The Manley Macro Memo
In the current inflationary environment, we expect interest rates will rise, and we see a significant opportunity to invest in the value sectors of the market while avoiding the mega-cap tech stocks.
Executive Summary
In September, the S&P 500 suffered its worst monthly performance since the start of the pandemic. In addition to inflation concerns, supply chain constraints, and labor shortages, investors were concerned that the regulatory crackdown in China could lead to slowing global growth and systematic risk if China's real estate bubble burst.
The economy continued to accelerate in September, and inflation remained near a thirty-year high. The unemployment rate dropped to 4.8%, the ISM Manufacturing PMI increased to a robust 61.1, and inflation accelerated to 5.4%. The Federal Reserve indicated that it could begin tapering its $120 billion per month Quantitative Easing program as soon as their November 3rd meeting. We remained concerned that the Fed maintained its emergency measures too long and has made a severe monetary mistake.
After a sharp 5.8% correction in September, the S&P 500 has rallied to a marginal new high. We continue to believe that the market is susceptible to a correction this fall. Despite the S&P 500's recent record close, the market's breadth remains poor, and there is significant uncertainty regarding inflation, the labor market, the timing and magnitude of the Fed's QE taper. Additionally, China's recent regulatory crackdown has led to an energy crisis that reached Europe, and if they allow their real estate bubble to continue to deflate, systematic risk could spread globally. Although there is significant economic uncertainty and poor market structure, unbridled market speculation continues unabated. Typically, speculative financial markets that are detached from their fundamentals don't end quietly.
We expect economic growth and inflation will continue to accelerate as the pandemic wanes and the extraordinary level of monetary and fiscal stimulus kicks in. In this environment, we expect interest rates will rise, and we see a significant opportunity to invest in the value sectors of the market while avoiding the mega-cap tech stocks that dominate the S&P 500. Additionally, we expect market volatility to increase, and if/when it becomes clear that the Fed made a monetary mistake, the markets will be vulnerable to a significant decline.
Market Review:
The S&P 500 fell by 4.7% in September, which was the largest monthly decline since the beginning of the pandemic. Investors were concerned about accelerating inflation, rising interest rates, and uncertainty over the labor market. Additionally, investors were worried that the recent regulatory crackdown in China could slow global growth and increase systematic risk.
In September, the S&P 500 declined by 4.7%, while the NASDAQ 100 and the small-cap Russell 2000 dropped by 5.7% and 2.9%, respectively. Also, the MSCI EAFE index of international stocks fell by 3.3%, and the MSCI Emerging market index decreased by 3.9%. The safe havens performed poorly in this "risk-off" environment -- the U.S. long-bond and gold fell by 2.9% and 3.3%, respectively. Additionally, the U.S. 10-year bond yield increased by 0.19% to 1.47%, and the yield curve (2-year to 10-year) steepened by 0.14% to 1.24%.
After September's sharp market decline, the S&P 500 rallied to a marginal new high in October. While Q3 earnings have been solid, most other fundamentals remain uncertain. Despite the Fed's belief that inflation was "transitory," inflation continues to accelerate, and the strong housing, energy, and labor markets indicate higher prices for the foreseeable future. Additionally, there is significant uncertainty over the state of the post-pandemic labor market. Currently, 8.0 million fewer Americans are working than before the pandemic (chart 1), yet there are presently 10.5 million job openings (Chart 2). While there are numerous reasons why so many Americans have not returned to the workforce – i.e., early retirement, child or elderly caregiver, fear of Coronavirus, or a post-pandemic lack of desire to work in low-end jobs – no one can be sure if this is a temporary or permanent change.
Chart 1: Before the Pandemic, 152.5 million Americans were working. Today, only 147.5 million are working. It is unclear why eight million Americans have not returned to work
Chart 2: Before the Pandemic, there were 7.1 million Job Openings (JOLTS). Today, there are 10.5 million Job Openings, yet 8.0 million have not returned to the workforce
If this is a permanent change to the post-pandemic labor force and the U.S. is near full employment, the Fed made an egregious monetary mistake, and there is a significant risk of accelerating inflation.
