BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Neutral
The Rate-Growth Dilemma: An Elusive Endgame
"He who awaits much can expect little."
- Gabriel Garcia Marquez
It seems like quite a while ago, but the third quarter began with a seemingly goldilocks backdrop of strong growth and peaking interest rates. A fair dose of FOMO (fear of missing out) led to a broadening equity rally, and confidence in a soft landing increased. However, as the summer wore on, the market narrative quickly shifted, and a cautious air drifted in (the S&P 500 fell -2% in the third quarter). The most proximate cause in this change in sentiment has been some recognition on the part of holders of Treasury securities that the Fed is likely to keep short-term interest rates higher for longer than previously anticipated. The speed and magnitude of the corresponding rise in interest rates led to the recent pullback.
Fortunately, and counter to many bearish outlooks, growth has remained intact. Better-than-expected growth (e.g., real time third quarter GDP estimates are above +4%, an acceleration from the previous quarter). Paradoxically, as markets have become more comfortable with the likelihood that the US economy avoids recession and that the Fed has successfully engineered a soft landing, it also has had to consider just where interest rates may level off. While a spate of good data has offered plenty of ammunition to our no recession / soft landing view, it cuts both ways as it relates to the case for stocks. How the higher interest rate but better-than-expected growth dilemma is resolved could re-catalyze the market for further upside, or lead to more profit-taking.
So, how will the rate-growth tradeoff play out? We believe we are near the end of the Fed’s tightening campaign and see few signs that higher rates have completely derailed the global growth outlook. We are well-aware of the fact that tighter financial conditions (e.g., higher interest rates) work with a lag, but so is the Fed. If forecasts for economic expansion hold (we suspect it will) and rates stabilize (we suspect they will), the investment environment should turn more hospitable. In the near-term as the market narrative sways between concern and optimism, investors should brace for volatility (October tends to be the most volatile month of the year) that sets the stage for a better seasonal stretch.
As we pen this update, the geopolitical backdrop has turned trickier. It goes without saying that our thoughts are with those impacted. Outside of human tragedy, we like to remind our clients that events causing global instability tend to influence valuations more than profits. The scope and duration of conflict determine the extent. We are prudently monitoring the situation, but in this case, there are offsets (e.g., potential for higher oil prices, offset by potential for lower yields).
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. The elusive endgame to the rate-growth dilemma has not changed that view. 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 do recognize that resolution won’t come easy, and therefore want to be thoughtful regarding portfolio construction and risk control.
The Technical Perspective
The technical backdrop remains volatile, but structurally intact. We believe the market is in better technical shape relative to last autumn, with several indices holding steadily above key moving averages. Price momentum is strong, but internal metrics (e.g., market breadth, new high vs. new lows, etc.) are on the weaker side. Small cap and equally weighted indices have lagged significantly over the past several weeks, confirming the narrow backdrop. Despite the recent consolidation, leadership has remained within the pro-growth pockets of the market and defensives have lagged. We are intently focused here as we consider portfolio tilts.
We do expect the market to broaden out and leadership to continue to adjust as we move into the final months of 2023. A handful of stocks (primarily large cap technology stocks) still account for the majority of gains this year. Healthier markets tend to have strong participation rates, so we are on the lookout for improvement here. We are also encouraged by the higher performance dispersion within sectors and industries, as it supports more active oversight. We expect lower correlations will continue with macro-healing later in 2023, an environment we welcome.
Investor sentiment remains poor (e.g., bull-bear surveys have moved lower) and light positioning (e.g., cash balances, money flows, etc.) 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 this year already reflect considerable unease.
The Macro Perspective
The macro discussion must start with a view of the global economy. Incoming economic data continues to support our slow but not recessionary growth narrative (e.g., unemployment is close to a fifty-year low). GDP growth has surprised on the upside for the last several quarters and estimates for the current quarter remain positive (and have recently revised higher). Recent macro worries have centered on the mix of higher inflation combined with slowing growth and tighter financial conditions (e.g., restrictive monetary policy). While these certainly have our attention, we expect the inflation scare will continue to subside.
Interest rates will be the fulcrum by which investors express their economic growth, inflation, and thus Fed policy views. Yield curves have been inverted for over a year as the front end of the curve has moved higher with Fed rate hikes. Curve inversion should be respected, as they have a very strong track record in signaling recession over the past 40+ years. What they cannot predict accurately is the timing of the recession nor its depth and magnitude. One of the most pressing questions for investors is: Can the Fed get control over inflation without causing a deep recession? It was never going to be easy but, 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.
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 consumer spending resiliency and 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 high with a historically sizable gap between the highest and lowest priced assets. We see opportunities in both groups. 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 (e.g., despite the weakness in equities, credit spreads were mostly stable last month). 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 are somewhat elevated but remain at non-recessionary levels. Corporate cash flows remain healthy with dividend reinstatements (or increases) running well ahead of dividend cuts.
Concluding Thoughts
We continue to see markets in 2023 gradually shifting towards more bottom-up (micro) influence, particularly those centered on growth prospects. 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 do believe the frequency by which investors can actively tilt portfolios towards those pockets of opportunity or away from risk will become more pronounced as correlations come down. 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 any 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.
Disclosure: Past performance is not indicative of future performance.