Market Navigator – August 2022 edition

Monthly letter

A little good news led to a sharp market rebound in July. Indeed, as we discussed last month, one of the most constructive attributes for the market heading into July was a low hurdle rate for positive surprises. The S&P 500 was already down roughly 20% through June, making it the third worst first half since 1950.

Consequently, better-than-feared news was good enough to propel markets. Corporate earnings proved more resilient than expectations, and investors started to price in a less aggressive Federal Reserve (Fed) tightening cycle. And, the sharp reversal in interest rates – the 10-year U.S. Treasury yield peaked near 3.5% mid-month before finishing just above 2.6% – led to a sharp expansion in stock valuations.

It wasn’t a uniform rebound, however. As U.S. large caps, an area we remain overweight, were the clear winner, while emerging markets, where we remain negative, finished in the red. Riskier fixed income, such as high yield corporate bonds, also had a very strong month.

So what now?

Near the mid-June lows, we discussed that we would not be selling equities given markets were already pricing in a lot of bad news. However, with the strong equity rebound since then and our view that the near-term upside is capped, the risk/reward appears less favorable. Thus, for those investors who are overallocated to equities relative to their long-term targets, our view is this would be a more reasonable place to trim exposure.

Indeed, in our work, we tend to focus much more on the risk/reward potential than tops and bottoms, because the latter is only known with hindsight. Still, since we have been asked several times on the topic, we provide our rationale for and against a bottom call.

Signs that we did see the bottom in June:

• On the positive side of the ledger, before the rebound, the S&P 500 declined almost 24%, right in line with the median drawdown seen around historical recessions.
  
• Some price indicators registered among the most oversold readings of the past 30 years as did some measurements of investor sentiment.
• The strong upward price momentum since mid-June is consistent with what one has often seen coming off an important market bottom.
• And, the way Corporate America has navigated the complex pre- and post-pandemic world is nothing short of impressive, which could justify a higher valuation relative to history.

Signs that we did not see the bottom in June:

• On the negative side of the ledger, the most dramatic global tightening cycle of the past several decades is underway. Its full impact is yet to be felt.
  
• Recall, the Fed only started raising rates in March, and the aggressive action since then, as well as actions by other central banks, works with a lag. Thus, we expect this financial tightening to continue to weigh on economic activity, regardless of whether the Fed pivots. 

• Notably, in the post-WWII environment, stocks have always bottomed after, never before, a recession started. While there was much debate about whether we were in a recession in the first half – our base case was the U.S. was not, as evidenced by the second most jobs ever created in the first six months of the year.
• Regardless, many economic indicators have turned more cautious and suggest U.S. recession risk over the next 12 months is above 50%.  Furthermore, risks overseas, in regions such as Europe, are even more acute.
• From a fundamental perspective, after the rebound, stock valuations are slightly back above their 10-year average, and that may understate valuations given earnings estimates are falling.

Now, we must operate with a healthy dose of humility and recognize that this cycle is very different in many ways. The normal sequencing expected has been disrupted by a once-in-a-generation pandemic and the withdrawal of unprecedented stimulus. 

Although we recognize the wide range of outcomes and will shift our view if the data warrants, the weight of the evidence in our work leads us to remain somewhat more defensively positioned.

Positioning

We are sticking with our long-standing U.S. overweight. We see it as the big blue-chip country with higher-quality companies and more defensive and stable sector exposure relative to the international markets. Moreover, overseas markets continue to underperform, hitting fresh relative price lows, and geopolitical and macro risks remain front and center.

Although we have had a less positive view for some time, this month, we further downgrade our international developed markets view to least attractive. And, we remain negative on emerging markets, which also continue to underperform relative to the U.S. and are being hurt by slowing global growth and a heightened geopolitical backdrop.  

On the fixed income side, we recommend investors take advantage of the roughly 6% rebound over the past month in high yield corporate bonds to reduce allocations. Based on history, even if we had a mild recession, the potential downside to junk bonds is high. Likewise, we are downgrading leveraged loans one notch given rising credit risk. Conversely, considering the deteriorating economic data, we are slightly upgrading government bonds one notch to neutral. Although yields are less attractive after the recent pullback, they should help to provide portfolio ballast.