Financial conditions have been volatile in 2024, but the trend has been toward MUCH easier FCI (90th %tile easing YTD). Core CPI released this morning was in line with expectations and odds of a rate cut at the December FOMC meeting have settled around 95%. FCI are likely to be stable to lower into year-end, leaving the positive impetus to 2025 GDP in place.
YTD factor internals have diverged from what we expect to see during periods of FCI easing. Very broadly, when financial conditions are easing, risk-on factors tend to benefit. Tightening FCI is a support for Low Vol, Realized Growth, and other Quality/Defensive factors. The betas between factors and the Fed FCI-G index, which measures how broad financial conditions are expected to impact growth over the next year, backs up that intuition. Growth and Momentum (fundamental and price) and Low Vol have significantly outperformed the easing of FCI.
Outperformance of those more defensive qualities could be explained in part by the series of economic and inflation concerns that plagued the market during the year. With economic growth persistently firm and inflation low enough for the Fed to leave FCI at a stimulative level, the bid to defensive factors looks increasingly unsustainable.
When thinking about catchup trades, Value and Risk-on factors have lagged FCI easing. Even in the absence of the FCI support, market internals tend to converge to the macro backdrop. There are some signs of that trend starting to take hold with Momentum faltering and Low Vol stocks being one of the worst performers. Realized Growth and Quality look most at risk over the coming months if the catchup to easier FCI takes place.
At the sector level, YTD returns suggest the most downside risk is to Utilities and Financials while Cyclicals especially Materials, Energy, Technology and Discretionary have room to rally.
FCI Update Post the CPI Print: The CPI reading today is inline, cementing expectations for a Fed rate cut at the Dec meeting. Financial conditions, which have been volatile but have trended lower this year, should be biased flat to lower into the start of 2025. PPI tomorrow could complicate the inflation picture some, but there is little reason to expect any meaningful tightening of FCI near-term.
Defensive factors tend to high the highest beta to FCI tightening (FCI tighter == Defensive outperformance). Quality, Realized Growth, Low Volatility all tend to gain wen FCI tighten. Risk-on/Earnings Turbulence, and fundamental Momentum have a more negative beta exposure to FCI (FCI easier == Risk-on outperformance).
Comparing factor returns YTD relative to the move in FCI show consistent surprising outperformance by Defensive factors. Value and Risk-on factors have persistently lagged the easing of FCI. Interestingly, Low Volatility also lagged within mega cap groups, reflecting less risk averse tendency in mega cap index. Broadening out of that risk appetite to smaller stocks is starting to take place, with Low Vol underperforming recently. A larger rotation into historical low FCI beneficiaries would mean Defensive factors giving up their leadership to more risk-on factors.
As we expect the market internal regime to converge to its typical pattern during Normal economic expansions next year (HERE), Realize Growth, Quality of Earnings, and Size are likely to underperform the market. While Earnings Growth and Growth Momentum which are less gained YTD and tend to benefit from easing financial conditions has room for more return, especially outside the mega cap group.
For sectors, Defensives such as Utilities, REITs and Staples tend to benefit from tightening financial conditions while Early Cyclicals especially Communications and Technology fare better when the FCI backdrop is easing.
The YTD sector return relative to financial condition moves this year shows higher than expected returns from Utilities and Financials across all market caps. Cyclicals especially Materials, Energy, Technology and Discretionary have lagged the FCI easing.
