The Pause That Depresses

What do we make of the last six months? Once again, the market has done the thing that makes the most people wrong. Dire forecasts of economic doom are looking laughably hyperbolic. Strategist after strategist is either reversing their calls or at least toning down the pessimism. CNBC producers have stopped asking for the latest perma-bear to appear on Squawk Box. The Vix fear gauge is depressed - stuck on empty. Blame the Fed pause for that!

3 Month Expected Volatility

With Powell and Co. moving off the front pages of the business section, investors are left wondering what the market will do next. Earnings have been mixed but better than feared. Interest rates are stable after the past two years of high volatility. Stock market volatility, like an aging senior at home alone, has fallen and can't get up. There is no new geopolitical crisis on the horizon. The economy is gliding to a slower trajectory but without the blow-ups that characterized the past. Snoozefest!

The positioning and sentiment rally is over for now. Any sign of rotation to left-behind areas of the market is nowhere in sight. Growth has crushed Value this year but until the monetary cycle turns outright stimulative, that won't change. The action of the yield curve over the last month is ominously negative. It's still a case of 'no banks, no thanks' for me. The equal-weighted market has lagged due to the skew towards the quasi-monopoly mega caps, but their earnings profile is under threat from the Fed's actions over the past year. On the other hand, there is universal praise for U.S. technological dominance that has the Growth stocks in bubble territory.

Is boring the new panic? Can we just wander sideways across the next three months? Is a 'summer off' in the offing? I guess so, but it shouldn't last long. The current soft landing talk may create a self-fulfilling tradeable summer rally that favours the Value segments. But it's only a trade until the rate structure normalizes. I will continue to maintain the view that a normal curve - either way it happens - can only come at a major cost to risk assets.

I assumed the market would have an upward bias in the first half of the year as the inflation shock began to wane and investors had priced in the worst case last fall. I now believe this will be followed by renewed downside once the inflation gauges bottom out and begin to surprise on the upside. Easy financial conditions and a persistent low 'real' rate structure argue for a soft patch followed by a renewed upsurge later this year. That won't treat either bonds or risk assets well. The Fed will be forced to be back on the brakes early next year and those expectations are totally heretical in the current narrative. The market has actually priced in a series of rate cuts for 2024. Once the market realizes it's mistake, the fireworks should start.

The violence of the sell-off in the overpriced Growth sector could be significant as their rate sensitivity, now underappreciated and forgotten due to the current AI hype, reasserts itself as a valuation governor. Value stocks, while already priced for 'imperfection' will suffer a further earnings reset. That could be the low-risk entry point of the decade but save some dry powder for now as the market may get ugly. October low??

Like the 'stop-start-stop' monetary cycle that I witnessed firsthand in 1980-82, this market is not for the faint of heart. If you thought 2023 has been tricky so far, you weren't around back in the eighties. We are just getting started.

Good luck, see you in a few weeks. I'm doing lots of travel and family hosting over the next few weeks, so this is it for me til later this summer. Cheers!

Risk Model: 5/5 - Risk On

All systems go in risk land it seems. The Chinese have rescued the copper market for now (you heard it here first!) but it seems tepid so far. Their real-estate Ponzi scheme will be hard to restart given the unaddressed debt burdens in their system

By my calculation, the TSX has done nothing for 2 years. For the Canadian markets, internal churning is a sign of the balanced risks of a stagnant economy that is offset by cashed-up investors that have little alternative to find growth. The FOMO-driven rise down south is a case of a similarly weak economy meeting with investors happily chasing the few stocks that still command pricing power and have a growth story attached. Either way, there aren't enough good stocks to go around.

What has surprised me is the belief in the bond markets. After two successive years of failure, the 60/40 portfolio seems to have made a comeback of sorts. Thanks to the immaculate disinflation narrative currently in vogue, there seems to be a renewed belief in the popular strategy. I can remember a time (my hair was much longer) when bonds were similarly overvalued by the structural rigidity engendered by 'prudent' risk policies of institutional investors. That groupthink gave us a decade-long negative 'real' return on fixed-income assets that soured investors for years after.

One of the prima facie supports for 60/40 was the global weights of the two respective asset classes. There was a time when stocks represented 60% of investable public assets. No longer. Bonds are now the dominant asset class globally in terms of the size of issuance. And like a crop that never fails, the stock of debt is growing ever larger each successive year. Should current profligate trends persist, as we saw in the failed auction of 1987, there could be an ugly period ahead for the bondies. The soft landing we all hope for may not be as soft as you think should inflation prove stickier than thought.