BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Neutral
The Choppy Path: When Good Is Bad
"Great things are done by a series of small things brought together."
- Vincent Van Gough
The market has had a difficult time trying to make new highs recently. With a backdrop that’s often hard for investors to grasp, the choppy trading is a result of the economic data starting to look a bit too good. Economists now expect over 2.5% GDP growth in 3Q, up from an estimate of -0.9% in May. Real time estimates are running even higher (e.g., the Atlanta Fed’s GDPNow forecasts +5.6% for the quarter). 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.
The positives associated with are clearly understood (e.g., stronger corporate earnings, higher multiples, consumer resiliency, etc.). However, there are some compelling reasons why the recent run of good data has been “bad news” for asset prices. First, higher economic growth would seem to coincide with the notion of higher-for-longer interest rates. The Fed and their control over financial conditions (via the Fed funds rate), and more specifically investors interpretation of their outlook, has been an influential variable for the markets since they started raising rates almost eighteen months ago. Stronger economic growth may provide the cover to be more aggressive. Second, no material job losses - a growing concern given the resilient labor market - could mean stubbornly high inflation and therefore, again, rates. A disinflation narrative catalyzed returns for a good portion of the year.
So, how do we see this “good news is bad news” narrative playing out? We believe three reasons allow a more sanguine outlook. First, less uncertainty. It wasn’t long ago that a recession was a foregone conclusion to many. A sustained run of better-than-expected economic data, while unsettling initially, also serves to lessen one of the biggest long-term headwinds to valuations, economic uncertainty and the risk of recession. The second we will label short-sightedness. In the autumn of , near the market lows, investors were also hoping for “bad” economic news to help stem the rising tides of elevated inflation and tighter monetary policy. What they really wanted was deflation, not weak economic growth. It is possible to have both, as evidenced by the recent trajectory of inflation (down) and growth (up) over the past year. Finally, we suspect the data will indeed start to balance out. Economic surprise models are running near multi-year highs and due for some normalization. In short, investors will get what they want (a slower growth trajectory).
It is important for investors to remember a backdrop is better than many alternatives. 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 our expectations of slow but non-recessionary growth. A provisional environment doesn’t change that view. Ultimately, another year of economic and earnings growth should be enough to offset the monetary tightening in place and support 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, but internal metrics (e.g., market breadth)some work; small cap and equally weighted indices have lagged over the past several weeks, a sign of breadth reduction. 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 expect the market to broaden 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 has improved (e.g., bull-bear surveys have moved higher), but positioning (e.g., cash balances, money flows, etc.) should continue to 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 two quarters (2.1% last quarter) 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, andFed 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. 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, 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 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. So far, the credit backdrop has supported the move in equities (e.g., despite the weakness in equities, credit spreads were 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.
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. 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.