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The calendar has flipped to a new year, but our Three Tactical Rules are still fighting the demons of 2022: a Federal Reserve determined to fight inflation, a trend that continues to fall, and a crowd that hangs out near extremes. While the demons remain, progress has been made and the tactical rules of “Don’t Fight the Fed”, “Don’t Fight the Trend”, and “Beware of the Crowd at Extremes” are trending towards a more neutral portfolio positioning, in our view.
‘Don’t Fight the Fed’: Red Light - Fed hawkish, but Treasury Market Disagrees.
The Fed raised interest rates at the eighth consecutive meeting on February 1, 2023, moving the target fed funds range to between 4.50% and 4.75% (see blue line in chart, right). Market expectations are for the Fed to end its interest rate hiking campaign after the May meeting, as recent economic data has indicated that the economy is slowing with one exception: a strong labor market. If market expectations prove correct, the terminal fed funds rate will be 5.125%, in line with the Fed’s forecast at its December meeting. Despite the Fed having raised rates nearly five percentage points since March 2022, core Personal Consumption Expenditures (PCE) inflation remains at 4.4% year-over-year, well above the Fed’s preferred target of 2.00%.
The Fed has been insistent that it would not cut interest rates upon reaching the terminal fed funds rate; however, it appears the Treasury market has not gotten the memo. Long-term interest rates have fallen since October, as investors anticipated slower growth and the rising probability of a recession due to the Fed over-tightening monetary policy. While Treasury investors may be proven right eventually, we believe that this view is premature given the strong labor market and an unemployment rate of 3.4%, the lowest rate since May 1969, according to the White House. A strong labor market can give consumers confidence to spend and thus reverse the progress the Fed has had in bringing headline inflation down from its June 2022 high of 9.1%, in our opinion. The Fed is concerned that this dynamic will force it to have to do more later if it does not stay the course, hence the need for further hikes, albeit at a slower pace.
Internationally, the Bank of England (BOE) and European Central Bank (ECB) have been actively fighting inflation as well. The central banks have raised interest rates significantly, but at different paces relative to each other and the Fed. The BOE has raised interest rates over the last 14 months by 3.9%, while the ECB has raised rates by 3% in the last 8 months and has signaled for additional rate increases. The BOE on the other hand, is getting closer to the end of its rate hiking campaign. Regardless of the pace of rate hikes, as shown in the chart above, major central banks are not on the side of investors as they attempt to contain inflation, in our view. While headline inflation has shown signs of slowing globally, the fight is not over. Thus investors who chose to purchase longer-dated maturities in the bond market are fighting central banks, and this is a mistake, in our opinion. For stock investors, central banks’ continuing to hike will likely continue to be a headwind.
Don’t Fight the Trend: Neutral - Improving with the Hopes of a Softer Landing.
The S&P 500’s trend is currently falling at a 12% annualized rate, which sounds like the broken record of 2022 (see chart, right). However, with the Fed getting closer to the end of its interest rate hiking cycle, there may be light at the end of the tunnel. The S&P 500 has recently broken above the 200-day moving average and has stayed there for 12 trading days, indicating improvement in the trend, in our opinion. If the S&P stays at its current level, the trend will turn positive in early March. In our view, a positive trend increases the odds of having positive returns over the subsequent three months dramatically.
Internationally, the trend of the MSCI ACWI ex US is falling at an annualized rate of just 6% (see chart, right). After prolonged weakness, the trend for international stocks is flattening faster than the US. At current levels, the international trend will turn positive by the end of February, bolstering the odds for positive returns over the subsequent three-month period, in our view. Given that both the domestic and international trends are improving and could turn positive in Q1, we believe the trend is still not an investor’s ‘friend’ yet but is becoming a closer acquaintance.
Beware of the Crowd at Extremes: Neutral and Searching for Direction.
We regard Crowd Sentiment as the contrary indicator of the Three Tactical Rules. Over the last year, the crowd has experienced highs and lows as investors attempted to handicap and navigate the evolving monetary policy landscape. The chart below shows a measure of investor sentiment 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 way to measure investor psychology.
Recently, the crowd moved out of the extreme pessimism zone into neutral for the first time since April 2022, according to Ned Davis Research. The crowd moving to neutral does not warrant a change in portfolio positioning, in our opinion, as we do not believe we are at the types of optimistic or pessimistic extremes that would justify such moves. On its own, the crowd is not providing much of a signal, but when combined with an improving trend, the odds of a positive return over the next three months improves significantly in our model.
Conclusion:
Today, our three tactical rules of “Don’t Fight the Fed”, “Don't Fight the Trend”, and “Beware of the Crowd at Extremes” are collectively sending a neutral signal, in our view. However, despite the Fed taking a hawkish tone, the improving trend and neutral crowd are on the verge of shifting our tactical stance to more bullish. Given that tactical asset allocation is tough to time, we like to ‘skate to where the puck is going’, not to where it is currently (to use a hockey euphemism). Given our view of an improving tactical landscape, our longer horizon portfolios are slightly ‘overweight’ positioning relative to their benchmarks, while in our shorter horizon portfolios we are waiting for further confirmation.
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.