Stocks & Bonds - Only One Will Be Right

1580 words – a 5 minute read.

As we discussed last week, its different this time. Given that, it’s no surprise that markets and investors are confused about what is happening and more importantly what’s next.

We see this clearly in the price action of both stocks and bonds, especially here in the US. Bond investors seem all in on recession, expecting the Fed to raise 25 bp next week and again in March and then pausing before cutting some 200 bp by YE. The Fed will only cut like that if there is indeed a recession and most likely a deep one.

Stocks on the other hand have jumped out to a strong start to the year, bringing into sight the January Trifecta: a Santa Clause rally, positive returns over the first 5 trading days of the year & being up for the month itself. The first two are in the bag and given SPY’s 5% MTD performance it would seem likely that the trifecta will soon be in hand. History then suggests not only an up year but a strong up year ahead according to the Carson Group.

We continue to expect that as 2022’s headwinds turn into 2023’s tailwinds – inflation, rate hikes, EU energy, China Covid etc., volatility will fade and historical analogues will return as useful indicators for investors. That low volatility is already visible in both stocks and bonds with the VIX under 20 while the MOVE index closes in on 100 after peaking last Fall around 160.

FinTwit is full of folks noting the risk of buying stocks with the VIX under 20 – from this armchair the risk would seem to lie in buying long bonds hand over fist with the MOVE around 100. Its worth noting, as Bloomberg did this morning, that the big buyers of recent UST auctions at the long end have been foreign investors. These investors look at the Fed vs the ECB and even the BOJ and see those rate cuts priced in to FFR and decide USTs are the bond place to be.

Granted the ECB is likely to raise rates more than the Fed this year – one of the reasons why we continue to expect USD weakness. We also see the BOJ moving off its YCC strategy by widening it out to roughly 100 bps from the current 50 so yes we get that DM sovereign is probably not that exciting – one of the reasons why we remain massively UW FI in our Global Multi Asset (GMA) model portfolio.

Yet just because one isn’t keen on German bunds or Japanese JGBs doesn’t mean the 10 yr. UST is a good buy at 3.5% either. As the title suggests only one of the two main assets is likely to be right – last year of course both were down and the 60-40 portfolio has one of its worst years ever. This has led many recessionistas to suggest the bond allocation should be 60% and the stock allocation 40% for 2023 – we do not think this recommendation will age very well.

We think stocks have the right read, that the US will not go into recession and thus the Fed will not be cutting rates in the 2H of the year. As such long bonds will not be great places to be as rate cuts will have to be priced out of the market. US stocks are also unlikely to continue this torrid pace of gains – we continue to expect a flattish year for the S&P as there is little room for valuation expansion and earnings are likely to be just ok – again no recession, but not overly strong either as inflation’s decline puts paid to the pricing power of the past two years.

One of the main reasons why we don’t expect a US recession is the current state of the housing market. Its 2H weakness led to a significant hit to Q4 US GDP (Axios reports a 1.3% ding) and make no mistake the pullback in activity has been aggressive given the sharp spike in mortgage rates. Yet this pullback is already ebbing as mortgage rates rally sharply while multiple data points such as NAHB builder sentiment & foot traffic indicators suggest housing is finding a bottom. Freddie Mac reports loan applications have started to tick up as rates are back to September levels while Redfin reports December pending home sales are up 2.9% (seasonally adjusted) for the 1st M/M gain since October 2021. The recent price action in XHB (a recent addition to the GMA) would support that assessment.

Housing in a bottoming process would suggest that recession risk is fading not gathering. We will watch next week’s jobs data (Bloomberg consensus at 180k) but with housing bottoming, services remaining robust and manufacturing starting to stabilize as the cap ex boom we have highlighted unfolds we continue to struggle to see the catalysts for the recession call. What happens when the manufacturing PMI pops back above 50 as Bloomberg’s Conor Sen (one of its best ) thinks could happen in the next few months – it’s not gonna be bond friendly.

Inflation’s sharp unwind has finally gotten folks to focus on the trend of recent inflation data being well in line with the Fed’s objectives & with very little to suggest a reversal of that trend, its hard to see the Fed tightening until something breaks (we expect a 25 bp rate hike next week & then a long pause). NDR’s Inflation Timing Model is on a sell reading, one of its lowest in a decade, suggesting “low inflationary pressures” ahead. LPL notes that with the 2 yr. UST yield now below the upper bound of the Fed’s target range, history would suggest the end of the rate hike cycle is approaching.

No deep imbalances, no inflation spikes or Fed on a rampage = no recession = no Fed rate cuts = not very attractive long bond market. Consumers, corporates and banks all remain in very good shape as the credit markets, which have begun the year in fine fettle, are telling us.

Yet, the Bloomberg consensus continues to call for recession this year (65% agree) expecting flat growth in Q1 and negative growth forecasts for Qs 2 and 3. Goldman’s forward looking US Economic Activity Indicator would seem to disagree – it is now “firmly in expansion territory”.

We see the risk being in the overbought nature of the US recession call; as that overbought condition gets worked off, we expect rising rates to put a damper on the US equity space given the still large weight of the big cap tech names. This in turn suggests the continued appeal of the non US equity markets which are leading the way in terms of both growth (China) & Central Bank pause (Malaysia, Chile, Canada) not to mention valuation & under ownership.

 Europe’s continued economic resilience has been on display with January Composite PMI breaking above the 50 boom bust line, up three months in a row for its best reading since last June. Germany has joined most major IBs in trashing its 2023 economic outlook calling for negative GDP growth mere months after releasing it – it now sees a slight positive GDP outlook and no recession – talk about Narrative Speed.

We are all in on the China reopen story and note that mortgage rates sit at record lows under 4.5% leading to a pickup in residential property transactions while CNBC reports that Lunar New Year domestic travel is far exceeding 2019 levels. We expect Japan to be a big winner of Chinese overseas tourism. JPM notes that back in 2019 China accounted for roughly 30% of Japanese inbound tourists – given that the RMB is up roughly 20% vs the yen since then tourism should help drive Japanese growth. Note Japan’s Composite PMI also just broke above 50.

We agree with JPM who notes the prospects for a rerating of Japanese equity should YCC fade & inflation remain around the 2% level. It notes that in past periods when JPBs yielded between roughly .5% -  .7%, Japanese equity traded at roughly 14x 12M forward estimates vs the current 11.7. When rates break above 1% (exit deflation) that forward PE expands to 20x! We are double weight Japanese equity in our GMA model.

Sure, BofA’s FMS suggests large inflows into EM and even European equity for the first time in ages but that’s the point – we are just at the very beginning of the move out of US financial assets and into the ROW. Does that mean one should be buying with eyes closed?

Of course not – it helps to be forward looking so as to already have solid positions built up in these spaces (as our GMA does with close to 20% in EM debt & equity). Otherwise, now is the time to build that buy list so when things calm down and they will – they always do – one is ready to step in and buy from the traders who hopped on and made their 5-10%. Currently, many leading equity segments (ACWX, EEM, China, Japan, EU banks, metals/miners) are overbought.

Remember, patience is an investing virtue! At TPW Advisory, we & our clients are in it for the long game – a multi year run of non US equity OP led by a combo of DM (Japan, Europe) and EM (China, Brazil, Mexico, SE Asia).