BakerAvenue Prudence Indicator Says...
Long-term: Neutral | Short-term: Neutral
Finding Equilibrium
“The present is the ever-moving shadow that divides yesterday from tomorrow. In that lies hope.”
– Frank Lloyd Wright
Markets are trying to strike a fragile balance between hope that inflation is peaking and fear of a recession. Growth is slowing just as financial conditions tighten, but we suspect prolonged recessionary conditions can be avoided. Volatility has remained elevated, and investors are sure to remain on edge as the path to a soft landing is narrow. As always, we will defer to our technical, fundamental and macro disciplines to assess the risks and guide our outlook.
Markets are trying to strike a fragile balance between hope that inflation is peaking and fear of a recession. May's inflation report was a big surprise, and this is not a market that wants surprises. Confidence in the Fed’s ability to engineer a gradual, non-recessionary slowdown (that helps to lower inflation) took a big hit. Prior to the report, hopes of a September pause in rate hikes fueled a sizable bounce in the markets. The recent update quickly tightened financial conditions (e.g., the market is now pricing in five 50 basis point rate increases for each meeting left in 2022) and rekindled recessionary talk.
If the market is correct, then today's 0.75% Fed Funds rate will move to 3.25% by year end, and to 3.75% before this hiking cycle is complete. The primary concern for investors is that those higher rates will not address the inflation problem and lead to a prolonged, wealth-destructing recession. Investor fears of stagflation (i.e., slow growth, high inflation) are at the highest since the Global Financial Crisis, while global growth optimism has sunk to a record low, according to Bank of America Corp.’s monthly fund manager survey. Last month we acknowledged the narrow runway the Fed has, but concluded that while the brakes are being pumped, we do not forecast a break to our longstanding view of slowing, but non-recessionary growth. That view remains, but risks have increased.
Tightening financial conditions (e.g., more restrictive monetary policy, higher interest rates, wider credit spreads, wider earnings variability, etc.) tend to be associated with volatile markets. Encouragingly, these developments are happening at a time of strong employment and record corporate profitability that should soften the sting of a more restrictive policy. While May was a flattish month for most assets (e.g., the S&P 500 was flat in May), June has gotten off to a rocky start. Interest rates around the world have continued to move higher while geopolitical volatility and stubborn lockdowns are pressuring economic growth. Investors should keep their seat belt on as finding equilibrium is tricky business. As always, we will defer to our technical, fundamental, and macro disciplines to guide our outlook.
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, both our short-term and long-term metrics are in a balanced (neutral) position.
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 that the pandemic-related retrenchment in economic activity, while necessary, was self-inflicted, not structural, and prone to snapping back as re-opening resumed or vaccines entered the narrative. That snapback has now matured, and growth is slowing.
While the backdrop has weakened, we do not forecast a break to our longstanding view. We suspect another year of above-trend economic growth, robust consumer spending, inventory restocking, and double-digit earnings growth will be enough to offset monetary tightening and support an eventual grind higher in equities. While we expect the direst outcomes can be avoided, we acknowledge uncertainty remains. We want to be thoughtful regarding portfolio construction and risk control in these volatile times.
The Fundamental Perspective:
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. It doesn’t feel like it, but, in aggregate, they remain healthy. Our weekly series for forward revenues, earnings, and margins have risen to record highs. Concerns about rising input costs have meant little to the robust trend in profit growth. In fact, corporate margins are higher now than they were pre-pandemic. We see more of the same in 2022 and expect earnings growth to again outpace economic growth. Stubborn pricing pressure and supply constraints are headwinds we are monitoring, but so far, strong demand has more than compensated. While the frequency and magnitude of earnings and sales beats are normalizing, consensus estimates look beatable, and another double-digit expansion in profits is within reach.
Valuations have corrected and are now below long-term averages. The pace of the expansion in corporate profits has far exceeded stock prices over the past couple of years, so multiples are now well below where they were at this point last year. Valuation dispersion remains high with a sizable gap between the secular growers and the more economically sensitive recovery stocks. Predictably, the backup in rates has caused this dispersion to shrink as the more speculative assets have corrected to a greater degree. We continue to see less dispersion going forward as investors embrace a more balanced view.
