When bull markets end, they seldom go gentle into the night. As the market turns down, sharp rallies can occur, inflicting enormous pain on anyone underweight or short the declining asset class. Every decade or so, markets get carried higher by a structural theme which triggers an enormous re-rating of the favored asset class. Examples include Energy in the 1970’s after fears of “peak oil”, Japanese equities in the late 1980s, Internet stocks at the turn of the century, and most recently, US mega-cap tech stocks on the belief that “software eats the world”.
That brings us to 2023. This year, we have had a sharp rally in all thing’s tech, and especially in the “Magnificent Seven” stocks that have driven so much of US and global equity market performance in 2023. So, was the 40% gain in the Nasdaq between early January and July a typical post-bull-market surge? Or is this rally a continuation of the US growth stock bull market that started in 2011? Or is it the start of an altogether new bull market? (Chart 1).
(Chart 1) Source: Bespoke Investment Group
While the answers to those questions will only come with time, since the beginning of August, it has looked as if the tech rally has run out of steam. Major equity indices are off their peaks, and the technical backdrop has become less clear. The S&P 500 and Nasdaq have both dipped below their 50-day moving average, and for the most part, the “Magnificent Seven” mega caps are showing cracks.
US long-dated bonds have not been sending the same message as stocks this year. Treasuries have rolled over, and yields have taken out highs from October 2022. Equity multiple expansion and yields, which have recently moved in tandem, have meaningfully decoupled. (Chart 2).
(Chart 2) Source: Bespoke Investment Group
The discrepancy in the performance of US equities and long-dated bonds defies easy explanation. The invention of ChatGPT and AI wave is certainly a catalyst… as is the resiliency of the US economy this year. However, ultimately, declining inflationary pressures have helped strength beget strength in the stock market.
The re-emergence of inflation remains the key risk to portfolios.
So, which asset class is right? Is the inflation genie really back in the bottle?
Is There Still Inflation Risk?
Many of the tailwinds that have pushed inflation lower this year have either receded or flipped. Higher energy prices, higher food prices, a weaker dollar, and fiscal loosening all set the stage for another bout of inflation. And falling inflation could even sow the seeds of its own demise. Consumption and real income growth are highly correlated. If inflation continues to fall, real wages will rise further. If that were to happen, the resulting increase in consumption could cause inflation to reaccelerate. As previously mentioned earlier in the year (Feb MIM), we discussed deflationary pressures for 2023 and that inflation is following a similar path to the 1970’s, where we saw a second surge of inflation. There are other structural forces like aging demographics providing tailwinds.
Therefore, we believe there is uncertainty over how quickly inflation will fall, and if it does fall, whether it will stay down. This against a backdrop of equities discounting a return to a “2% world”. We believe the US is not out of the woods when it comes to inflation, which means that it is too early to conclude that the Fed can stop raising rates. Any further increase in inflation risk would prompt us to turn more cautious on stocks. (Chart 3).
(Chart 3) Source: Bespoke Investment Group
Is There Still Recession Risk?
Given the normal range of “long and variable lags” between tightening financial conditions and recession ensuing, the US economy is not out of the woods. The yield curve inverted 300 days ago. On average, it has taken 589 calendar days for a recession to arrive after the curve first inverts. (Chart 4).
(Chart 3) Source: Bespoke Investment Group
Rarely do overshoots lead to soft landings. While recession has been pushed out, it is probably a question of when not if.
Given market uncertainty, we have initiated a position in our tactical income fund within our models. Our fund currently holds a mix of high-quality low duration bonds that offer high risk-adjusted returns within the context of high short-term rates. It will also give us the flexibility to shift assets to longer duration bonds when fundamental elements change and other defensive assets to protect capital.
Additionally, we are using this pullback to leg into a new strategic position for our portfolios. We initiated a position in an active climate action fund. We believe climate change is both a major threat to global economies and a significant investment opportunity. Strong relative outperformance and an asymmetric risk profile can be achieved by investing in companies with decarbonization technologies and business models. Reducing greenhouse gas emissions and increased energy efficiency is driving new innovation and broad-based economic opportunity. In combination with our exposure to real assets, we believe we are aptly allocated for the present and future of energy consumption.
Overall, with mixed messages, our asset allocation is close to neutral. We will continue to monitor our portfolios as the facts change and will remain tactical as the situation evolves. We believe markets are at a point of inflection and will manage assets accordingly.
Recent Portfolio Changes
John A. Forlines III
Chief Investment Officer
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