~55x. on a non-GAAP basis (per Bloomberg). Such valuations are not for the faint-hearted. There is more than a whiff of late 1999 in certain market segments.

Against such a background, it’s important to caution against complacency especially when banks are still failing, the Fed retains a bias towards tightening, the economy is slowing and political differences over the debt ceiling remain severely elevated. It’s also critical to distinguish nearer-term dynamics from longer-term ones. Begin with the debt ceiling, a topic which has occupied multiple column inches elsewhere. An apparent agreement between the two parties is not a cause for celebration as such. Major principles have been and remain at stake. At the least, the issue will come up again, given the large differences between the two parties. High debt levels are clearly not sustainable over the longer-term. Globally, they stand at record highs (per the Bank of International Settlements). It may be an extreme (but not totally inconceivable) scenario to imagine a US default at some stage in the future. In the near-term, more debt issuance – to fund a higher ceiling – is also not an optimal outcome since it effectively takes cash out of the system, thereby tightening liquidity.

To what extent might political machinations over the debt ceiling and the corresponding uncertainty they have engendered have an influence on Fed policy? It’s impossible to know at this stage. Certainly, the messaging from Jerome Powell and his colleagues is that the US Central Bank remains data dependent in its decision making. What we do know is the following: there is still a disconnect between the Fed’s stance and what the Fed Funds Futures market is assuming. The former’s ‘dot plot’ suggests no interest rate cuts are imminent, while the latter assumes that US rates will be at least 50 basis points lower in six months’ time (and substantially more on a 12-month view). Of course, there is little to be gained from the Fed cutting too early, especially if it undermines hard-earned credibility. At the same time, no Central Bank Governor wants to be remembered as the official responsible for bringing about recession, particularly with a US Presidential Election little over a year away. For now, it’s a waiting game.

If we do accept the data-dependent narrative, then there are two conflicting dynamics to consider: inflation and growth. The war on inflation is far from won. While some may draw comfort from the first sub-5% Consumer Price Inflation print in two years last month, a 4.9% reading is still well over two times the Fed’s desired level. Further, even if US price pressures may now be beyond the peak, inflation elsewhere remains a concern. In the Eurozone, it is currently running at 7%. The Fed may not relent until inflation cracks.

This thesis is valid on the assumption that the economy does not crack first. Much evidence abounds to support the notion of a credit crunch. A 25 basis point hike in US interest rates in May is hardly likely to have helped. Even prior to this, the most recent Senior Loan Officers Survey highlighted loan standards tightening and demand for new loans correspondingly weakening – at its lowest since 2009. Bloomberg data show that credit tightening has been referenced more times on earnings calls in the past quarter than at any time since 2008. There is a certain circularity to the view that the US banking crisis won’t come to an end until either the macro backdrop or monetary policy changes.

We may be getting to this point. Jerome Powell has at least been consistent in his message that Fed policy works with a lag. For context, don’t forget that we have seen 500 basis points of tightening in the US in just 14 months. This is bound to have an impact. No surprise then that manufacturing data is already pointing to recession on both sides of the Atlantic, small business sentiment in the US is at its lowest in a decade and corporate bankruptcies in the States year-to-date are at their highest level since 2010 (all data per Bloomberg). Even if unemployment is at a 50-year low, the rate of new jobs added is at its weakest since the start of 2021.

It’s not all bad news, however. Set against this conflicting macro backdrop, it’s important not to forget that markets are very forward looking. We caution against comparing this cycle to prior ones given the unprecedented circumstances of the last two years (the pandemic, supply chain shock and monetary response). Similarly, no two recessions are alike. Nonetheless, what we do is that there was a major valuation reset last year in both equities and fixed income. Against this background, it would be fair then to recognise that even with a pause in the very near-term, the path of least resistance for both equities and fixed income may be up. As we’ve noted previously, it may be no more complicated than simply adopting the mantra of follow the money. Put another way, risk assets will likely continue to discount an imminent easing (or at least no further tightening) in Fed policy. At the same time, equities may well be able to weather any recession, simply since its impact could be offset by growing disinflationary forces. In this scenario, lower bond yields would also be supportive in helping to underpin equity multiples.

Investors may be able to have their metaphorical cake and eat it. An optimal scenario, which is far from inconceivable, would be one of a mild recession, ongoing disinflation (from its highs) and still positive earnings growth. Set against this dynamic needs to be a recognition that the current combination of still-high inflation and low real GDP growth is neither desirable nor sustainable over the longer-term. The path forward then will be far from linear, but judicious asset allocation decision can help navigate through potential hazards. Stay nimble and opportunistic.

Alex Gunz, Fund Manager, Heptagon Capital