Navigating Market Dynamics: Insights From Managed Asset Portfolios
Jun 05, 2024Risk-On or Risk-Off?
Investors, who contended with one of the Federal Reserve’s (the Fed) most aggressive rate hiking cycles since the 1980s, experienced a significant risk-off market in 2022 as both stock and bond markets grappled with the highest levels of inflation in forty years. The introduction of ChatGPT towards the end of 2022 ushered in the era of Artificial Intelligence (AI), the Magnificent 7 (Mag Seven) and the start of a new risk-on market. Those seven stocks led that risk-on market and accounted for the lion’s share of stock market gains in 2023. Although market breadth has broadened a bit since then, a handful of stocks are still carrying the major averages. Specifically, year to date, the S&P 500 is up approximately 10%, with a third of those gains being attributed to NVIDIA, and gains from NVIDIA, Microsoft, Amazon and Meta, accounting for about half of S&P 500 gains.
Market Dynamics
So where are we now? We believe it would be hard to argue that we are in anything but the risk-on environment that started at the end of 2022. However, the question we need to ask is does the data support this? At the start of 2023, it did not seem like there would be much to look forward to given the poor market performance in 2022. While we did not believe that high interest rates would tip the economy into a recession because of the changing credit profiles of many different borrowers (corporate and households), we did think the economy would continue to slow. To our and many others’ surprise, economic growth not only did not slow, but grew robustly in 2023. We believe this growth seems to have come from the fact that, despite the Fed being very aggressive at the short-end of the yield curve, they were consistently using the quarterly dot-plot and speaking events to guide future short-term rates lower. By doing this, they were lowering rates at the long end of the interest rate curve, allowing cyclical parts of the market to rebound. Furthermore, inflation, while still high, began declining from historically high levels for many consumers. Slowing inflation, paired with growing wages, resulted in rising consumer confidence and translated into higher-than-expected consumer spending. Lastly, the AI trade lifted pockets of the equity market, crypto markets rebounded, and home prices remained stubbornly high. All of this flowed into the economy and the markets via the wealth effect. This helped the consumer and eased financial conditions.
To top it off, during the fall of 2023 the Fed declared, incorrectly, in not so many words that the rate hike cycle was over and that they had conquered inflation. This led to the market pricing in more than six rate cuts in 2024. The markets have a way of believing the Fed when it works in their favor. As such, bond prices rose, causing rates to fall, which led to a strong risk-on feedback loop. This rewarded investors who added more beta (volatility) and momentum to their portfolios with the iShares Momentum Factor ETF (MTUM) returning 32.58% and the Invesco S&P 500 High Beta ETF (SPHB) returning 24.23% between October 31, 2023, and May 24, 2024. This is compared to the S&P 500, which returned 21.71% during that same period.
The question everyone is asking today is whether today’s data supports the risk-on strategy that worked in 2023. We believe that the historic rally over the past six months and investors' seemingly singular focus on AI and its future potential has caused many to shift their focus away from the numerous structural issues still prevalent in the economy. Recent inflation reports have come in stronger than expected causing investors and the Fed pulling back on their expectations for the number of anticipated rate cuts from over six to between one and two, supporting the case for higher for longer interest rates and inflation persistently above the Fed’s stated 2% goal. In turn, interest rates across the yield curve, but more importantly, on the long end, began retracing their cycle highs. The debt dynamics and unsustainable spending by the U.S. government are coming into focus, with even the International Monetary Fund stating the United States is on an unsustainable trajectory.
As it pertains to AI, investors are very good at pontificating the productivity benefits to corporations but less so at forecasting what the potential job losses could do to longer-term consumer spending. China, which, despite its best efforts, continues to struggle to reignite its economy as the global growth engine it once was. Add to this the most geopolitical risk we have seen since 9/11 or maybe even the Cold War and we believe we have a situation where it is very tough to warrant aggressively buying stocks that are above their historical valuation multiples or add more beta and momentum to portfolios. We are open as to why we might be wrong in our forecast, but to us, the data continues to indicate slower growth with the potential for more inflation volatility.
Conclusion and Commitment
Accordingly, our portfolios remain positioned with a defensive bias. While we do not anticipate an immediate economic contraction, we recognize the elevated risk of external shocks that could prompt such a downturn. We are currently overweight Consumer Staples and Health Care. We have some equity exposure to copper and agricultural commodities (included in our Consumer Staples weight). We also have exposure to some areas of the market that we think will benefit from structural technology growth, such as cloud computing and semiconductors, as well as utilities and infrastructure companies. We believe this blueprint will successfully navigate a market where growth is likely to slow, and inflation is expected to remain volatile and above the Fed’s 2% target. We have always said our strategies tend to outperform in down, flat, and modestly higher markets and underperform during risk-on periods where markets rise significantly. As the below table depicts, this has been the case for MAP’s Global Equity strategy over time. Furthermore, over the last 30 years, the MSCI ACWI has averaged a 6.6% compound annual return. As such, we don’t believe further periods of double-digit returns are sustainable given today’s elevated valuations.
¹Net composite results are presented net of highest fee. ²You can’t invest directly in a benchmark index. A full performance fact sheet can be found here.
To conclude, we want it to be perfectly clear that we are never complacent and always challenge our team, ideas, themes, and stock selection. However, as we continue to synthesize the data being released, our analysis continues to lead us toward an economy that is going to be slowing down and not one that will keep accelerating. If this proves true, historical data supports the investment thesis that overweight positions to defensive areas of the market will be rewarded. Furthermore, we remain confident that we have portfolios well-positioned to take advantage of changes in the technology sector without adding too much risk. On that note, we thank you for your trust as we work towards delivering attractive, long-term risk-adjusted returns. It is a responsibility we do not take lightly or take for granted. As always, please feel free to reach out to your MAP representative with any questions or concerns.
Managed Asset Portfolios Investment Team
Michael Dzialo, Karen Culver, Peter Swan, Zachary Fellows, John Dalton, and Nicolas Vilotti
June 2024
Certain statements may be forward-looking statements and projections which describe our strategies, goals, outlook, expectations, or projections. These statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements. The information contained herein represents our views as of the aforementioned date and does not represent a recommendation by us to buy or sell this security or any other financial instrument associated with it. Managed Asset Portfolios, our clients and our employees may buy, sell, or hold any or all of the securities mentioned. The data regarding yield curves was generated by Baird. We are not obligated to provide an update if any of the figures or views presented change.
