SUMMARY: For US risk assets, one question is if what is going on in the rest of the world – economic growth concerns in Europe and China – drag the US down with it (we will have more on this later, but we don’t think this will be the case). As covered in the quant report today (HERE) our Macro Regime model suggests the US economy remains in “Transition” (i.e. data is not giving a clear recession or normal economic signal), but the probability of moving into a “Normal” economic backdrop increased over the past month. That is in line with other macro growth indicators such as NY Fed Weekly Economic Index and the stabilization in PMIs.
Value and Momentum factors have outperformed during Normal periods historically, while returns to Low Volatility diverged the most between Transition and Normal. That makes sense, uncertain “transition” periods should favor de-risking and the Low Volatility factor. Since mid-May, risk-on factors have outperformed and Low Vol has been one of the worst performers, consistent with higher odds of moving into a more normal backdrop.
The above being noted, there is still an extrapolation problem, which has plagued markets for OVER A YEAR. First, there is still a historical divergence between how much the S&P is driven by “macro” (as seen in the first principal component) and the low level of the VIX. When macro influence is very high, typically the VIX is also higher. And vice versa. Our read of this divergence is as follows. The stability of macro forces over the past few months has allowed equity vol to decline, but market trends remain tied to those macro forces. Market vol (and internals) will remain tied to unpredictable shifts in macro data and transition periods tend to see unpredictable shifts in the data. Hence, we need to be careful with extrapolation of current trends. FYI: A continued decline in macro influence on the S&P (Blue line) would make us feel better about extrapolation.
Since we are still technically in a “transition” phase with high macro influence over the S&P, we don’t want to get too carried away with pricing in a normal economic backdrop. Our Tactical call of being long destocking losers, Earning Turbulence relative to Low Volatility, and a bias toward Deep Cyclicals, remain, but we are conscious of how quickly the economic ground can shift.
Full report below…
MARKET VIEWS: Global economic headwinds, as US growth prospects stabilize, has been the conversation the past few weeks. Data overnight reinforced that focus. The China Caixin Services PMI was much weaker than expected and the final European service PMI reading was weaker than expected (both still in expansion, but weaker). For US risk assets, the question is if the rest of the world drags the US down with it (we will have more on this later). Quantitively, our Macro Regime model suggests the US economy remains in “Transition” (data is not giving a clear recession or normal economic signal), but the probability of moving into a “Normal” backdrop increased during the last month. That is in line with other macro growth indicators such as NY Fed Weekly Economic Index and the stabilization in PMI readings.
Value and Momentum factors have outperformed during Normal periods historically, while the performance of Low Volatility diverged the most between Transition and Normal. That makes sense, uncertain “transition” periods should favor the Low Volatility Factor. Since mid-May, risk-on factors have outperformed and Low Vol has been one of the worst performing factors, which has been in line with the slight increase in odds of the economy moving towards a more normal backdrop.
Extrapolation Problem: There has been a divergence between macro influence and market vol and it has reached extreme levels. This can be seen by looking at the divergence between how much the S&P is driven by “macro” (as seen in the first principal component) and the low level of the VIX. When macro influence is very high, typically the VIX would be higher. And vice versa. Our read of this divergence is as follows. The stability of macro forces over the past few months has allowed equity vol to decline, but market trends remain tied to those macro forces. Market vol (and internals) will remain tied to unpredictable shifts in macro data and transition periods tend to have unpredictable shifts in the data. Hence, we need to be careful with extrapolation of current trends.
Since we are still technically in a “transition” phase with high macro influence over the S&P, we don’t want to get to carried away in pricing in a normal economic backdrop. Our Tactical call of being long destocking losers. Earning Turbulence relative to Low Volatility and a bias toward Deep Cyclicals, remains, but we are conscious of how quickly the economic ground can shift. Stocks that benefit from lower correlations have had a great run recently and we would expect that to continue in 2H23. Unless the economic backdrop deteriorates much quicker than we are expecting.
