Financial conditions are at increasingly at risk of tightening as growth remains resilient, the labor market healthy, and inflation above target. Recent hawkish policy comments by Warsh have increased market implied odds of a September Fed hike, suggesting a tightening cycle could start as soon as this month.
Our Fed FCI-G simulation shows financial conditions have tightened since mid-August, primarily driven by the -1.7% decline in the S&P 500 from its peak. Further tightening through higher short rates presents a downside risk for equities.
From a factor perspective, Low Volatility, Quality of Earnings, and Value have historically benefited from tighter financial conditions, while Earnings Turbulence, Liquidity, Momentum, and Growth underperform. Price Momentum specifically has become negatively sensitive to financial conditions, partly reflecting its greater AI exposure.
At the industry level, Energy, Commercial Services, and Insurance currently have the strongest positive sensitivity to FCI, while Semiconductors, Tech Hardware, and Autos are the most negatively sensitive industry groups.
Stock-level dispersion of financial-condition sensitivity is also near historic highs, making security selection increasingly important. A long-short portfolio of buying stocks with the highest FCI sensitivity and shorting those with the lowest has returned 16.8% YTD. A L-S portfolio where the Longs are stocks with top decile average exposure to the two most positively FCI correlated factors and the Shorts have top decile exposure to the two most negatively correlated factors have been tracked moves in financial conditions.
Therefore positioning toward stocks and factors that benefit from tighter financial conditions while avoiding negatively sensitive names. We list the long and short side baskets based on stock and factor betas with financial condition at the end of the report.
Trading Under Tightening Financial Conditions Risk: The risk of tighter financial conditions near term has increased over the past few weeks. Growth remains strong, labor market demand remains healthy, inflation is above the Fed’s target, and oil prices have backed up. Warsh’s latest comments on financial conditions have been hawkish, pushing market implied odds of a Fed rate hike in September higher. The direction of travel for financial conditions is increasingly tilting toward tightening.
Financial conditions, measured by our Fed FCI-G simulation, have increased (tightened) since mid-August. The leading driver has been the S&P’s -1.7% decline from its peak. Tightening financial conditions is a risk for equities, and that is why we favor the VIX hedges suggested by Jeff Jacobson, 22V’s derivative analyst (details HERE and HERE).
Internally, financial conditions have been most positively correlated with risk-off factors such as Low Volatility and Quality of Earnings, along with Value factors, which are likely to benefit from tightening. Risk-on factors including Earnings Turbulence and Liquidity, along with Momentum and Growth factors are likely to face downward pressure. Momentum factors are more AI driven and their sensitivity with financial conditions has shifted more negative, especially Price Mo. The factor sensitivity with financial conditions has been roughly in line with factor performance during Risk Averse periods. A tightening cycle threatens to extend the Risk Averse market internal regime (HERE).
The Industry Groups most sensitive to financial conditions currently are Energy, Commercial Services and Insurance, while Semis, Tech Hardware and Autos are most negatively correlated with financial conditions. Industry group relative performances since mid-Aug has been positively correlated with their sensitivities to financial conditions as well.
Currently, stock sensitivity with financial conditions has diverged than usual, suggesting the impact of tighter financial conditions at the stock level will be more varied than normal. Therefore, picking stocks more positively sensitive to financial conditions and avoiding those negatively correlated becomes more important.
A L-S portfolio of S&P names where the longs have the highest betas to financial conditions and the shorts the lowest beta has been positive correlation with financial conditions y/y. YTD the portfolio has generated a 16.8% return.
The S&P stocks with the highest beta to financial conditions measured by our Fed FCI-G simulation are listed below. These are names likely to benefit if financials conditions tighten.
The names with the lowest beta to financial conditions are below.
In addition to directly trading stocks based on their return beta with financial conditions, a portfolio based on top vs. bottom correlated factors, with is long names that have top decile average exposure to top two positively FCI-G correlated factors and short names with top decile exposure to top two negatively correlated factors also perform positively. This is another group that should benefit from a tightening financial conditions backdrop.
The long basket based on current factor exposure is below.
The short basket names are listed below as well.
