Markets haven’t seemed to make much sense this year. They’re starting to make sense again.
- We’re nowhere near ready to hear a victory cry from central banks. If we did, markets would likely run higher, undoing the tightening policymakers have accomplished.
- There is a lot of wishful thinking that central banks will cut rates early next year. A soft landing is predicated on policy rates staying higher for longer. Lower policy rates signal trouble.
- Longer dated bond yields have pressed higher from where they were earlier this year. That move higher is a positive. Investors have growing confidence the worst of recession fears are behind us.
- We’re fully invested in stocks and bonds. There is a lot of good news priced into markets. Portfolios have low tracking error with overweight positions to credit, U.S. equities as well as the dollar.
Talking Heads have been a personal favorite band of mine since they formed. For the tiny apartment my wife and I moved into when we were first married, we had a large, framed movie poster of their 1984 concert film Stop Making Sense hanging in the room where I kept +500 vinyl albums in blue spray-painted milk crates. I’ve only added to the collection since.
Stop Making Sense is back with A24’s launch of a 40th anniversary film re-release in 4K. I can’t wait to see it. I’m boldly using that as an anchor to the market and macro environment we find ourselves in. Markets haven’t seemed to make much sense this year. They’re starting to make sense again.
Fear and greed have driven a lot of the market volatility we’ve seen. When we came into the year, I thought there was a 1/3 chance we might see a recession in 2023. I inched that up to a coin toss mid-year as the banking sector became wobbly. Bad things can happen when the banking sector trembles, which compounded concern that we might get a policy error from central bank overtightening.
The banking sector has settled, and confidence returned that developed market policymakers are navigating their fight against inflation well. We’re nowhere near ready to hear a victory cry from either the Federal Reserve (Fed) or European Central Bank (ECB). In fact I’d argue if we did, markets would likely run higher, undoing the tightening policymakers have accomplished. It would force their hand to lean into rate hikes.
Burning down the house. The ECB and Fed don’t want to squander the chance of a soft landing. My base case is back to 1/3 odds of recession in the coming year. In any given year I’d say the risk of recession bounces somewhere between 15-20%. Where policymakers go from here gives me pause regarding the outlook next year. Inflation is coming down yet remains too high.
I hope we’ll see the Fed and ECB shift into a holding pattern regarding additional rate hikes. Monetary policy acts with a lag. With momentum on their side, pausing is prudent. Labor markets are cooling, not breaking. Wage inflation is slowing as is consumption. We’re seeing the froth come off demand as markets and the macroeconomy press to reset back to a pre-covid stimulus world.
While a pause in rate hikes is warranted, I continue to believe there is a lot of ‘wishful thinking’ that central banks will cut rates early next year. My base case view of soft landing is predicated on policy rates remaining where they are – higher for longer (Figure 1). A move lower signals trouble.
It’s going to take patience and discipline. I’m sure we’ll see a few false dawns as it relates to inflation. Policymakers know what they can’t know about the pace and trend of inflation. They do know they don’t want to break the economy overtightening. They also know cutting rates too soon repeats prior central bank policy errors.
The ‘last mile’ of fighting inflation is the hardest. Focusing on the US, I believe core PCE (the Fed’s favored inflation measure) needs to get down to a low 3% level by early next year. While 2% is the Fed’s long-term target, it’s going to take time to get there. If inflation directionally continues to trend lower, investors can remain calm. You gotta have faith.
Making flippy floppy. The US Government bond curve inversion has been making ‘flippy floppy’ as it continues to become less inverted. Longer dated yields have hit reset and pressed higher from where they were earlier this year. While that will be a drag on the cost of capital and demand, I continue to view the move higher in long-term rates as positive. Investors have growing confidence the worst of the recession fears are behind us.
That’s good news. And that good news is well priced into markets. Year to date, money market fund assets have risen by over $800bn (Figure 2). That is a great deal of sidelined cash that would like to buy a market pullback and keep us—barring an extreme event—in choppy, range-bound markets.
Fair value has me focusing on 4.5% (+/- 25bps) for 10-year US Treasury yields. That seems a level consistent with higher for longer policy rates and no recession. We will undoubtedly continue to see fierce swings in yields as recessionists and the soft landing crowd battle it out. I think a level above 5% would be destabilizing for risk assets.
This must be the place (naïve melody). With China back in the news and weighing on sentiment, de-globalization is back as a headline risk to the macroeconomy. Taking something complex and making it ‘simple’ is art. Oversimplifying something complex is a fool’s errand.
A lot of what I read about de-globalization is oversimplified, trying to turn gray into black and white. It certainly makes for a more incendiary narrative. Globalization isn’t going away (Figure 3). As we watch a multipolar world being built, strategic trade and security alliances are also being reconstructed. Onshoring and ‘friend shoring’ are here to stay.
The recent expansion of the BRICS (Brazil, Russia, India, China and South Africa) to include Argentina, Egypt, Ethiopia, Iran, Saudi Arabia and the United Arab Emirates is a powerful example of a burgeoning multipolar world. So is India’s leadership at the recent G20 meeting. Geopolitical power is broadening.
I think a lot of what gets missed regarding China is that, as a nation, it has been willfully moving away from low cost production to higher value added goods and services for well over a decade. That trend will continue. The West will continue to pivot away from dependence on China for cheap goods. That’s not new news. And yes, it’s far more complicated than that.
China faces real structural demographic and balance sheet challenges, including in the real estate sector, which are well-identified and overplayed recently in the media. China can afford to address the structural issues it faces ahead. The key question is whether in the process they avoid a middle-income trap, where they are unable to keep up with more developed economies in higher value added markets.
Once in a lifetime. There’s a quote from Sun Tzu I’ve always liked: “Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.” Timing a market is hard to do. I’ve known accomplished traders that have made money trading. But they aren’t all in or out of markets; they have a strategy and employ tactics well.
J.P. Morgan Asset and Wealth Management will launch our Long-Term Capital Market Assumptions (LTCMA) shortly. It’s an annual exercise we do collaboratively across the organization. It allows us to fervently debate the macro landscape as well as relative valuations across major asset classes. It’s a disciplined exercise.
I’m saying this because we use the LTCMA effort to inform our strategic asset allocation design. It’s the starting point to structure our approach to goals based investing. It helps us set suitability parameters around risk tolerance so that long-term money stays invested throughout a cycle’s ups and downs.
As fiduciaries, that’s important to the entire CIO investment team. Strategy is separating short and long-term money. For long-term money, it is critical to determine the right suitability parameters and goals, then stay invested. Tactics are how we navigate any given market environment we find ourselves in to ensure your long-term investment goals are met.
We aren’t taking a lot of tracking error right now in portfolios. We’re fully invested in stocks as well as bonds. We are holding a normal level of duration in our multi-asset portfolios. We continue to hold a modest overweight to credit, but those are positions we’ve been trimming throughout the past year.
In equities we are modestly overweight the U.S. equity market and the dollar. Right now those tactical tilts continue to feel appropriate. While we remain overweight ‘big tech,’ we trimmed positions as valuations have moved higher. They’ve added to this year’s performance.
Sometimes it’s important to stand still. When market uncertainty is high, the emotional response tends to be more along the lines of ‘hurry up, do something.’ I’m a big believer in moving quickly, but when driven by fundamentals. Not emotion. Like policymakers staring down the last mile of inflation, investing requires not only discipline, but patience. Strategy and tactics. Same as it ever was.