BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Neutral
Resilient Economy, Nervous Markets: Rounding the Bend
"Well done is better than well said."
- Benjamin Franklin
We get the sense that the markets’ run during the first half has been frustrating for many investors. Not because investors don’t appreciate the strong start to the year (and 20%+ move off the October 2022 lows!), but rather because so many have been focusing on bearish outcomes, and perhaps missing out. Despite countless calls for a recession, the S&P 500 was up for the third straight quarter and now moves into the back half of the year with some encouraging momentum. We are not immune to the well-covered concerns but feel a more balanced interpretation is appropriate.
Bears who are still forecasting a recession typically offer three reasons. First is the lagged effects of tighter Fed policy and corresponding market disruption (e.g., higher interest rates and the inverted yield curves). Second is that consumers’ excess saving accumulated during the pandemic could run out as soon as this quarter. And finally, that a significant retrenchment in corporate profitability is simply a matter of when, not if. There are others, of course, but this is what we hear most frequently. We are highly attuned to all but offer a more nuanced takeaway on each.
Let’s start with tighter financial conditions. We believe investor concern rests less on the actual (higher) interest rate backdrop slowing down the economy. After all, higher rates should help lower inflation. Rather, we believe the probability of a corresponding credit crisis that would accompany that slowdown is what keeps most bears troubled. This is understandable as most recessions that followed an inverted curve had significant credit stress. We envision a less dire scenario. Corporate cash flow metrics remain strong, and while it is certainly more expensive to operate (e.g., interest costs are up), business is getting done and credit is flowing. It is also worth mentioning that inflation trends (trending lower) are encouraging, and the Fed is in the final stages of their tightening campaign.
Consumers running out of excess savings bears watching. There were trillions of excess savings accumulated post Covid-19. We believe it is correct to assume a more calculated consumer spending environment going forward. Importantly, calculated does not mean concluded. Historically low unemployment, strong wage gains and healthy consumer balance sheets relative to previous recessionary environments lead us to this more balanced takeaway. While the days of a rising consumer spending tide lifting all boats may be over, the willingness, and the means, for consumers to spend remains intact.
Concerns about corporate profitability are running on borrowed time. Estimates for corporate profits (and revenues) have moved higher in recent weeks, not lower. Earnings resiliency over the first half of the year have reinforced our belief that, while the growth backdrop remains challenging, there are offsets. While slower economic growth and this years’ flashpoints (e.g., the banking crisis) have made growth harder to come by, we believe incoming tailwinds offer ballast (e.g., AI spending). We have championed a ‘braking but not breaking’ view regarding corporate profitability and see no reason to change that now.
We understand it is tricky out there, but we have benefited by not overly discounting the less discussed optimistic scenarios. 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.
After a notable downtick, we do believe volatility will increase here in the summer months, but ultimately, another year of economic and earnings growth should be enough to offset the monetary tightening in place and support an eventual continued grind higher in equities. We want to be thoughtful regarding portfolio construction and risk control in these volatile times.
The Technical Perspective
The technical backdrop remains volatile, but structurally intact. We believe the market is in much better technical shape relative to last autumn, with several indices holding steadily above key moving averages. Price momentum is strong, and, outside of breadth, internal metrics are in decent shape (e.g., advance-decline lines are still holding well above October lows). Leadership has shifted back-and-forth from a pro-growth to defensive value over the past few weeks. We are intently focused here as we consider portfolio tilts.
We expect the market to broaden and leadership to continue to adjust as we move through 2023. Through the mid-point of the year, the market has narrowed with a handful of stocks (primarily large cap technology stocks) driving gains. 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 a catalyst by our work, but less so relative to last month. Investor sentiment has improved (e.g., bull-bear surveys have ticked higher), but positioning (e.g., cash balances, money flows, etc.) is still leaning defensive and will continue to 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).
The Macro Perspective
The macro discussion must start with a view of the global economy. Incoming economic data continues to support our slowing but not recessionary growth narrative (e.g., unemployment is close to a fifty-year low, economic surprise models are running near multi-year highs). Real-time GDP estimates for the second quarter of this year remain positive (and were 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 continue to expect the inflation scare will subside. Cooling input prices 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. As mentioned earlier, 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 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, are balanced by consumer spending resiliency and improving supply chain commentary. Our weekly series for estimates of revenues and earnings have increased over the past couple months. Importantly, they remain far from recessionary. Another important earnings season is upon us. We expect corporate results to match expectations and provide some stalwart defense against any profit-recession narrative.
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. 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.
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 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. 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 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.