Invariant was active across portfolios in early February. This interim market update will discuss these moves and provide initial thoughts on important recent economic developments.
1. Invariant came into 2023 heavily overweight risk assets.
2. Stocks rallied sharply to start the year. From the end of January through February 8th, we sold stocks and other assets to lock in gains and significantly reduce risk across strategic portfolios.
3. Markets priced in a pause in the hiking cycle, which reduced key borrowing costs such as mortgages and auto loans. In addition to other technical factors in the bond market, we believe this played a major role in the rally in risk assets and surprisingly strong economic numbers. Paradoxically, it will likely lead to a tighter path of monetary policy.
Stocks got off to a blistering start to 2023, rallying into our proprietary quantitative targets only one month into the year. We initially executed our plan to bring portfolio risk asset exposure from max overweight back down to neutral, trimming positions added last year on weakness.
In our view, these targets represented challenging valuations even when making optimistic assumptions about the forward path of interest rates and earnings. Regardless of our macroeconomic views, we intended to adjust portfolio exposure into these levels.
Subsequently, over the course of about a week at the beginning of February, we continued to reduce portfolio risk. As measured by portfolio-level volatility estimates, we cut model risk in half. Strategic portfolios went from significantly overweight stocks to significantly underweight, exited tactical positions in local-currency emerging market bonds and gold miners, and rolled those proceeds into short-term bonds that would not lose much money if yields continued to rise.
While valuation concerns justified bringing exposure back down to neutral, another meaningful input in our decision to take more significant action was that under the surface, the rally looked an awful lot like an “echo bubble.”
Within an economic backdrop diametrically opposed to the one that underpinned the speculative growth stock frenzy that finally went bust in 2021, these same stocks were rallying 20, 50, even 100% in a day back in January. This included companies like Bed Bath and Beyond, whose debt was trading at 5 cents on the dollar. A company on the inevitable march to bankruptcy was a leader of the “meme stock” group day in and day out. (https://www.cnbc.com/2023/01/11/bed-bath-beyond-jumps-50percent-to-lead-last-gasp-rally-in-meme-stocks-amc-gains-15percent.html )
The nature of the year-to-date rally put us on high alert that it was unlikely to sustain. At the same time, our opinion was met with fierce opposition from retail investors seen both anecdotally and in positioning data.
We have found one torchbearer for this idea in Ruchir Sharma, chair of Rockefeller International. He articulates the case as well as anyone in this recent editorial in the Financial Times: “Investors refuse to give up on ideas that recently made them a lot of money and so they keep piling back in. The echoes gradually fade away, until serial disappointment kills the faith.” (https://www.ft.com/content/0c35d878-56c4-4fc2-bb66-979f1247c7ec )
A historical analog to this period comes from January 2001. Our friend Lawrence Hamtil of Fortune Financial Advisors dug up and shared this news article from that period, which reads as if was written in January 2023. Sound familiar? (https://money.cnn.com/2001/01/03/markets/jan_effect/index.htm)
By the end of 2022, inflation and certain measures of economic growth had moderated enough for investors to start pricing in the likelihood that the Fed would pause rate hikes either in January, or after one final 0.25% increase in March. Short term interest rate futures markets were also pricing in a possibility that the Fed would cut rates shortly thereafter.
As borrowing costs fell in response, economic data picked up to start the year. More recently, investors began to question the idea of a “fed pause” after the blowout January Non-Farm Payrolls report. The economy added 517,000 jobs (seasonally adjusted) vs. 187,000 expected. The unemployment rate at 3.4% was the lowest since May 1969. Retail sales were up next and similarly exceeded estimates, rising 3% vs. 1.8% expected. (https://www.cnbc.com/2023/02/03/jobs-report-january-2023-.html )
The data were so strong relative to consensus estimates that many economists were quick to dismiss them. Surely, they must be overstated due to inappropriate seasonal adjustments or the unseasonably warm winter we’ve had. (https://www.marketwatch.com/story/no-wonder-powell-didnt-commit-to-extra-hikes-here-are-five-reasons-the-january-jobs-report-may-be-too-good-to-be-true-11675856911)
Fed Rate Hike Expectations
In two weeks, pricing of the terminal rate in futures markets jumped 50 bps from 4.9% to 5.4%, and cuts later this year were priced out. Expectations for December are now 5.2%, nearly 100 bps higher than where the market thought not even a month ago.
The Fed has been consistent in its messaging about keeping rates in restrictive territory for an extended period. Over the last year, investors have been going through the five stages of grief, mourning the death of the era of easy money. They have finally entered the acceptance phase.
Just two months ago, the percentage of forecasters calling for an imminent recession was at an all-time high. Recent economic strength has brought this number down considerably. Many are now embracing the idea of a “soft landing” for the U.S. economy, meaning a slowdown that avoids recession. We think this is premature.
Warren Pies, of 3Fourteen Research, demonstrates that while recent strong data should not be dismissed as a statistical anomaly, they do not provide compelling evidence for a sustainable new trend. Furthermore, technical factors in the bond market amplified the reduction in mortgage rates and auto loans.
For now, suffice it to say Invariant is concerned about recession risk later this year. If interest rates follow the forecasted path, this will apply continued pressure to the economy and corporate profits. Particularly at risk are commercial and residential real estate, which are primary drivers of the cycle.
Invariant followed its game plan coming into 2023, reducing portfolio risk as equities hit the top end of our valuation range. Given the “echo bubble” nature of the rally, we took subsequent action to get defensive across portfolios.
These moves were not primarily driven by developments in our economic outlook, rather our view on the risk/reward from those levels across the distribution of future outcomes. However, Invariant is concerned about downside risks to the economy and the effects of tighter monetary policy. How these play out over the next 3-6 months is critical.
Bear markets outside of recessions tend to stop around here. If recent economic strength was the result of a temporary reduction in borrowing costs from the markets front-running a Fed pause, then its impact paradoxically will be to delay a loosening of monetary policy. The next leg will be about earnings estimates coming down. In that environment, we would anticipate significant distress in parts of the market until now considered bulletproof.