“I simply dropped in to see what situation my situation was in.”
(Kenny Rogers & The First Version, 1967)

The primary three quarters of 2023 had been marked by a handful of things and points, amongst them: (1) the continued efficiency dominance of large-cap “mega-cap tech” shares (and the corresponding continued underperformance of small-cap shares); (2) a U.S. economic system that continues to be extra resilient than many anticipated; (3) a Fed that appears to be at or close to the top of its charge hike cycle; (4) the continuing Russia/Ukraine conflict; (5) simmering tensions between the U.S. and China; and now, in fact, (6) the outbreak of conflict between Israel and the Iran-sponsored Palestinian Hamas.

As at all times, when reviewing the present state of the worldwide economic system and funding markets, we suggest specializing in Market indicators and hunting down market noise. We consider the 5 major financial and market indicators that present perspective on the place we go from listed here are GDP development, earnings, rates of interest, inflation and central financial institution coverage.

This isn’t to dismiss geopolitical points or political dysfunction in Washington, DC. However these are what we check with as “recognized unknowns”—we’re conscious of them however don’t have any strategy to forecast how they may prove or what results they may have (or not) on the economic system or funding markets.

Spoiler alert: We now consider that any U.S. recession will probably be pushed out till later in 2024, perhaps not even till 2025. The proverbial financial “gentle touchdown” is now not dismissed by analysts.

So, let’s dive in.

GDP, Inflation and Central Financial institution Coverage

Let’s begin with a take a look at the yield curve (i.e., rates of interest), particularly two carefully watched “spreads”: the 2-12 months/10-12 months (2s/10s) and the 3-Month/10-12 months (3m/10s).

Whereas the yield curve stays inverted (traditionally, a number one indicator of recession), the current steepening of the yield curve (particularly, the dramatic rise in longer-term charges) means that the Treasury and bond markets are “normalizing.” “Larger for longer” stays our mantra.

Traders who’ve solely been within the markets for the reason that nice monetary disaster in 2008 may interpret the current improve in charges as a “disaster” when, in actuality, we’re merely transferring “again to the long run” to the place the Treasury curve is more and more pushed by traders (accurately) versus Federal Reserve intervention.

We see that the 2s/10s has been inverted since roughly July 2022, whereas the 3m/10s in October 2022. The current pattern towards “normalization,” nevertheless, means that the market is responding to the Fed decreasing its market interventions and to ongoing financial resiliency, particularly given the continued energy of labor and retail gross sales indicators.

Whereas some argue that inflation stays a priority in 2023, it actually is trending in the suitable route. We consider the Fed is at or close to the top of its charge hike cycle, and it continues to scale back its steadiness sheet. The market itself isn’t pricing in any charge cuts till June of subsequent yr—fairly a reversal from the start of the yr when cuts had been anticipated as early as this previous June.

We notice that the headline CPI quantity is considerably impacted by housing and shelter information, that are topic to round a six-month reporting lag. CPI would look a lot decrease if present or contemporaneous shelter information had been used.

Estimates for annual GDP development in 2023 and 2024 are muted however optimistic.

Estimates for Financial Development exterior the U.S. are additionally muted however optimistic.

Translation: Whereas financial development could also be slowing, it’s proving to be extra resilient than anticipated. Right here within the U.S., there stays optimistic financial information, particularly in consumption and labor, however some indicators—particularly manufacturing—are in “contractionary” mode.

Whereas the Fed will probably be extremely “information dependent” as we transfer via 2023, we consider we’re at or near the top of the speed hike cycle, with maybe yet one more hike in 2023. The market presently isn’t pricing in any charge cuts till nicely into subsequent yr.

Earnings and Valuations

The Q3 earnings season is simply getting began. The consensus is that 2023 will witness a small decline in company earnings however then enhance once more as we transfer into This autumn and 2024. Wage will increase and declining productiveness are placing downward stress on margins, however that is considerably mitigated by the continued energy of the labor markets and the labor participation charge.

One query is whether or not the “AI-themed” shares which have pushed a lot of market efficiency YTD will have the ability to proceed to generate enough earnings to take care of their present elevated valuations. In a current weblog put up titled “Development Shares Are Much less Costly than Conventional Measures Indicate,” nevertheless, we recommend that valuations will not be as excessive as advised if “intangible adjusted” valuation metrics are used.