Chart 3: Wages are growing at 5.5% per year, the highest rate since August 1982. If the labor market is near full employment, wages and inflation will continue to rise
Despite the significant economic uncertainty, the S&P 500 rallied to an all-time high in October. Unfortunately, the market's breadth was very narrow, and the S&P 500 was driven to an all-time high by a small number of mega-cap technology stocks. In fact, most stocks have not appreciated since the first quarter of this year (chart 4). Historically, poor market breadth leads to sharp market corrections.
Chart 4: Since March 15th, the S&P 500 has increased by 15.4%, while the small-cap Russell 2000 has declined by 4%. Also, the S&P 500 reached an all-time high this week, while the Russell has not reached a new high in seven months.
Chart 5: While the S&P 500 is near an all-time high, only 67.7% of NYSE stocks are above their 200-day moving average. Narrow market breadth is a sign of an unhealthy market.
Conclusion:
We expect economic growth and inflation will continue to accelerate as the pandemic wanes, and the extraordinary level of monetary and fiscal stimulus kicks in. In this environment, we expect interest rates will rise, and we see a significant opportunity to invest in the value sectors of the market while avoiding the mega-cap tech stocks that dominate the S&P 500. Additionally, we expect market volatility to increase, and if/when it becomes clear that the Fed made a monetary mistake, the markets will be vulnerable to a significant decline.
Sector Review:
In September, every sector, except for energy, declined because investors became concerned about accelerating inflation, supply chain constraints, higher interest rates, and energy shortages. Additionally, investors feared that the regulatory crackdown in China could lead to slowing economic growth and systematic risk if their real estate bubble was allowed to burst.
Typically, when stocks decline, there is a flight to quality, and investors rotate to the safe-havens (gold and U.S. 30-year Treasury bond) and the defensive sectors (staples, healthcare, utilities, and REITs) that perform well when interest rates fall. During September's sell-off, the defensive sectors of the market and the safe-havens (gold and U.S. 30-year Treasury bond) performed poorly because the higher inflation and interest rates were the primary catalysts for the decline.
Source: Factset
Our Model Portfolio:
The benchmark for our model portfolio is the Traditional Blend — 60% equity, 40% bonds. Our goal is to outperform the benchmark with less risk. To outperform, our investment portfolio is diversified and economically balanced. We eliminate laggards and tilt the portfolio toward our location in the business cycle. Finally, we risk-weight our positions to manage volatility.
We remain positioned for a reflationary economic environment (accelerating growth and inflation). We are concerned that significant monetary and fiscal policy errors could lead to an inflation problem as the pandemic abates, the global economy accelerates, and interest rates rise. Our core investments remain in the economically sensitive value sectors of the market (industrials, financials, and energy), commodities, TIP's (U.S. Treasury Inflation-Protected Securities), and floating-rate debt ETFs. We remain underweight equities and fixed income duration and overweight commodities relative to our benchmark.
Our portfolio's risk level (annualized volatility) is 10.3%, which is slightly less than our 60/40 benchmark.
Current Risk-Weighted Model Portfolio:
Our short-term (three-months) outlook is neutral:
We believe that the market offers a mixed short-term risk-reward because investors are complacent, speculation is rampant, and market breadth is poor. Despite no selling capitulation, it appears that September's sharp correction is over, and the tremendous liquidity and favorable seasonality should drive the markets higher into the end of the year. We will become more constructive and increase our tactical risk exposure when investors are fearful, the market is oversold, and breadth begins to improve. Our short-term market outlook is neutral.
Our long-term (more than four years) outlook is neutral:
We believe that the S&P 500 offers a poor risk-reward because it is extremely overvalued. Also, we are concerned about the long-term unintended consequence of the unprecedented monetary and fiscal policy that was used to combat the pandemic. Artificially low-interest rates and historic peacetime deficits have led to a record debt burden, which will become problematic as the economy grows, and interest rates normalize. We continue to see a significant opportunity to invest in the value sectors of the market while avoiding the mega-cap tech stocks and the S&P 500. While we expect to profit from the reflationary rotation into the cyclical stocks, longer-term, we remain concerned about the impact rising interest rates will have on profitability and stock valuations. Our Strategic Asset Allocation is underweight equities relative to our benchmark.
Disclaimer: The material in this newsletter is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This newsletter is not a substitute for professional investment services. Past performance is no guarantee of future results, and there is no assurance that investment objectives will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.
