SUMMARY: Low Volatility names have outperformed Earnings Turbulence names by 2.1% WoW. Our risk-on factor call for the month of June is based on lower near-term recession odds and more patient central banks. Central banks appear less patient now (this could change quickly as data changes), working against the risk-on factor call for now. The odds of a recession happening in the next 3-4 months have declined significantly. That helps Cyclical and risk-on factors. At the same time, the Fed IS probing for a soft landing, and the valuation spread between Cyclicals and Defensives remains unusually wide historically. So, we are not abandoning the trade and think it will still work into July.
The above being noted, the Fed needs to keep economic growth at a below-trend pace for a long time to get core PCE inflation back toward 2%. That makes playing for an enduring (12 mo+) move higher in risk-on factors tough. Especially when most investors still think a recession is highly likely. 81% of the investors we polled (HERE) put the odds of a recession in 2023 or 2024 above 50%. That’s roughly consistent with the percent that expected a 2023 recession when we asked in January (81%), during our post-SVB survey (83%), and in our May survey (72%). The main source of recession risk is the Fed. For the 81% recession odds to come down and for an enduring move higher in risk-on factors to emerge, central banks need to become less hawkish and labor markets need to ease gradually.
We recommend selling calls on the S&P now (HERE).
Longer Term Thought: A higher estimate of r*, meaning a 4-5% fed funds rate drives core PCE below 3% without crushing for economic growth, is how higher for longer doesn’t lead to a risk-off reversal. Defensive headwinds increase in a higher r* backdrop because 1) earnings growth will be strong if the economy can tolerate higher interest rates. 2) Defensives have poor earnings growth expectations. 3) Higher interest rates make Defensive yields relatively less attractive. Currently, dividend yields for Utilities, Staples, Health Care, and REITs are all below the 2yr and near their lowest relative levels. Given our forecast for higher, but not too high, inflation and higher r* over the next Cycle, Defensives are particularly unattractive longer term. Short term they need much weaker economic growth to work.
Full report below…
MARKET VIEWS: Over the past few days several central banks have either resumed/stepped up the pace of tightening, or warned that more rate hikes may be needed due to stickier inflation. Combined with disappointing flash PMIs overnight and China’s lack of follow through on stimulus, the outlook for risk-on factors ha deteriorated short term. Low Volatility names outperformed high Earnings Turbulence stocks by 2.1% WoW. Our risk-on factor call for the month of June is based on lower near-term recession odds and more patient central banks. Central banks appear less patient now (this could change quickly as the data changes), which has worked against the risk-on factor call for now.
It is understandable why investors are quick to fade risk-on factors or Cyclical sectors. 81% of the investors we polled (HERE) put the odds of a recession in 2023 or 2024 above 50%. That’s roughly consistent with the percent that expected a recession this year in January (81%), in our post-SVB survey (83%), and in our May survey (72%). The main source of recession risk is the Fed. For the 81% recession odds to come down, central banks need to become less hawkish.
The main source of recession and market risk is tighter financial conditions, which helps explain why 10yr yields have been volatile, but in a tight range for the last few weeks. The curve has inverted more, reflecting increased risk of slower economic growth, as short rates have moved higher. The 10s-2s Yield curve has moved back to its March pre-SVB lows.
Also in our Investor survey, investors who do not expect a recession have eps estimates of $220 and $245 for 2023 and 2024, respectively. With a recession, the estimates drop to $210 and $220. That is a very wide EPS spread. Since we don’t have clarity on a soft landing, $245 is still uncertain for 2024 and why the market has little upside (we recommend selling calls on the S&P, more HERE). Since 81% of investors think a recession will happen, the base case for earnings appears to be $210 and $220. That implies downside risk for the market, but not a sharp selloff.
R* and Defensives – A Longer Term Thought: We’ve been talking about higher estimates of the neutral rate (r*) as the market prices in higher rates for longer. A higher estimate of r* (so a 4-5% fed funds rate is not crushing for economic growth but is required just to keep core PCE below 3%) is how higher for longer doesn’t lead to a risk-off reversal. A couple of reasons it’s a headwind to Defensives… earnings growth will still be solid if the economy can tolerate higher interest rates. Defensives have poor earnings growth expectations.
Higher interest rates make Defensive yields relatively less attractive. Dividend yields for Utilities, Staples, Health Care, and REITs are all below the 2yr and near their lowest relative levels. Defensives work when a higher 2yr yield implies a more aggressive Fed and higher recession risk. That does not appear to be the case right now. Given our forecast for higher, but not to high, inflation and higher R* over the next Cycle, Defensives are particularly unattractive longer term. Short term they need much weaker economic growth to work.
