DAILY STRATEGY: Labor data on Friday did not change the median term growth outlook – economic growth is slowing toward ~2% real, the speed limit imposed by the Fed to keep core inflation in check. As Gerard put it HERE, “The labor market looks a bit easier now than it did several months ago and that the labor market is nevertheless strong enough to confirm that the central case for the expansion is that it is sustainable and that demand side worries are not most prominent here.”
At the margin, the data lowered the odds that growth will slow the hard way – a significant tightening of financial conditions – because there is little inflationary pressure from the labor market. In isolation, that is better for Price Momentum and risk factors, which are the most sensitive to financial conditions (HERE). That’s the good news. The bad news is inflation is still too high and not just because of the effects from tariffs and the Iran war. Core services inflation is running ~70bps too high (HERE). Fed Chair Warsh emphasized price stability, increasing the risk that financial conditions eventually tighten, keeping the vol in Price Mo and risk factors elevated. Going forward, CPCE needs to track ~21bps a month to hit the Fed’s forecast (CPI is next week).
Th above means the median term equity market outlook hasn’t changed either. Fundamental factors (Growth, Earnings Momentum, Value, GARP) perform best in a benign economic slowdown. The risk that financial conditions will tighten increases the volatility (and lowers the risk-adjusted return) of risk factors and Price Momentum, at least until there is more clarity around inflation and how growth slows (details on scenarios HERE). Idiosyncratic risk (AI) remains a major influence on returns.
MOMENTUM DRAWDOWN: We have been focusing on hedging Price Momentum over short-term horizons, given the vol in Price Mo because of the risk financial conditions need to tighten. Price Momentum’s drawdown, at -19% (S&P 1500, unconstrained), is a 93rd percentile drawdown. The forward returns of Momentum after similar drawdowns are still lower than normal, even after removing recessions from the sample. Hedging is still a point of emphasis.
Jeff Jacobson, 22V Derivatives specialist, released 4 new ways to hedge against further Momentum weakness last night. See HERE for details.
Charts…
The employment data was noisy. The prime age participation rate fell -60bps MoM, one of the worst readings outside of a recession, which is unlikely to be reality given recent Payrolls readings and activity data.
The current Price Momentum drawdown is -18.6%, a 93rd percentile drawdown.
Roughly 55% of the samples with drawdowns at or below current level fall into Recession periods, which is not the macro backdrop today. Separating recession and non-recession regimes, the forward 1mo, 3mos and 6mos Price Mo median return has been negative, and weaker than the all periods median.
