Macro & Strategy - July 2023

Has the bear truly left Wall Street?

We have to acknowledge the obvious: so far 2023 hasn’t been a year for macro investing.

According to the usual definition, the S&P 500 just exited a bear market phase and is now back in a bull market, having closed on June 9 at a level 20% higher than its October lows.

Liquidity is of course a major part of the current macro financial story. We note that global central banks, despite clear signals about wanting to shrink their balance sheets and to draw liquidity out of the system, actually increased their assets in the first half of the year, which has most likely supported risk appetite. A very basic model suggests that, as defined by liquidity conditions, the recent momentum on Wall Street may have pushed its valuation about 400 points, or 10%, above fair value.

This performance was led by a handful of sectors, with the AI theme continuing to be a major contributor to investor optimism. We recognize that optimism about such a theme can create self-sustaining momentum that could push equities higher in the next few months, despite the clear signals we’re getting from our macro framework.

Even though we’ve stayed the course and continue to favour a somewhat cautious stance, we think it might be time for some tactical adjustment to our views; therefore, we’ve cut in half our underweight position in U.S. equities. We expect this move to stand for only a short period because we sense echoes of 1999, when calling a market peak amid conflicting signals was a perilous task.

The four most dangerous words in investing: “This time is different”

As we’ve discussed in these pages in recent months, the accumulation of monetary tightening continues to make its way into the system, particularly through the credit channel, and our leading indicators are pointing to weakness that should eventually weigh on market valuations. After all, corporations’ ability to increase their sales and earnings is deeply rooted in the business cycle. And, from the macro standpoint, the road ahead looks bumpy.

But we also have to acknowledge that monetary policy works with lags that are both long and unpredictable. As students of history, we firmly believe that it is never different this time; instead, we must be patient long enough to let the inner workings of the economic machine run their course.

Continuing the thread of recent months, we’ll now take a deeper dive into the relationship between recessions and bear market bottoms. Last month, we applied one of our go-to mental models to estimate the risks that we are wrong and that a recession could be avoided over the next 24 months in Canada and the United States. We concluded that the odds of a soft landing were low down south but medium in Canada.

One cornerstone of our macro framework is that a bear market is a process, and that the process is not complete until the economy falls into a recession. The table below speaks for itself: recessions tend to be caused by monetary tightening (which acts with lags of 18-24 months), and even though markets tend to be forward looking, the monetary delays are generally longer than the 12-month window of investor foresight. Thus, when central banks start cutting rates in the face of deteriorating economic data, the bear market process is generally not yet complete.

Defining a recession

Contrary to popular belief (and what is still commonly taught in economics classes), a recession is not defined simply as two consecutive quarters of negative GDP growth.

The work of identifying start and finish dates for recessions is in fact entrusted to committees of experts: the C.D. Howe Institute in Canada and the National Bureau of Economic Research (NBER) in the United States.

According to the NBER’s definition, “a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.… The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesaleretail sales adjusted for price changes, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions. In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.”

As one can infer from the above, no definition of recession is set in stone, and different observers (including markets) can look at the same data and see different things.

When looking at the current state of things, we acknowledge that we are not currently in a recession. In fact, the usual suspects from the NBER’s dashboard as well as those followed by the Conference Board seem to suggest that the economic cycle is still doing fine.

If we were truly out of the bear market, it would be the first time in recorded history that the market bottomed out before the economy officially slipped into recession territory. But, looking forward, we see that the pieces are continuing to fall into place for an economic contraction.

Looking forward rather than backward

Our job as investors, to quote the Great One, is to “skate to where the puck is going, not where it has been.” Our main leading indicator, which summarizes in a single metric the cumulative amount of global monetary tightening, is pointing toward more global headwinds until the end of the year.

Will this be enough to tip some countries into recession? We continue to see a recession in the U.S. as our base case in the next 12 months but remain more balanced when it comes to Canada because of its massive demographic tailwinds. The most recent Bloomberg survey of economists also suggests that the consensus is circling the second half of 2023 as the most likely time for a U.S. recession.

Drawing lessons from history to build a recession checklist

As recession start dates are known only in retrospect, we find it useful to look at a broad list of indicators that can give us a head start when we evaluate the odds of an imminent recession.

Even though history is a useful guide, every cycle has its particularities, and there is no such thing as a perfect checklist for recession start dates. To correct for this deficiency, we tend to focus on a handful of time-tested signals, mostly macro in nature, that have a strong track record of collectively calling shifts in the business cycle. A short list, along with the signals we’re getting, is shown below.

Even though the U.S. economy may not yet be in recession, our checklist signals are 100% in alignment.

The conclusion we draw is that 1) if history is clear that no S&P 500 bear market has ever bottomed before a recession was under way and 2) the U.S. economy is clearly not in a recession now, but 3) our signals are pointing toward high risks ahead, we need to maintain our stance of underweighting the U.S. stock market until we’re convinced that the bear market process is complete.

