By: Stash Graham
Financial asset prices used an end-of-month speech by Federal Reserve Chairman Jerome Powell to generate a solid gain in November. Chairman Powell told market participants that inflationary data had started to weaken and that participants should expect the Federal Reserve to stop rate hikes on the Federal Funds Rate in the coming months. During the month, we saw both bond and stock prices appreciate on the prospects of the end of rate hikes. Looking forward, we have started to witness a separation between speculative financial asset prices like stocks that have appreciated the last 75 days and a deterioration in forward-looking economic data, domestically and abroad. Year to date, the benchmark S&P 500 is down approximately -15%. The tech-heavy Nasdaq Composite Index is down roughly -27% year to date. Bonds and precious metals, like, gold, continue to be in negative return territory during the same time frame.
We received many questions in the past couple of months about whether we have seen the stock market bottom. We have yet to see events that historically signify a significant market bottom. When reviewing major sell-offs and the subsequent market bottoms dating back to the 1960s, we have always seen a positive shift in monetary policy. A positive change in monetary policy would be rate cuts in the Federal Funds Rate. Second, you would typically expect a formal recession already declared by the National Bureau of Economic Research. We have yet to see such a declaration. Third, you would see the bond market rally and then reverse (i.e., the interest rate on the 10-year United States Treasury would plunge and then change to move higher). Finally, it would be best to see current and forward-looking consumer expectations turn positive. Except for 1966 and 1987, market bottoms coincided with consumer sentiment shifting positively. Consumer sentiment is very negative on both current and forward time frames.
As discussed in previous partner letters, global excess liquidity and leading economic indicators are unfavorable. The Eurozone might have the darkest near-term outlook, but the United States continues to signify economic contraction in the late Spring of 2023. In addition, domestic leading indicators continued to deteriorate during the month, increasing the chances that a recession would happen sooner and possibly be more severe. As a result, we have continued to lighten our equity exposure as this market rally ends. The bear market rally had generated above-average equity inflows to levels not witnessed since early August, when the previous bear market rally began to end.
Events that caused U.S. Treasury interest rates to fall quickly give us confidence that our high-quality, short-duration corporate bond and U.S. Treasury bond positions we have started over the last 90 days have additional life left in them. The consumer price index peaked in October, and the growth rate of the inflation index will continue to move lower in the coming quarters, albeit at elevated levels. The main story for the first half of 2023 will be market headlines less focused on inflation and more stories focused on recession. Consistent with history, when the broader market grasps the elevated recession risks, Treasury prices will traditionally move higher. Adding to the risk of an imminent slowdown, the Federal Reserve’s preferred yield curve recession indicator is now inverted. The spread between the estimated yield of the 3-month U.S. Treasury in 18 months and the current yield of the 3-month U.S. Treasury is now at a negative 25 basis points. These negative levels were seen in the months leading up to the 2020 COVID recession, the months leading up to the Great Financial Crisis (2007), and the Dotcom bubble (2002) and have generated no false positives.
While our portfolios benefited from the higher financial asset prices, we remain cautious of further downside pressure as we look forward. Our preference to be positioned defensively is centered on events that could unfold in the first couple of quarters in 2023. If we are correct about these downside pressures, we could be looking to the late Summer as an excellent time to allocate capital to risk assets like stocks. If you have any questions, please feel free to reach out to the team! We are grateful for your trust and are glad to report our continued outperformance this year.
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