Author: Amanda Ahne

Asset Allocation Bi-Weekly – Small Caps and the Hope for a Soft Landing (June 24, 2024)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

They don’t call him Maestro for nothing. In the mid-1990s, Federal Reserve Chair Alan Greenspan achieved what was once thought of as impossible: an economic soft landing. As the US labor market showed signs of tightening, he raised interest rates from 3% to 6% in 1994 to preemptively combat inflation. In 1995, he lowered rates strategically to avoid a recession. The seamless transition from a tightening cycle to an easing cycle led some to believe the Fed could pull the strings in the economy in a way that could both prevent a recession and tame runaway inflation.

The market took notice. Greenspan’s policies helped quell investor anxieties about a repeat of the inflationary surges that plagued the 1970s and early 1980s. Emboldened by this newfound confidence, investors poured money into smaller, unproven companies with strong earnings growth potential. This sentiment was epitomized in 1995, when tech guru Marc Andreessen and his partner Jim Clark did the unthinkable by taking their company, Netscape, public before it had turned a profit, paving the way for what is now viewed as the dot-com bubble.

Today’s elevated interest rate environment has sparked nostalgia for another soft landing. Eager for a repeat of Greenspan’s success, investors were waiting for a decline in rates to re-enter the market. However, their hopes were dashed in June 2023. Not only did Fed policymakers raise rates following the collapse of Silicon Valley Bank, but they also signaled their intention for two additional hikes that year. This spooked markets as investors were concerned that the central bank may keep rates high for long enough to tank the economy.

This commitment to raising interest rates discouraged investors from holding riskier assets, particularly those with floating rate exposure. Further pressuring the market were concerns about the rising national debt, which prompted Fitch to downgrade the US credit rating. Investors responded by offloading riskier assets within their portfolios. As a result, the 10-year Treasury yield soared to approximately 5%, a level not seen in over two decades, while the S&P SmallCap 600 Index plummeted to a nine-month low.

The tide began to turn in late October of last year. The US Treasury’s reallocation of bond issuance toward shorter maturities, coupled with Fed officials signaling an indefinite pause in rate hikes, significantly impacted market sentiment. Investors piled into longer-term bonds and risk assets in anticipation of the Fed’s next move, positioning themselves for an imminent rate cut, which they thought could take place in the first quarter of 2024. From October to December, the S&P SmallCap 600 Index outperformed the S&P 500, with a return of 21.5% compared to 13.7%, respectively.

Unfortunately, the early strength of small caps faded quickly as the S&P 500 recaptured its leadership position at the beginning of 2024. This new weakness in small caps stemmed from concerns that the Fed wouldn’t cut interest rates as deeply as the market anticipated, following a series of strong Consumer Price Index reports in the first quarter and a persistently tight labor market. This situation led investors to reduce their holdings of longer-term Treasurys and refocus on large cap companies due to their relatively strong earnings potential and resilience to changes in financial conditions.

In fact, recognizing this trend early on prompted us to take action in the second quarter. We strategically reduced our exposure to small cap stocks within the conservative portfolios of our Asset Allocation program. This decision also reflected our growing concern that small cap stocks may face longer-term challenges due to certain structural market factors, including the rising popularity of passive funds that funnel money into large cap stocks and the increasing ability of private equity firms to acquire the most promising small cap startups. Hence, an emphasis on quality while screening for indicators such as profitability, leverage, and cash flow should mitigate some of these factors.

Currently, the S&P SmallCap 600 Index has been in a holding pattern as investors await signals regarding the Fed’s next policy move. Should Chair Powell manage to orchestrate another soft landing in the coming months, it could attract investors back to small cap stocks. With the current multiples for the S&P 500 outpacing those of the S&P SmallCap 600 by the widest margin since the dot-com era, small cap stocks present appealing valuations compared to their larger counterparts. With that in mind, we think small cap stock values could rebound in the coming months if US economic growth remains healthy and both inflation and interest rates fall.

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Bi-Weekly Geopolitical Report – Mid-Year Geopolitical Outlook: Uncertainty Reigns (June 17, 2024)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, Thomas Wash, Daniel Ortwerth, CFA, and Bill O-Grady | PDF

As the first half draws to a close, we typically update our geopolitical outlook for the remainder of the year. This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international landscape for the rest of the year. The report is not designed to be exhaustive. Rather, it focuses on the “big picture” conditions that we think will affect policy and markets going forward. We have subtitled this report “Uncertainty Reigns” to reflect the fact that chaos and unpredictability have become entrenched as the post-Cold War era of globalization gives way to a new period of Great Power competition. Our issues are listed in order of importance.

Issue #1: China – South China Sea

Issue #2: Russia-Ukraine-NATO

Issue #3: Israel-Hamas-Iran

Issue #4: The US Elections

Issue #5: US Defense Rebuilding

Issue #6: Global Monetary Policy

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Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify 

Asset Allocation Bi-Weekly – Copper, Gold, Treasurys, and the New World (June 10, 2024)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

Early 2023 served as a stark reminder that correlations can break down when least expected. Last year, a decline in the copper/gold ratio led many investors to anticipate a fall in longer-term yields, particularly for the 10-year Treasury note. However, these expectations were shattered as yields not only increased but surged to multi-decade highs by October. This episode underscores the challenge of relying too heavily on old assumptions. In this report, we’ll delve into the dynamics between the copper/gold ratio and 10-year yields and explore whether this historical connection has been permanently severed.

