Macro Views

The Changing Landscape

For much of this year, our systematic macro process has kept us on the right side of the economic cycle, i.e., the economy was still expanding, although at a slowing pace. We called this dynamic “Slowing But Growing.” However, the same process has brought to light conditions that show that the slowing has intensified, which will likely have implications for markets.

Before we dive into the data driving these programmatic views, we think it’s important to contextualize that these changes are incremental, marginal changes that, at this junction, are mostly relevant to active, alpha-seeking investors. We currently do not see these changes as meaningful enough to warrant a dramatic change to asset allocation portfolios, which we characterize as long-only portfolios, turning over once a month or less. With that clarified, let’s dive into our views.

Over the last year, the economy is one that has remained in expansion, with slowing inflation and ample liquidity. We show each of these variables, starting with growth.

GDP growth has largely remained positive and broad-based.

Meanwhile, inflation has moderated relative to real GDP growth, i.e., nominal growth has slowed.

And liquidity conditions have remained ample.

The combination of these dynamics has been extremely supportive of equities, which benefit from high revenues, lower costs, and ample financial powder to allocate to equities, resulting in one of the highest equity allocations for the private sector on record:

These dynamics have led to one of the strongest equity rallies on record, both on an absolute and relative basis.

These growth, inflation, and liquidity conditions largely persist. However, we think the opportunity set has begun to shift. In our previous research, we have outlined why we think commodities are more likely to face headwinds, which is inconsistent with current market trends. The details are beyond this post, but you can read the whole note here.

Today, we are beginning to see increasing divergences within the drivers of equity markets. Particularly, we are beginning to see equity earnings expectations as rich to the likely forward earnings path. We see this divergence emerging large due to increased household savings, decreased net business investment, and a widening slowdown of cyclically sensitive sectors.

We begin with households’ impact on corporate profits. In the post-COVID world, households have been a dominant driver of corporate profitability, as they spend monetary stimulus into the economy, which gets recycled to them as wages. Until this year, household spending far outpaced employment and asset incomes received, creating a supportive backdrop for corporate profitability. We visualize how this has shifted in recent months:

It’s still early days for this move, which may well reverse, but it is a significant change nonetheless. In addition to this changing household impulse, we see muted business reinvestment. Perhaps unintuitively, businesses are a source of their own profitability in the macro economy, with business investment net of capital consumption driving most profit cycles. This is due to the circular nature of macroeconomic accounts and the fact that business investment simply flows back to companies unless households, the foreign sector, or the government are the beneficiaries. Today, business reinvestment has moderated upwards:

However, this business reinvestment is driven in significant part by inventory build-up:

This inventory build is highly likely to reverse, given the weakness in industrial activity, which we visualize below:

This weakness in industrial activity has been one of the long-standing weaknesses in the economy and cannot cause a big downturn. However, we have begun to see more signs of slowing activity for cyclical-sensitive (i.e., leverage-intensive) businesses. The two biggest changes we have seen in the recent past are the slowing of residential investment and transportation spending. We show how residential spending has begun to slow:

We see similar weaknesses emerging in transportation activity.

These cyclical sectors are the key determinants of profits over time. We visualize this below:

Adding these forces, we see bottom-line pressures emerging via resilient wages and higher household savings rates. Additionally, we see a slowing of leverage-sensitive sectors in the economy. Together, these forces create a much less suitable backdrop for corporate profits than we have recently experienced.

Does this mean we are entering a recession, and would it be prudent to exit all equity exposure? No. Corporate profits must decline significantly enough to illicit a major layoff cycle to create a recession. We think we are currently well-removed from that point. The biggest drawdowns in equity markets occur during recessions as the self-reinforcing downward loop of economic activity causes forced selling and repricing of risks. These moves tend to have long trends, given the self-reinforcing nature of the downturn. As such, adjusting portfolio exposure in anticipation of a recession is well warranted and benefits asset allocation portfolios immensely. However, the profit pressure we have described here today is not recessionary. It is simply a recognition that the expected returns on equities are now lower. In our view, what makes them lower is a potential sell-off as markets eventually move to reprice earnings expectations to be more consistent. Unlike a recessionary bear market, these moves can be fleeting and can conclude their repricing within a month or two.

Thus, we think the utility of this note is to provide the reader with an understanding that the extremely elevated reward/risk we have seen for equities is likely behind us. Expected returns are likely lower than we have recently experienced. We are at the prequel to pre-recessionary pressures for asset allocation portfolios, and making big allocation swings based on this information is unlikely to prove fruitful. For professional investors, alpha opportunities are growing.

Until next time.