The credit backdrop has weakened but remains supportive. Despite some widening over the past few weeks, both investment-grade and high-yield spreads vs. Treasuries remain at non-recessionary levels. Dividend reinstatements (or increases) are running well ahead of dividend cuts. We see deal activity picking up as cash flows remain strong and corporate confidence stays elevated.
The Macro Perspective:
The macro discussion must start with a view on the global economic recovery. Incoming data at the start of 2022 has supported our sustainable recovery narrative (e.g., unemployment reached a post-COVID low last month, manufacturing reports have stayed in expansionary zones, etc.). Recent worries have centered on the mix of higher inflation, combined with slowing growth and the beginning of the Fed exit. While these certainly have our attention, we expect the inflation scare will subside as conditions generating the price spikes ebb (e.g., bottlenecks ease, labor supply increases) and economic growth continues. Geopolitical conflicts have historically had little economic impact, provided they don’t result in a prolonged cutback in consumer spending.
Interest rates will be the fulcrum by which investors express their economic growth views, and we continue to expect them to move gradually higher throughout the year. The pace of the recent move higher has surprised us. The Fed has acknowledged that aggressive bond purchases (QE) are not a policy that fits well with a supply-constrained economy. They recently announced plans to taper those purchases (to help address inflation), removing the largest suppressor of rates. Further, they recently adjusted their views by indicating higher inflation could stay longer than expected, and they could speed up their tapering process. As mentioned, one of the most pressing questions for investors is: Can the Fed get control over inflation without causing a recession? It is going to be tricky, but at this point we believe they can.
Regarding COVID, we are mindful of the latest developments. Lockdowns, globally, need monitoring. The high-frequency data we monitor (e.g., hotel occupancy rates, restaurant bookings, retail spending, etc.) continue to support the notion that, while volatile, the recovery is intact. We do expect a shift in spending in 2022 as pent-up services spending starts to outpace goods spending.
The Technical Perspective:
The technical backdrop is volatile, to say the least. The sell-off over the past few weeks have taken their toll on many of the short-term indicators we monitor, and while several are pointing toward oversold conditions, internal metrics are less supportive. For example, the number of new lows has been outpacing the number of new highs, and several price change indicators are flagging a noticeable slowdown in momentum. We are on the lookout for sustained stability in these metrics with a more balanced short-term outlook.
We expect the market to broaden as we move further into 2022. Healthier markets tend to have strong participation rates, so we will be looking for improvement here. Admittingly, we are discouraged by the higher correlations we are seeing within sectors and industries. Lower correlations should come with macro-healing later in the year, and will support a more active approach, an environment we welcome.
Investor sentiment is quite bearish, which, from a contrarian point of view, is bullish. Surveys (e.g., AAII bull-bear survey, Investors Intelligence surveys, etc.) point to a skeptical investor base with the number of “bears” reaching the same levels as the pandemic peak (i.e., 60%, more than in March of 2020!). Tactical positioning data (e.g., put-call ratios, cash balances, etc.) is leaning defensive and will act as a catalyst should the macro backdrop improve. As higher interest rates have hurt bond performance, money flows have started to reverse their years-long preference for fixed income over stocks. Encouragingly, there is still more than $2 trillion in money market funds available to invest.
Concluding Thoughts:
We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. We see no reason to change that view given the recent volatility. 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 the recovery matures and growth slows.
Volatility should stay elevated given the macro uncertainties. Systemic risks that could result in prolonged recessionary or bear market conditions are increasingly present, but not overwhelming, given the accompanying growth backdrop. Our forecast for a maturing but sustained economic expansion (e.g., braking, not breaking) strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all. That “how” should continue to include both secular growth and cyclical allocations.
Our investment philosophy is based on a dual mandate of growing and protecting client assets. We have been focusing on strategy positioning vs. our respective benchmarks to control risk, but given the volatility, will now include exposure adjustments. Of course, should the backdrop continue to destabilize, we will take a more defensive stance.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical, and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid.
Should you have any questions, please contact BakerAvenue. We are happy to share our thoughts in greater detail and welcome your questions or comments.
Disclosure: Past performance is not indicative of future performance.