The devil’s advocate: how large an underweight in U.S. equities?

Given the above analysis, it might seem peculiar to increase our positioning in U.S. equities.

As we stated at the outset, the AI theme is starting to create echoes of 1999, with a clear momentum emerging in tech stocks. We’ve learned from such episodes that valuations can always get more expensive and that calling a top is a perilous task. Recognizing the short-term momentum, we’re inclined to tactically cut the U.S. equity underweight, if only for a short time.

Depending on how long it takes for monetary policy to work its way through the system, we could also see a rotation from tech to non-tech in the coming months, which could keep the market afloat despite higher rates.

Central banks could also be tempted to slow or even temporarily reverse their drainage of liquidity and, as we saw in the first quarter, support risk appetite. In the same vein, China is discussing the potential for stimulative measures (the PBoC is already at work cutting rates), and the Fed might be tempted to provide additional support if more banks face difficulties in the coming months.

To keep the portfolios properly exposed to sources of growth, we decided to cut the U.S. equity underweight from (--) to (-) this month, at the expense of cash. We think there may be a tactical opportunity to take advantage of the momentum on the U.S. markets before rate hikes begin to bite, affecting growth and return outlooks alike.

Bottom line

Equities

Our overall stance on equities remains slightly cautious, even though we recognize the disconnection between our macro signals and the momentum that has taken over the markets.

Even though valuations are not tightly linked to short-term performance, the valuation gap between the U.S. indexes and the rest of the world has become even larger; thus, we continue to keep a structural underweight position on Wall Street.

The equity risk premium tells us that U.S. stocks are the most expensive they’ve been relative to 10-year Treasuries since the global financial crisis, but the relative valuation still compares advantageously when we look at the period from 1980-2000. Given the long-term relationships at the core of our macro framework, we tend to expect more deterioration in sales and earnings growth by year-end, meaning that the valuation should continue to grow uncomfortably higher.

Again using history as a guide, we can show that recessions have not been kind to earnings on Wall Street. As we can see in the table below, S&P 500 earnings have fallen by 31.6% on average (median of 22.0%) during past recessions. While the brand of recession we’re expecting could be much milder than many in this sample, we would be surprised if businesses were able to shield their earnings altogether this time.

Looking under the hood, we note the lack of breadth on Wall Street despite the more than 20% bounce since the October 2022 lows. The smoothed share of stocks trading above their 200-day moving average is only about 50%, a figure that we would like to see move higher before we change our strategic stance.

Fixed income

During the month, we maintained an overweight in longduration sovereign bonds along with an underweight in highyield corporate credit.

Both U.S. and Canadian 10-year yields are sitting near 15-year highs and offer an appealing value proposition relative to the previous decade. Even though the “there is no alternative” (TINA) concept was omnipresent in the past decade, it now makes ample sense to hold a more balanced portfolio, with the fixed-income portion offering attractive returns, instead of mostly diversification benefits.

In the corporate credit space, all-in rates have also become highly generous: more than 5% for investment-grade products and about 8% for high-yield. Even though we recognize the attractiveness of these rates, we think the expected returns, corrected for swings in capital gains, favour the higher-quality end of the spectrum, as high-yield spreads tend to widen to a range of 800-1,000 basis points (bps) in periods of economic turbulence. If our macro framework is right and we see volatility return to the markets, higher-quality bonds should outperform despite the lower spreads.

Commodities and foreign exchange

The U.S. dollar is expected to see increased strength in second half of the year, after the month of May established a favourable background for it. With an undercurrent of slower momentum in Europe and China, the greenback is expected to benefit and retain its edge, particularly if volatility returns to risk assets.

The support for the U.S. dollar from liquidity factors is expected to continue, albeit in a more indirect and low-key manner. While the performance of G10 foreign exchange has thus far hinged largely on disparities in interest rates, such influences could wane as growth-inflation patterns become less synchronized.

The copper-to-gold ratio turned upward in mid-May, with the removal of uncertainty over the debt ceiling deal. We expect the coming quarters to bring renewed interest in gold as a source of diversification when/if the equity rally sputters. Copper remains under pressure since the highs of early 2022, and our leading macro indicators suggest that more downside is possible until we see clear signs that 1) the global economy has fully adjusted to higher rates and 2) China’s manufacturing activity has picked up.

The Canadian dollar has outperformed the greenback over the past month and seems to be breaking out of its recent range, pushed by stronger 2-year swap rates and economic resilience, as well as momentum in risk assets. We remain neutral on the loonie for now, because lasting outperformance for commodity-linked currencies tends to be concentrated in periods when the global economic cycle has clearly bottomed. We expect strong outperformance from the Canadian dollar in the next few years but think it might be too early to put an overweight trade in place.