SSO - Going Back To Base

2023-06-26 21:42:00 ET

Summary

• The bedrock of the asset allocation process is to create strategic allocations that work over the longer term, while then modifying those positions in response to the market realities.
• Some of what we have seen during 2023 has been due to exuberance around generative artificial intelligence.
• We still anticipate a lagged effect from the dramatic rise in short-term rates and the ebbing of excess liquidity and the resulting tightening of credit conditions.

In the face of conflicting signals from our short- and medium-term outlooks, our Asset Allocation Committee is adopting more neutral views.

The bedrock of our asset allocation process is to create strategic allocations that work over the longer term while then modifying those positions in response to the market realities. When we wrote about the advantages of tactical asset allocation programs a couple of weeks ago , we described “times when shorter-term themes in the market can be substantial enough to present meaningful risk or opportunity to the portfolio,” and noted how the first half of 2023 had highlighted the pitfalls of relying solely on “medium-term and strategic views.”

At our latest Asset Allocation Committee, this time horizon issue loomed large in our discussions. As regular readers will know, relative to neutral views, we have broadly expressed a preference for cash and fixed income while investors are being “paid to wait” for more attractive entry points for equities. Market movements over the first half of the year, however, have challenged that view.

We got much right on the economic front:

• Inflation has been sticky
• Central banks have been more aggressive than expected
• Economic growth has slowed
• Analysts’ corporate earnings forecasts have declined (albeit less than many, us included, expected)
• The dramatic rise in rates has caused accidents in the financial system

In the markets, too, cash and short-dated bond yields paid cautious investors well. For example, U.S. dollar cash has generated just over 2.5% so far this year, and the ICE BofA U.S. and Euro High Yield Indices have generated total returns of 4.8% and 4.5%, respectively, according to FactSet.

But the other side of the view has not behaved as we would have expected in that environment. With the S&P 500 Index up almost 8% at the end of the first quarter, we retested our views and concluded that it made sense to maintain an underweight view , especially on the mega-cap tech stocks that had been leading index performance. Then the S&P 500 went up another 8%, driven even more by the “Magnificent Seven” tech-related stocks at the top of the index—for perspective, the equal-weighted S&P 500 Index is up only 4.4% so far this year, according to FactSet.

The headline from the Asset Allocation Committee’s forthcoming Outlook is that we have upgraded our view on equities from underweight to neutral. But that is not because our medium-term views have changed, but because we think there may be persistent strength behind short-term market dynamics.

Broadening

Some of what we have seen during 2023 has been due to exuberance around generative artificial intelligence. With stocks of liquidity beginning to ebb but still well above long-term averages, with hindsight it is no surprise that some of it flowed into the “Magnificent Seven.” These were already perceived as relatively defensive stocks and are now perceived as AI beneficiaries, too.

Will they be the ultimate AI winners? Will the AI productivity tide lift all boats? We think these questions will generate considerable volatility in stock prices over the next three to six months.

Perhaps more notable, until the return of risk aversion last week we had started to see some evidence that the equity rally was broadening, and that the market in general was beginning to switch attention from concerns about inflation and monetary policy to optimism about nominal growth. As one Committee member put it, investors are simply celebrating that a 2023 global recession looks increasingly unlikely.

We do think that central banks are nearing peak interest rates as inflation shows some signs of abating. And as concerns about out-of-control inflation and the prospect of even higher real rates recede, investors have been able to focus on the way that high but gradually declining inflation creates high levels of nominal growth in corporate earnings and the broader economy.

This combination of factors edges us to a neutral view for stocks.

Overextended

To reiterate, however, this reflects increased short-term uncertainty, not a positive view on the asset class or the broader economy over the medium term.

We still anticipate a lagged effect from the dramatic rise in short-term rates and the ebbing of excess liquidity and the resulting tightening of credit conditions. We think those rates are likely to stay near their peak, as mopping up the last bits of excess inflation often takes longer than clearing the more transitory drivers.

At some point in the next 12 months, we believe these drivers will tighten profit margins and reduce earnings—even as we acknowledge that corporations have so far managed higher rates and rising costs much better than we anticipated.

We also expect these dynamics to uncover more overextended creditors and capital structures. We think the first cracks might appear in credit rather than equity markets—which is why the Asset Allocation Committee has, in light of the strong recent performance and tightening spreads, downgraded to neutral its view on high yield.

Looking further ahead , we think relatively high inflation may be sustained by labor supply, deglobalization and geopolitical challenges, leading to structurally higher rates and market risk premia.

That has left us with conflicting signals from our shorter-term outlook (which is more positive for equities even as spreads have tightened in credit) and our medium-term view (characterized by the negative impact of higher rates, sticky inflation, tighter financial conditions and ebbing liquidity). With less conviction on the application of our medium-term view in the short term, and greater overall uncertainty about near-term market direction, we are moving our overall view closer to neutral—while remaining ready to adjust as soon as the signals become clearer.

In Case You Missed It

• NAHB Housing Market Index: +5 to 55 in June
• U.S. Housing Starts: +21.7% to SAAR of 1.63 million units in May
• U.S. Building Permits: +5.2% to SAAR of 1.49 million units in May
• U.S. Existing Home Sales: +0.2% from 4,290k in April to 4,300k in May
• Japan Manufacturing Purchasing Managers’ Index: -0.8 to 49.8 in June
• U.S. Manufacturing Purchasing Managers’ Index: -2.1 to 46.3 in June
• Eurozone Manufacturing Purchasing Managers’ Index: -1.2 to 43.6 in June

What to Watch For

• Tuesday, June 27:
• Consumer Confidence
• U.S. New Home Sales

• Thursday, June 29:
• U.S. GDP Chain Price
• Japan Consumer Price Index
• Eurozone Consumer Confidence Indicator (Final)

• Friday, June 30:
• University of Michigan Consumer Sentiment (Final)

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