- The Fed is becoming less hawkish, in our opinion, as it nears the end of its rate hiking cycle.
- The trend is positive and we continue to look for confirmation to come.
- Crowd Sentiment is showing early signs of turning bullish, in our view.
Since the last update of our Three Tactical Rules on April 4th, financial markets continue to wrestle with inflation, rate hikes/cuts, and fears of recession. Gone from April’s list of macro concerns is the threat of a banking crisis, which appears to have diminished post fiscal and monetary intervention. Some progress has been made over the last two months with individual rules; collectively, the tactical rules are a flashing green light, and currently circling a roundabout in search of their next direction. We believe that the rules will take the green light exit once the Fed fully pauses in the coming months.
Don’t Fight the Fed: Becoming Less Hawkish - FLASHING RED
What a difference a week makes. A week ago, the market had expected the Fed to be finished with rate hikes and to subsequently cut the fed funds rate as many as 3 times by year-end. Then the economic data changed, and investors reduced their expectations of the Fed easing. While the Fed may be leaning toward pausing rate hikes on June 14, they have been clear that such a pause should not be viewed as an end to the rate hiking cycle, especially if the data continues to come in strong and the lag effects of monetary policy does not take hold. Today, the market is now only expecting one rate cut in 2023 and we believe that even that lowered expectation may be overly ambitious. Our base case scenario is for one additional rate hike in 2023 before pausing for the remainder of the year. This less hawkish tone is positive for markets, but far from a 'coast is clear' signal. For this reason, we continue to give the Fed a flashing red light.
Internationally, the Bank of England (BoE) and the European Central Bank (ECB) find themselves in similar positions to the Fed, wrestling with whether to hike rates further, slow the pace of hikes, or pause. Persistent inflation remains the culprit for each of the central banks, as they attempt to calculate the impact of previous hikes, and the likelihood they will reach their 2% inflation targets with or without additional hikes. While we anticipate more hikes are on the horizon for the BoE and ECB, we believe that the pace of hikes will slow, and that they too will pause in the coming months. Therefore, the Fed and foreign central banks are becoming less hawkish and are showing signs of beginning to move closer to the investor’s side.
Don't Fight the Trend: Market Breakout Above 4200 a Positive, Looking for Longer-term Confirmation - FLASHING GREEN
The trend of the S&P 500 has decelerated after peaking near a 10.5% annualized rate in late April, due to the index trading in a narrow range between 4050 and 4200. The rangebound nature of the index caused the primary trend, which we define as the 200-day moving average, to hardly move over the past month. As of June 2, 2023, the primary trend is rising at a 1.50% annualized rate. However, given the recent breakout of the trading range, the trend will become more positive in a couple of weeks if the index remains near its current level. Historically, a positive trend is good for stock returns. Therefore, the trend is signaling a flashing green light to us which calls for equity exposure that is roughly in line to slightly above long-term targets.
Internationally, the trend of the MSCI All Country World ex-US index is also decelerating but from a much higher peak. The international primary trend is rising at an annualized rate of 5.7% as of June 2, 2023, after peaking near 15% just under a month ago. While the international trend is under pressure as well, if current levels were to hold, the 200-day moving average would not turn negative. Therefore, the international trend is signaling a flashing yellow light to us that has the ability under the right conditions to turn green.
Beware of the Crowd at Extremes: Early Signs of Turning Bullish - FLASHING GREEN
We regard Crowd Sentiment as the contrary indicator of the Three Tactical Rules. Since the beginning of the year, the crowd has been either neutral or in extreme pessimism as investors attempted to handicap and navigate the evolving monetary policy landscape. The chart below shows a measure of investor sentiment as calculated by Ned Davis Research. When the line is high it shows extreme optimism, and when it is low, extreme pessimism. This is our preferred data to measure investor psychology, though we use our own analytical framework from which to draw conclusions on sentiment.
Generally, we believe sentiment is a contrarian indicator, meaning we look for opportunities to buy when there is extreme pessimism and vice versa. Currently, the crowd is pessimistic, which has historically been a contrarian (bullish) signal. However, like our previous two updates, the crowd is not at an extreme within the pessimism zone, thus we have not reached a level which could warrant significantly increasing our stock holdings. By historical standards, we do not believe sentiment is depressed enough to ignite a significant stock rally.
Conclusion: Signals Still Mixed but Improving
The message of the tactical rules is still mixed. In our opinion, the most likely scenario is for the Fed to hike once more and pause, and for the trend to improve. Thus, we think the rules will change to a green light over the next 3 months, giving us an opportunity to add stocks. If we are wrong, it will likely be because the recent breakout is not sustained, and the Fed hikes more than once after pausing in June. Our portfolios are currently positioned roughly in alignment with our long-term stock and bond targets. If the signals continue to improve, we anticipate adding to our stock allocation.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.