Key Questions: Is the Recent Stock Market Rally a Breakout or a Fake-out?
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In our view, a “pivot to a pause” may be in the offing but a “pivot to a cut” is not.
At the beginning of 2022, and for the entirety of 2021, we thought stocks should be overweighted relative to your strategic asset allocation strategy. Even though we believed inflation would prove more persistent than many policymakers desired, we felt economic growth would remain robust and boost corporate profits.
Our optimism, however, was tempered by the Federal Reserve (the Fed) signaling it would start to tighten financial conditions in an attempt to cool inflation. Thus, we coined the phrase, “Hot, Crowded and Flat” – hot inflation, combined with crowded (or concentrated) markets would likely lead to flattish returns for risk assets. The US would avoid a recession, we believed, but stock prices would struggle to produce meaningful results in the face of higher interest rates.
Soon thereafter, the horrific scenes of war in Ukraine emerged. At the time, we noted that such an event likely would have profound geopolitical ramifications in the long run and would further exacerbate inflation in the short run. That would leave policymakers to confront a huge conundrum of tackling inflation amid slowing economic conditions.
A Toxic Mix for Investors
This toxic mix led us to recommend scaling back from risk assets in early spring. We continue to maintain a view that a portfolio’s weight toward stocks should be in line with, or neutral, relative to one’s strategic policy target. We also believe a modest allocation to cash is appropriate as a source of dry powder to be used during sharp drawdowns (although we have no foresight when they may occur). We also continue to believe various diversifying strategies may provide important elements of diversification as traditional diversifiers may offer less diversification than they have in the past.
In the first six months of this year, stocks swooned over 20% and bond prices fell 10%. High-growth/high-multiple stocks were hit especially hard, falling over 50% (using the ARK Innovation Exchange Traded Fund as a proxy); value stocks retreated a more modest 15%.
Since late June, however, stocks have rebounded. Well-known indices such as the S&P 500 Index have appreciated over 15%, paced by high-growth stocks. Those are up nearly 25%, roughly double the gains posted by their value peers. Bonds have gained back about 3%, and as of last week, stocks and bonds are both now down roughly 10% year-to-date.
The proximate cause for these sharp rallies has been a combination of resilient economic growth (employment data, in particular, has impressed) along with market expectations over a possible pivot from the Fed. More specifically, some market participants believe that inflation has peaked. They think the Fed will soon turn its focus on slower economic growth and respond by cutting interest rates in early 2023.
Don’t Expect an Abrupt Change of Course
No one knows for certain the path inflation will take and how the Fed will respond. But by our lights, such an abrupt change in course in the next few months seems unlikely. Inflation is clearly moderating in some key categories (just check the price of gas at your local pump), but it remains too high in other important areas like food, housing (rents recently reached a new high in several major cities), and wages, despite some recently announced job cuts. Furthermore, consumer confidence surveys continue to hover near recessionary-level lows, even though consumer spending remains brisk.
At his last press conference, Fed Chair Jay Powell suggested that interest rate increases may moderate. He also opted to suspend giving explicit guidance regarding future policy moves. Since then, markets have reacted positively. But in our view, the markets are assuming incorrectly that interest rates will be lowered. As one economic expert recently noted, “There’s a big difference between a pivot to a pause and a pivot to cuts [in interest rates].” And while “a pivot to a pause” may be in the offing, “a pivot to a cut” is not.
Later this week, Chair Powell will have the opportunity to restate his views. His comments could ignite a renewed bout of volatility should he opt to talk tough about inflation. Moreover, corporate earnings still appear overly optimistic based on excess inventory levels, elevated input costs and elevated labor costs. In addition, lagged effects of tighter monetary policy will intensify at the same time that a recession in Europe seems unavoidable and China faces considerable political uncertainty.
In sum, we believe the recent market rally is somewhat justified but is also somewhat vulnerable. We, therefore, maintain a balanced view on risk assets and continue to focus on high-quality assets, maintaining some level of cash to deploy if stocks are materially marked down and gaining exposure to diversifying strategies as appropriate.
For more information, please contact your advisor.
About George Mateyo
As Chief Investment Officer, George Mateyo is responsible for establishing sound investment strategies for private and institutional clients, expanding internal and external research capabilities, and managing the delivery of solid risk-adjusted investment performance.
In previous roles, George spent more than 15 years in investment management and investment consulting, where he acquired firsthand knowledge and insights into the capital markets and the stewardship of investment portfolios for institutional and high net-worth investors.
George received his MBA from the Weatherhead School of Management at Case Western Reserve University and completed additional studies at the London School of Economics.