Monthly letter
Crosscurrents and market divergences persist.
The traditional economic and market cycle playbook remains challenged in the post-pandemic environment. Today, roughly 18 months after the Federal Reserve (Fed) started hiking the Federal Funds rate, which has gone from near 0% to an upper bound of 5.5%, the economy is showing some signs of cooling but has proven resilient, especially the labor market. On the other hand, historically reliable recession indicators, such as the yield curve and leading economic indicators, continue to point to weakness ahead. In part, this divergence has resulted from an unusual environment relative to recent history.
Indeed, the decade prior to the pandemic was dominated by monetary policy; arguably, since the rebound during the pandemic, the economy has been “fiscally” dominated. This fiscal dominance has been underappreciated. It’s also helped to offset the fastest Fed Funds rate increase in several decades in addition to the fact that the economy appears to be somewhat less interest rate-sensitive relative to past cycles. This may be because many corporations issued longer-term debt at low levels during the pandemic and many homeowners have locked in their biggest liability, their mortgage, at historically low interest rate levels.
“We are now in a tricky part of the cycle where there is a fine line between the normalization process following the post-COVID boom and a more pronounced economic slowdown.”
That said, we are now in a tricky part of the cycle where there is a fine line between the normalization process following the post-COVID boom and a more pronounced economic slowdown. When and how deep the rate hikes in the pipeline will begin to show a greater bite is an acute concern. And while inflation has cooled from elevated levels—giving the Fed room to take a pause in September, it’s premature to give the all-clear, especially as energy prices have rebounded sharply of late. Moreover, equity markets continue to contend with a higher 10-year U.S. Treasury yield, which at 4.3%, is trading near the highest level since 2007.
Outlook and positioning
Given the crosscurrents, we continue to advocate a neutral posture across stocks, bonds, and cash in line with long-term allocation targets, with a focus on being up in quality. It is still premature to go on offense. However, within asset classes, broad divergences should continue to provide tactical opportunities.
We had anticipated that August was going to be a more challenging period for markets after five-straight months of gains and a higher bar for positive surprises.
We expect this market choppiness to persist near term. September, like August, has tended to be a more challenging month, and there remains a dearth of obvious near-term upside catalysts as stocks continue to digest the big year-to-date gains.
Rhetoric out of Washington surrounding a potential government shutdown is also set to heat up as we move through September. While shutdowns have historically not tended to have a lasting impact on the economy or stock market, we expect headlines around this topic to inject volatility.
The good news is we have already seen a slight reset in market prices and sentiment over the past month, while forward earnings estimates for the market continue to improve.
From a positioning standpoint, we still favor the U.S. over international, large caps over small caps, and a focus on high quality within fixed income.
Indeed, our long-standing U.S. bias has been additive this year, supported by better relative economic and earnings trends. At the same time, emerging markets (EM), our least favored equity asset class coming into the year, remains under pressure.
China’s market, which comprises about 30% of EM’s market capitalization, was down 9% alone last month as its post-COVID reopening has disappointed and real estate challenges remain. While this market has now become oversold, and recent Chinese stimulus steps may provide some near-term relief, we remain structurally negative over the intermediate term, especially as profit trends remain lackluster.
U.S. small caps remain attractively valued, and we see longer-term upside. But over the near term, the macro environment remains a headwind. Small caps, on average, hold much more floating-rate debt relative to large caps, and, therefore, are much more exposed to the impact of higher rates.
From a fixed income perspective, upward momentum remains behind yields. Still, as we look out over the next six-to 12-months and see a cooling economy, the risk/reward for extending bond duration appears more attractive.
The main risks to this view are the potential for sticky inflation and an abundance of issuance. That said, current yield levels offer a meaningful offset to rising rate environments. Over the next 12 months, if yields were to rise 50 basis points (0.5%), the most recently issued 10-year U.S. Treasury note would still have a positive total return.
Conversely, we have a less favorable view of riskier areas of the fixed income market. A credit cycle appears to have begun with high yield corporate bonds and leveraged loans witnessing rising default rates. We expect this trend to continue and reiterate our up-in-quality bias within fixed income portfolios.
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