Outdoors the U.S., elementary and dividend-driven traders might discover relative valuations to be engaging. That mentioned, we’re much less optimistic about financial development exterior the U.S., particularly in Europe and China, and the greenback has been on a powerful rally for a number of months.

For these causes, we not too long ago diminished our exposures to EAFE and EM in favor of going over-weight within the U.S. relative to the MSCI ACWI Index.

Translation: International fairness markets stay comparatively “complacent,” although they do react to adjustments in rates of interest (and have fallen with the current rise in charges). Ex-the mega-cap tech “AI” shares, market valuations are according to historic averages, with maybe relative worth out there exterior the U.S. For U.S. traders, non-U.S. markets stay delicate to slower financial development charges and an upward-trending greenback.

We noticed a powerful issue rotation towards large-cap development and mega-tech shares via the primary three quarters of 2023. These elements “rolled over” barely in Q3 as rates of interest rose however stay the dominant ones in total market efficiency.

Small-cap and worth shares proceed to characterize a relative worth alternative going ahead, although small caps are additionally extra delicate to rates of interest and to the monetary and power sectors, which have carried out comparatively poorly thus far this yr. Q3 confirmed indicators, nevertheless, of a possible “re-rotation” again towards worth shares in each massive and small caps.

We consider “high quality” (i.e., firms with robust steadiness sheets, earnings and money flows) will develop into more and more necessary as margins and earnings get squeezed. Companies that may keep their pricing energy and dividends ought to extra persistently carry out.

Curiosity Charges and Spreads

The yield curve stays an merchandise of intense focus today. We mentioned the extent and form of the curve above, however what about credit score spreads?

Credit score spreads stay according to historic ranges (regardless of a current uptick in high-yield spreads). This, mixed with optimistic actual charges throughout the maturity spectrum, interprets into “there may be revenue again in mounted revenue.”

Company steadiness sheets and debt constructions are in respectable form, so coupons ought to be secure. We elevated the period of our strategic mounted revenue mannequin a number of months in the past however stay brief period relative to the Bloomberg Combination Index, in addition to over-weight in high quality credit score.

We consider that, given their present yields, high-yield bonds supply an satisfactory “buffer” to hostile actions in both charges or spreads, and given the form of the yield curve, we nonetheless like floating charge Treasuries.

Regardless of our favorable view of excessive yield, we did not too long ago make the choice inside our Mannequin Portfolios to scale back our high-yield over-weight positions and reallocate into mortgage-backed securities.

Traders proceed to not be rewarded for taking up period threat. This chart illustrates why we nonetheless favor floating charge Treasuries and U.S. company high-yield.

Abstract

When specializing in what we consider are the first financial and market indicators, the “situation our situation is in” is optimistic, with some uncertainties—particularly, a nonetheless publicly hawkish Fed and heightened geopolitical tensions.

Financial development is proving to be resilient, and recessionary fears have been pushed again till nicely into 2024. Earnings are anticipated to say no in Q3 however then enhance going ahead.

To summarize our major funding themes and views for the rest of 2023 and into 2024:

• There’s revenue again in mounted revenue. We consider there continues to be relative worth in excessive yield, and we proceed to love U.S. floating charge Treasuries.

• Regardless of market performances YTD, we keep our conviction in worth, small-cap and dividend shares.

• High quality continues to be essentially the most persistently performing threat issue (hardly ever one of the best or the worst) and stays the “anchor” issue tilt in our Mannequin Portfolios.

• U.S. small-cap shares proceed to current engaging valuation performs.

• Non-U.S. markets current attention-grabbing valuation and dividend alternatives, however we’re involved about financial development and the route of the greenback.

• Energetic administration and clever threat issue tilts ought to be rewarded versus passive administration (i.e., cap-weighted “beta”).

• Actual property (e.g., commodities and MLPs) and different methods (e.g., managed futures and option-based) proceed to current attention-grabbing diversifying alternatives.

As typically strategic traders, we proceed to suggest specializing in a longer-term time horizon and the development of “all-weather” portfolios, diversified at each the asset class and threat issue ranges.