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

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.

View PDF

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

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

Read the full report

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

Asset Allocation Bi-Weekly – The Peace Dividend, Government Debt, and Yield Curve Control (April 29, 2024)

by the Asset Allocation Committee | PDF

Danish Prime Minister Mette Frederiksen recently castigated the European governments that slashed their defense spending at the end of the Cold War and then remained far too complacent about the growing threat from Russia in recent years. According to Frederiksen, hiking their defense budgets as is now necessary will require countries to reverse the tax cuts and welfare spending hikes they have been funding with their post-Cold War defense reductions. The United States may be in the same position since it also spent its post-Cold War “peace dividend” on civilian programs. This report looks at these fiscal dynamics and what future fiscal and monetary policy might really look like.

As our regular readers know, we at Confluence believe the intensifying rivalry between the US geopolitical bloc and the China/Russia bloc will lead to bigger future defense budgets in many countries. Western nations that cut their defense spending dramatically after the Cold War and spent the resulting peace dividend on civilian programs will soon be under great pressure to reverse course. We have also argued that growing geopolitical tensions will likely lead to stronger government intervention in Western economies. Frederiksen is one of the first Western leaders to state the trade-offs so clearly: Hiking defense budgets as required now may well require tax hikes and/or civilian spending cuts.

To scope out the prospects, we compared today’s US federal budget to the budgets of the late years of the Cold War. In the chart below, we show the Office of Management and Budget’s estimated fiscal year 2023 federal receipts and outlays as a share of gross domestic product and compare them to their average shares from 1985 to 1989. The chart shows the US has cut its defense spending by about 2.7% of GDP since the late Cold War. However, it also boosted its outlays on Medicare, Medicaid, other healthcare, and Social Security retirement benefits by a total of 5.1% of GDP. (In large part, those spending hikes probably reflect the aging of the US population and rampant healthcare price inflation.) The excess of new spending over the peace dividend is mostly explained by a small rise in tax receipts and a major expansion in the budget deficit.

Comparable data for European countries is hard to come by, likely because of relatively bigger economic, financial, and political changes after the Cold War. Nevertheless, a review of government outlays in the United Kingdom suggests European countries spent their peace dividend in roughly the same way that the US did. As shown in the chart below, the UK cut its defense spending by 1.9% of GDP and then hiked healthcare, social security, and other civilian spending by a total of about 8.1% of GDP. It would not be a surprise if other Western nations shifted their budget spending in similar ways.

This reorientation of the West’s public spending will have enormous political and financial implications in the coming years. Of course, much of the increased social security and healthcare spending has benefited politically powerful senior citizens. We think those seniors would thwart any substantial cuts to that spending to fund higher defense budgets. For example, if US leaders now wanted to boost the defense budget back to the late-Cold War average of 5.8% of GDP from today’s 3.1% of GDP, not much of the required $708 billion in new military spending would likely come from cuts to Social Security, Medicare, and Medicaid outlays. Other civilian outlays today are not much higher (as a share of GDP) than they were in President Reagan’s second term. Therefore, even if those programs were cut to their share of GDP in 1985-1989, the savings would cover less than half of the targeted boost in defense spending. The shortfall could theoretically be made up with new revenues, but we think today’s strong political opposition to taxes means the required tax hike of about $400 billion would be a nonstarter in Congress.

If political realities mean defense rebuilding can’t be fully funded by cutting civilian spending or hiking taxes, what will Western governments do? We think the likely answer would be even bigger budget deficits coupled with financial repression. In other words, Western governments would likely fund higher defense spending largely by borrowing. To limit the resulting interest costs, agencies such as the US Treasury and central banks such as the Federal Reserve would probably adopt policies to keep bond yields artificially low, such as by forcing banks to buy and hold more Treasury bonds. The central banks could also adopt yield curve control, in which a central bank, such as the Fed, caps long-term yields by buying up Treasurys. While this may seem implausible to many investors, it’s important to remember that there is a precedent for this policy. Indeed, financial repression was used in the decades right after World War II to help the US government weather the debt overhang left after the war ended. The implication for bond investors is that the yields on their future government bonds may not keep up with consumer price inflation, and their purchasing power may slowly erode over time.

Note: there will not be an accompanying podcast for this report.

View PDF