Balance Is Critical for the Obstacles Ahead

Rising inflation may be behind us, but now a nervous market parses every data release for signs of recession.

Regular readers know that, in early September, I hear the starting gun for the race to the end of the year. As we get back to our desks after summer breaks, focus turns to end-of-year portfolio results, and calendars fill to review the year’s achievements, lessons and progress, and to begin peering into the year to come.

Last year, I characterized this sprint as a hurdle race. In one important respect, this year’s race may be simpler to negotiate: Twelve months ago, investors weren’t sure whether to worry about stubbornly high inflation, slowing growth or both; this time, the area of concern is more clearly growth, as my colleague Fumi Kato wrote in his discussion of Jerome Powell’s change of tone at Jackson Hole.

Even so, with a consequential U.S. election and the first U.S. Federal Reserve rate cuts ahead of us, many obstacles remain on the track ahead. An intensified focus on the path of economic growth still leaves key data releases and central bank meetings with the potential to move markets substantially. And because we think investors may be overestimating the probability of outright recession in the U.S., those moves could present attractive entry opportunities as market performance continues to broaden beyond U.S. mega-cap technology stocks.

Bad News

The recent obstacles have already knocked markets off their stride. In an action replay of early August, last week’s soft U.S. Manufacturing Purchasing Managers’ Index (PMI) triggered notable declines in the S&P 500 Index and government bond yields. Friday’s mixed nonfarm payrolls data may have eased, but not reversed, that trend.

Six months ago, that kind of manufacturing data might have assured investors that inflation was easing and supported equity markets. Today, bad news is just bad news.

Do we think the news will deteriorate further? We expect growth to head downward, but stay positive.

Over the past six months or so, we have argued that our outlook of gently declining inflation, more accommodative monetary policy and resilient nominal growth is positive for equity markets. We acknowledge, however, that valuations are full across many market segments and geopolitical risks still loom. As a result, we are positioned with modest active risk exposures as we prepare for the coming obstacles. It’s good that bonds have provided diversification during the recent jolts to equity markets, but with yields already anticipating significant fed rate cuts, too much duration exposure could be costly if, as we expect, the next few months’ economic data obstacles prove easier to clear than the bond market fears.

Recession

That said, we continue to see a very strong case for adjusting equity exposure, even as target allocations are maintained.

The fed fund futures market is priced for more than 200 basis points of rate cuts in the next 12 months, which, as Fumi observed, certainly does suggest a recession. As a result, equity investors with one eye on the bond markets have their fingers hovering nervously over their sell buttons.

In our view, however, the reason recent bad news has had such a pronounced impact on the S&P 500 Index is not that the entire index would be grossly mispriced in the event of negative growth, but that it has become so dominated by a handful of mega-cap tech stocks that really are priced for perfection.

While last Monday’s PMI data sent the S&P 500 down by 2.12%, an outsized contribution to that drop came from stocks like Nvidia, which fell almost 10%, thus explaining the much smaller losses in the S&P 500 Equal Weighted Index (down 1.33%) and the Russell 1000 Value Index (down 1.21%), where mega-cap tech is far less prominent.

Balance

One of our key investment themes for this year was that the laggards of 2023 would find favor as performance broadened beyond U.S. mega-cap tech. As we have seen, that kind of positioning would have taken some of the sting out of recent sell-offs while still offering upside exposure.

Should the data or U.S. election obstacles cause further stumbles, we think investors could use that volatility to add risk in those areas: smaller companies, value stocks, more attractively priced markets outside the U.S., such as Japan. By the same token, bounce-backs, such as the one seen in the second half of August, could be used to further diversify equity allocations with profits taken from mega-cap tech.

The race to the end of 2024 is underway. The key risks—slowing growth and the U.S. election—are perhaps clearer than they were a year ago, but they remain formidable obstacles. And, as always, the crucial attribute for negotiating obstacles is good balance, both among and within asset classes.