DAILY STRATEGY: Our framework for thinking about macro backdrop remains the same. The Speed limit on economic growth is a constraining factor. The speed limit for the US economy is roughly 2% real (See video HERE). As Gerard put it, when growth is running above the 2% speed limit, “the economy is at full employment and inflation is running above target and the fiscal authority is dumping a ton of demand and “safe” assets into the economy, then the capital markets are going to figure out a way to deliver some restraint.” That is what is happening now.
Important background – Strong Real Economic Growth is Still the Primary Driver of 10yr Yields. Not an Expected Inflation Shock. That is MUCH LESS BAD for equities. 10yr yields registered a 98th%tile dod move yesterday, but the VIX is still at 16, well below the 20 level registered in late July, when the 10yr was ~4.65%. HY CDS spreads are LOWER than they were in late July. Inflation expectations have declined. 10yr yields are providing the needed restraint to guide economic growth and inflation lower. The economic restraint that the capital markets/Fed is providing will slow growth. Our call is that the growth slowdown will be gradual (toward 2% real), inflation risk will be lower and that is eventually positive for equities.
The risk to our call is 10yr getting to a level (5.2%? 5.5%?) that leads to much higher recession probabilities (VIX higher, HY CDS spread blow out). We are not there yet.
Strong Data Yesterday and Especially Relative to Expectations – The S&P US PMI beats on both services (58.7 vs 55.8 expected) and manufacturing (57.0 vs 53.7 expected) were 90th percentile+ and strong PMIs were a global phenomenon (Eurozone aggregate services 53 vs 51.4 expected, manufacturing 52.7 vs 52.6 expected). One of the reasons the reaction in UST yields was so dramatic was expectations of downside risk to the S&P PMI given some recent weakening in the regional PMIs. We got a 90th percentile beat instead.
In a cycle that is above the economic speed limit, stay long the primary source of strength. In this case AI, both the buildout beneficiaries and the companies effectively implementing the tools (lot more on the fundamental strength HERE and HERE).
Momentum Drawdowns & Returns – The current Momentum drawdown (-23%) is in the 9th decile. Similar drawdowns had worse forward returns, but those were in the GFC and COVID, a bad sample. Based on (admittedly smaller) non-recessionary drawdowns, there is no evidence of a higher probability of negative forward returns. In other words, the historical data does not suggest returns are stacked against Momentum here.
The returns also do suggest volatility is likely to remain elevated, which will be important to risk manage around. We will have more on that as earnings season approaches.
Breadth of Returns – Doesn’t Tell You Much: The percent of stocks making new highs relative to new lows is unusually low (18th percentile), but the forward return profile is roughly the same. The ratio of advancers relative to decliners isn’t at an unusual level, and the forward returns from unusual signals are the same as all periods anyway too. We are not bullish. Just noting that using market breadth as an indicator has not yielded much historically.
Charts…
Fed rate hike expectations continue to move higher as GDP growth remains firm.
High yield CDS spreads remain tight though. The market is not pricing in a high probability of a recession.
The VIX at 16 is what you would expect in a normal economic expansion. If the normal economic expansion was at risk, the VIX would be significantly higher. 10yr yields could get to a point that leads to a much higher VIX. It just hasn’t happened yet.
The current Momentum drawdown is a 94th percentile drawdown, exceeded only by the GFC and COVID.
Cutting up the forward return profile of Momentum given different decile bucketed drawdowns shows 1) better forward returns starting in the 4th – 6th decile buckets, with 2) forward vol increasing exponentially as drawdowns deepen. The forward return profile deteriorates for even deeper drawdowns, but the sample becomes recessions, which is not a good comp to now. We take the practical implications to imply forward returns aren’t stacked against Momentum here. We can be comfortable leaning into a macro thesis to be long Momentum.
New highs – new lows are at an unusually low level (18th percentile), but the forward return profile of equities from similar levels skews slightly better than normal. Nothing to be concerned about here.
The breath spread measured as (advancer – decliner)/(advancer + decliner) isn’t at an extreme level, and similarly wouldn’t signal much anyway.
The S&P PMI beats were 90th percentile+ beats, contributing to 90th percentile+ increases in Treasury yields.
