February 2023: The BakerAvenue Prudence Indicator
BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Neutral
Rescheduling That Retrenchment
“Storms make the oak grow deeper roots.”
– George Herbert
The odds of a soft landing have increased as robust US job growth, robust household consumption and business investment, better inflation trends, slightly less restrictive monetary policy and China’s re-opening have reduced recession probabilities in the near term. While forecasts for sluggish global growth in 2023 remain, recent forecasts have been revised higher (e.g., the International Monetary Fund raised their global growth forecast last week). Markets have cheered the improved backdrop (e.g., the S&P 500 was up +6.2% in January, the Nasdaq was +10.7%).
We have consistently stated that while slower growth looks inevitable, a prolonged recession is not. It should be noted that after two consecutive negative quarters to start 2022, GDP growth accelerated back to positive territory to close out the year. Also, real time estimates for the first quarter of 2023 remain positive. At the same time, we suspect that we are closer to the end than the beginning for several factors that have pressured growth (e.g., the Fed has signaled a less restrictive path regarding rate hikes, China has reworked their Covid policies and is in the process of reopening, supply chains are in better shape, and the dollar has stopped advancing and has weakened).
While uncertainties remain, the mix of improving growth surprises and falling inflation surprises has been a ‘goldilocks’ scenario for markets. The risk, however, is that premature easing in financial conditions, and in turn, a pick up in growth expectations, may be counterproductive from an inflation fighting point of view (and thus Fed policy). Indeed, post the strong January payrolls report, several Fed speakers have talked up rates expectations. To be sure, it is a tricky environment for investors, as catalysts for growth carry restrictive offsets. Nevertheless, we suspect calls of significant economic retrenchment (and corresponding bear markets) will need to be rescheduled.
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 that while growth is slowing, the downturn is more cyclical rather than secular. We do not forecast a break to our longstanding “growth normalization” view.
We do believe volatility will stay elevated, but ultimately, another year of economic and earnings growth should be enough to offset monetary tightening and support an eventual grind higher in equities. 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. Earnings takeaways over the past several weeks have reinforced our belief that, while the growth backdrop remains challenging, there are offsets. Headwinds like dollar strength and input cost pressure are slowly abating and are balanced by consumer spending resiliency and improving supply chain commentary. Our weekly series for forward revenues, earnings, and margins are well off their peak, but remain far from recessionary. We have championed a “braking but not breaking” view in regard to corporate profitability. Importantly, while the frequency and magnitude of earnings and sales beats are normalizing, consensus estimates look reasonable. On balance, we expect corporate results to match expectations and provide some stalwart defense against any profit-recession narrative.
Valuations are near 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 providing a compelling opportunity for long-term investors, but prospects are not universally favorable. Valuation dispersion remains high with a sizable gap between the secular growers and the more economically sensitive stocks. Predictably, the backup in rates has caused this dispersion to shrink as the more speculative assets have corrected to a greater degree. We see opportunities in both groups.
The credit backdrop will be important to monitor as growth concerns persist. One of the defining criteria between pronounced or shallow recessions 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.
The Macro Perspective
The macro discussion must start with a view on the global economy. Incoming economic data continues to support our slowing but not recessionary growth narrative (e.g., unemployment is at a fifty-year low). After two consecutive negative quarters to start 2022, GDP growth accelerated back to positive territory to close out the year. Real time estimates forecast the first quarter of this year to remain positive. 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 continue to expect the inflation scare will subside. Cooling input prices (e.g., transportation costs, used car prices, etc.) and easing supply chain pressures amid softening demand and tighter policy suggest inflation momentum has peaked.
Interest rates will be the fulcrum by which investors express their economic growth, inflation, and thus, Fed policy views. Yield curves have inverted as the front end of the curve has moved higher with the prospects of further 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. As mentioned, one of the most pressing questions for investors is: Can the Fed get control over inflation without causing a deep recession? It is going to be tricky, but at this point we believe they can.
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 Technical Perspective
The technical backdrop has improved. A broadening rally has led to meaningful downtrend reversals in many popular averages (e.g., the 200-day moving average on the S&P, the downtrend line from the market top in 2022, etc.). Internal momentum has picked up and rotation within the market has had an offensive feel with more pro-cyclical pockets picking up relative strength. The recent run brings with it higher odds of some short-term consolidation, but we are encouraged by the recent technical improvement.
We expect the market to broaden and leadership to continue to adjust as we move into 2023. One interesting dynamic of the latest rally is that the broader the index is (e.g., Russell 1000 vs. the S&P 500), the better the news. Also, equally-weighted indices have been outperforming their market-cap weighted brethren. Both developments point to a broader participation rate. Healthier markets tend to have strong participation rates, so we are encouraged by the improvement here. We are 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 has improved, but on average tilts bearish, which, from a contrarian point of view, is bullish. Surveys (e.g., AAII bull-bear survey, Investors Intelligence surveys, Consumer Sentiment, etc.) point to a skeptical investor base with the number of “bears” still elevated. Tactical positioning data (e.g., put-call ratios, cash balances, fund flows, etc.) are still leaning defensive and will act as a catalyst should the macro backdrop improve. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher or lower).
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 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 growth slows.
Volatility should stay elevated given the macro uncertainties. Systemic risks that could result in prolonged recessionary or bear market conditions exist, but are not overwhelming, given the accompanying growth backdrop. 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, 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.