The copper-to-gold ratio is a closely watched indicator of investor risk sentiment. This ratio compares the price of copper, an industrial metal heavily used in construction and manufacturing, to the price of gold, a traditional safe-haven asset. A rising ratio generally signals investor optimism about economic growth. As economic activity picks up, demand for copper rises and pushes its price higher relative to gold. Conversely, a declining ratio suggests investor pessimism and a potential economic slowdown. This could be due to fears of recession or other economic troubles, leading investors to seek the perceived safety of gold.

As shown in the chart below, a rising copper-to-gold ratio has historically coincided with increasing long-term Treasury yields. This reflects investor expectations of accelerating economic growth, which can lead to inflation. To compensate for the potential erosion in bond values, investors demand higher yields on longer-term bonds. The relationship also works in the opposite direction. Investor fears of geopolitical risks or recession trigger a decline in both the copper/gold ratio and bond yields as investors seek safety in gold and US government bonds.

The once strong correlation between the copper/gold ratio and interest rates seems to be unraveling in the post-pandemic recovery. While the ratio initially surged with the global reopening, China’s economic slowdown has caused it to fall over the last couple of years. In contrast, the 10-year Treasury yield has climbed as stubbornly high inflation has prompted central banks to tighten monetary policy, leading to further interest rate increases. This disconnect between the traditional indicators suggests a potential shift in market dynamics.

Prior to the pandemic, investors largely operated under the assumption of a stable, low-inflation world. This fostered an environment where long-term investments were attractive, and there was minimal fear that duration risk would erode their value. Consequently, investors primarily focused on the long end of the yield curve only during periods of economic concern or during major events that might prompt the Fed to cut rates and stimulate growth. This preference for bonds during economic downturns mirrored that of gold — a safe-haven asset. As a result, both bond yields and the copper-to-gold ratio had previously moved counter-cyclically.

However, these market relationships started to change as government efforts to prevent a recession through the creation of massive deficits led to higher long-term interest rates. The issuance of new Treasurys pushed up interest rates as the market struggled to absorb the new bonds. A further contributing factor to this dynamic is the Federal Reserve’s hawkish monetary policy. The Fed’s tapering of its bond holdings has reduced a key source of demand. Additionally, recent interest rate hikes have discouraged investors from holding long-term bonds as short-term bonds offer more attractive yields.

The metals market has also seen a transformation. So far this year, China’s modest industrial rebound has lifted copper prices from their 2023 lows, while the collective central bank buying of gold, spearheaded by China, has sent bullion prices skyrocketing. This unusual gold surge has offset the rise in copper prices, which explains why the ratio has been relatively subdued this year. While this trend may seem fleeting, evidence suggests emerging economies are accumulating gold as a potential hedge against the US government’s frequent use of sanctions tied to the dollar. As a result, it is possible that the copper/gold ratio could continue to move in the opposite direction of 10-year Treasury yields.

The breakdown in the relationship between the copper/gold ratio and 10-year Treasury yields likely stems from a new global economic reality. Higher deficits and inflation expectations have driven up long-term yields, while China’s slowdown and central bank gold purchases have suppressed the copper/gold ratio. A return to the prior correlation could occur if investors become confident in a return of price stability and if the accumulation of gold by foreign central banks proves temporary. However, we are doubtful of a near-term return, given persistent labor shortages, inflation pressures, and rising geopolitical tensions, particularly between the US and China.

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Bi-Weekly Geopolitical Report – The Philippines, China & Escalation in the South China Sea (June 3, 2024)

Posted on by Amanda Ahne

by Daniel Ortwerth, CFA | PDF

On the short list of seemingly constant topics in the news today is the rising tension between the United States and the People’s Republic of China.  Across the spectrum of issues, disagreement between these two great powers seems increasingly unavoidable.  Geopolitical developments in every corner of the globe often find a way to become another point of US-Chinese friction.  When conditions become stormy like this, the question arises as to whether this tension will escalate into greater conflict, possibly even outright war.  If it does, what will be the flashpoint?  Where will the spark occur?

A storm is currently brewing in the South China Sea (SCS) that might make this body of water the area of greatest risk.  Like so many conflicts in history, this one does not involve a direct conflict between the opposing great powers, but rather a local dispute involving a small but significant country, the Philippines, and China.  This dispute holds the potential to stir up a storm that engulfs the region or that even spills into the world beyond it.

This report explains how the current Philippine-Chinese dispute developed and how it could further escalate.  After providing a recent history of key developments in the SCS, we explain in detail the dispute at hand.  Next, we show the strands that connect the tiny outcropping of land at the heart of the dispute to the broader world.  As usual, we conclude with a review of implications for investors.

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Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify 

Business Cycle Report (May 30, 2024)

Posted on by Amanda Ahne

by Thomas Wash | PDF

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

The Confluence Diffusion Index fell deeper into contraction, in a sign that the expansion is struggling to gain traction. The April report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index slipped from -0.1515 to -0.2121, below the recovery signal of -0.1000.

  • Financial conditions loosened as Fed officials kept rate cuts on the table for 2024.
  • Goods-producing activity tapered as households grow more pessimistic about the economy.
  • Employment gains slowed in a sign that the labor market is starting to cool.

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.

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