Market Update and Portfolio Positioning From the Equity and Fixed Income Teams
The long and variable effects of tighter monetary policy might finally be starting to take hold.
Two weeks ago, worries about the U.S. consumer started to mount as micro data points from earnings season began to emerge. Visa Inc. talked about low-end consumer spending moderating this quarter and debit growth overtaking credit which tends to indicate a developing sense of stress for consumers. McDonald’s Corporation, Chipotle Mexican Grill, Inc. and Lamb Weston Holdings, Inc. pointed to slowing restaurant trends in July. Existing home sales missed expectations with a growing concern that the pace of recovery would elongate. Luxury companies LVMH, Kering AG and Hugo Boss AG noted weak trends in cutting their forecasts.
Further clues emerged this past week. Amazon.com, Inc. called out consumer spend pressures with lower average selling prices and signs of trade down on discretionary, high-ticket items. Comcast Corporation noted weakness at its Universal Parks division with attendance missing bogeys. Host Hotels & Resorts, Inc.and Marriott International, Inc. were among the leisure companies cutting estimates on lower rates per night. The list goes on…
On July 24th, Bill Dudley, former President of the Federal Reserve Bank of New York penned a Bloomberg opinion piece titled: “I Changed My Mind. The Fed Needs to Cut Rates Now”. Long in the higher-for-longer camp, Dudley pled for change arguing for a cut at the recent July Federal Open Market Committee (“FOMC”) meeting. His premise was that the middle and lower classes had depleted savings from pandemic-era government fiscal transfers and the impact of higher rates was starting to sting on credit cards and auto loans. He argued forward-looking growth would slow, thereby impacting the labour market.
This past week, the FOMC met and, while opening up a window to a September cut, left rates unchanged for the time being. What ensued in the two days following left many wondering if the U.S. Federal Reserve (“Fed”) had in fact made a policy error by not acting sooner. On Thursday, the ISM Manufacturing Index missed expectations for a tick up to 48.8, instead falling to a weak 46.8. The details were just as ugly with production, new orders and employment all coming in sluggish. This followed a jump in unemployment claims released earlier in the day. On Friday last week, the July employment report saw a spike in the unemployment rate to 4.3%. Clearly the data turned far weaker and far faster than the Fed had anticipated. With inflation seemingly on a path to containment, the labour market now becomes of utmost focus for the Fed.
If all this weren’t enough, markets have had to deal with the unwinding of a massive Japanese “carry trade.” In essence, with Japanese yields at zero, investors were able to borrow yen freely and use the proceeds to buy their favourite U.S. Artificial Intelligence (AI) stocks. With inflation now starting to bite in Japan, the BOJ (Bank of Japan) recently moved interest rates higher in the first real tightening since 2006. The fallout from these actions was a historic move higher in the yen vs the U.S. dollar to the tune of 12% since mid-July. Ultimately, if you borrowed yen to buy dollars to purchase your favourite AI stock, then suddenly you are experiencing a tremendous amount of pain on both legs of the trade. This causes widespread de-grossing as people are forced to unwind the trade.
Summarizing the combination of drivers and their impact on rates and credit:
lackluster jobs report drives a renewed focus on a “hard landing” and impression of a Fed policy mistake;
BoJ hike and ending of QE (quantitative easing) points to a wave of Japanese selling globally and causing a massive Yen carry-trade unwind;
unrest in the Middle East;
stretched positioning in mega-cap tech stocks and general complacency in market.
U.S. rates reacted sharply with 2yr -40 bps and 10yr down -30 bps and now the rate market is pricing in a 50 bps cut for September (or perhaps even an intra-meeting cut?). Credit spreads saw a sharp widening with IG (Investment Grade) spreads +25 bps and HY (High Yield) spreads +100 bps from recent levels. That said, the sharp rate move has cushioned the move in corporate bonds as the actual bond price (and yield) moves have been relatively muted.
From here, the bond market is now suggesting 4.5 rate cuts into year end. The hope is that this preserves a soft landing. Once again, recession has re-entered the debate. Many cite the re-inversion of the yield curve. They note the tendency for recessions to begin as the reinversion is complete. The current spread between the 10- and 2-year yield is -7bps after sitting at -50bps in June.
On the equity side, stocks have undergone a clear rotation since mid-July that has caught many off guard. De-grossing has commenced but could still have room to go. Our belief is that long de-gross is most likely to be in focus in the weeks to come (i.e. selling of winners). Within that, technology, which has generally been a bastion of safety when recession/hard landing fears have surfaced, may not act the same this time around. The AI theme has been strong for some time but seems to be running into resistance as mega cap tech companies face questions about return on investment on their AI spend.
Within our equity portfolios we have:
added to lower-quality shorts that have rallied significantly amidst the July rotation;
added to regional bank shorts that rallied on a soft-landing narrative and now might have to answer questions about credit quality amidst a weakening labour market, and finally;
nibbled on rate sensitives that stand to benefit from a faster-than-anticipated Fed cutting cycle.
Within our income portfolios we have been:
net selling generic credit for the last few months on valuation;
adjusted rate positioning to anticipate lower treasury yields on slowing economic data;
layered in additional credit hedges due to expensiveness and complacency.
Through the recent volatility, we have taken profits and rolled overlay macro hedges while gingerly tucking-in watchlist names. Looking forward, we remain constructive on credit fundamentals, and are positioned to navigate the follow-through and take advantage of dislocations as they develop.
Some of our updated thoughts on economic risks and bullish positioning (now being unwound) are captured in our most recent Picton Live event with David Picton. We highly recommend reaching out to your sales representative to hear a replay.
This material has been published by Picton Mahoney Asset Management (“PMAM”) on August 6, 2024
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