August 2024: The BakerAvenue Prudence Indicator

BakerAvenue Prudence Indicator Says... 

Long Term: Positive  |   Short Term: Neutral

Summertime Unwind

"I was taught that the way of progress was neither swift nor easy."
- Marie Curie

Last week, volatility spiked to levels not seen since peak Covid fears and the Global Financial Crisis (e.g., the “fear gauge,” the CBOE Volatility Index, or VIX, hit 65). The drivers of the sell-off began with a batch of weaker-than-expected employment data that raised recession fears. The data came on the heels of a Fed meeting where interest rate cuts were again pushed out, thus igniting concerns that the Fed is falling behind the data. Yields fell sharply on the news.

Around the same time and thousands of miles away, the Japanese Central Bank raised interest rates. This pressured a popular trade called the ‘yen carry trade.’ Trillions had been borrowed in Japan, the world’s last haven of rock-bottom interest rates, and plowed into assets all over the world, but undoubtedly over-indexed to the U.S. where growth assets have shined. Investors swapped yen for dollars, for instance, to buy higher-yielding Treasury bills, or invest in popular AI stocks. For years the value of the yen kept falling, and those loans became even cheaper to repay, and the payoffs turned that much bigger.

The trade unraveled over the past month as the gap between U.S. and Japanese government bond yields narrowed. As those rates started to reverse, investors bailed out of the trade. Changes in economic or financial conditions can force investors to sell one piece of their portfolios, such as U.S. or Japanese equity holdings, to deal with losses from another, such as leveraged bets on a weak yen. We suspect margin calls played a role as well. Of course, this deleveraging or “unwind” came at perhaps the worst time for markets - smack in the middle of summer months where liquidity was light.

The messy process to reduce risk takes time to settle, but this one is mostly technical in nature. Unfortunately, investors must deal with more volatility in their stock and bond prices than the underlying data would suggest. For example, although the job market is cooling, talk of an emergency intra-meeting Fed cut while the economy is creating 170,000 jobs per month (3-month average) seems premature to say the least.

The key to stability is growth, and, encouragingly, there has been little change (e.g., U.S. GDP growth continues to run around +2.5%). Prices have already retraced much of the correction. The historical experience during growth scares suggests that both correlations and volatility will only gradually recede back to “normal” in coming months. If economic fears abate, as we expect, then the recent sell-off represents an opportunity for portfolio adjustments (e.g., reallocations, tax-loss harvesting, etc.).

In times like these, it is important to have an investment process in place that removes emotion from the equation. At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental, and macro analyses indicate. Currently, our short-term metrics are in a balanced (neutral) position while our longer-term view is positive.

For those who have been following our market updates (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated our expectations of slow but non-recessionary growth. There are subtle changes to consider, but our view remains the same. Ultimately, another year of economic and earnings growth should be enough to offset the higher rate backdrop and support a continued grind higher in equities. We believe it is a good time to be active and want to be thoughtful regarding portfolio construction and risk control.

The Technical Perspective

The technical backdrop remains structurally intact with several indices holding steadily above key moving averages. Price momentum is strong, but internal metrics (e.g., market breadth, new highs vs. new lows, etc.) have room for improvement. Last month, small cap and equally weighted indices started to pick up relative strength and have helped to broaden the market a bit. There remains opportunity for tactical positioning as leadership moves from pro-cyclical, to defensive, and back. We are intently focused here as we consider portfolio tilts.

While we have embraced the growth momentum (we own several of the secular leaders), we do expect the market to continue to broaden out as the year progresses. Healthier markets tend to have strong participation rates, so we are on the lookout for more improvement here. We are encouraged by the higher performance dispersion within sectors and industries, as it supports more active oversight. We expect the lower correlations backdrop will continue into 2024, an environment we welcome.

Investor sentiment is now more balanced (e.g., bull-bear surveys reflect a neutral bias), but positioning remains light (e.g., investors have poured over $6 trillion into money market funds) and should act as a catalyst. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher or lower). While there is certainly a high bar for allocations given elevated risk-free rates, our view is that investors have room to increase equity exposure as the lack of inflows already reflect considerable unease.

The Macro Perspective

The macro discussion must start with a view of the global economy. Incoming economic data continue to support our slow but not recessionary growth narrative. GDP growth has surprised on the upside here in the US for the last several quarters and estimates for the current quarter remain positive, albeit slightly off the pace of early ‘24. Globally, last month saw further encouraging signs of economic optimism. Recent macro worries have centered on slowing growth and still tight financial conditions (i.e., restrictive monetary policy). We understand the concerns but continue to see peaking Fed policy as a sustained catalyst. Given the recent growth scare, we expect growth metrics to carry more influence as we move deeper into 2024 (a “good news is good news” backdrop).

Interest rates will continue to carry outsized significance. We don't think the lagged effects of prior policy tightening has been fully digested, thus our focus on growth. We expect lower, but not low, interest rates going forward with the first Fed cuts coming this September. One of the most pressing questions for investors is: Can the Fed get control over inflation without causing a deep recession? So far, so good.

Macro themes will remain important, no doubt, but we anticipate markets to sharpen their focus on specific security characteristics as the year progresses (e.g., company fundamentals, asset class relative strength, etc.). Security selection, identification of investable themes, and traditional bottom-up analysis will play an expanding role and help portfolios ride out the lingering macro-induced market gyrations. Geopolitical and political events will represent increasingly material considerations for investors. While particularly difficult to position for, we have several market- and non-market-based factors to lean on that help assess materiality and support positioning.

The Fundamental Perspective

Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Headwinds, such as higher financing and input cost pressure, have been more than offset by solid demand trends. Estimates for revenues and profits have been revised higher over the past few months and remain a stalwart defense against any recession forecast.

Valuations are in line with long-term averages. However, valuation dispersion within sectors and industries remains elevated with a historically sizable gap between the highest and lowest priced assets. We see opportunities in both groups (continued leadership in one, reversion to the mean in the other). Several of the secular growers are commanding high multiples, but also market-leading profitability. Value-oriented pockets offer opportunity, but investors will need to be selective.

The credit backdrop will be important to monitor as growth concerns persist. So far, the credit backdrop has supported the move in equities. One of the defining criteria between recessions and slowdowns has been the behavior of the credit markets. Both investment-grade and high-yield spreads vs. Treasuries have moved lower and remain at non-recessionary levels. Corporate cash flows remain healthy with dividend reinstatements (or increases) running well ahead of dividend cuts.

Concluding Thoughts

Despite the volatility spike driven by the summertime unwind, we have made few changes to our long-standing narratives. Growth has slowed a touch, but resilient economic and earnings growth remain. Market narrowness has started to loosen, and we continue to forecast a gradual pickup in participation as investor confidence builds. We have championed an active approach of investing with secular winners, while simultaneously allocating capital toward assets that will benefit most in a sustained recovery. We see no reason to alter that view. Our forecast for a maturing but sustained economic expansion strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all.

Our investment philosophy is based on a dual mandate of growing and protecting client assets. We are staying active, using volatility to harvest losses while opportunistically deploying capital where appropriate. Our cash weightings remain residual in nature and are focusing on strategy positioning vs. our respective benchmarks to control risk. Of course, should the backdrop destabilize, we will take a more defensive stance.

Should you have any questions or comments, please contact BakerAvenue. We are happy to share our thoughts in greater detail, and we welcome the opportunity to speak with you.