July 14 2023

Now On With The Rotation

The shift in narrative on inflation came in with a bang this week. Jun23 CPI numbers undershot expectations and, most importantly, confirmed the dis-inflation trend. Services prices were still leading the pack, but energy was in full retreat. PMI numbers only confirmed the trend.

Analysts were not too long to play down rate hike expectation, and venture to say that rates had probably peaked. Asset allocators took note and started putting cash back at work in risk assets. USD took a plunge against major international currencies, breaking down a rather stable trend YTD23.

Therefore, the main themes for now are: weaker USD, rates in check, and stable economy with landing inflation.

By geography, EM & Europe assets had a field trip, and strength is meant to continue as valuations are relatively attractive.

By sector, we noticed a continued lead from large cap tech names, of course, but also some rotation into materials and consumer discretionary. Financials are likely to push ahead too, as earnings of JPM and Wells Fargo show that banks’ net income benefits from higher rates. Big banks are fine, thank you. However, note that the situation might be rather different for regional banks, which are still paying for deposits through the teeth.

As proof of an ongoing rotation, market breadth improved. About 73% of S&P500 stocks are trading above their 200-day average, compared to only 42% at the end of May23.

Outside the world of S&P’s large cap, there is also a breath of fresh air flowing across small and midcap names. Russell 2000 overperformed S&P500 this week, and look resolute to bottom out. Smaller caps are arguably more sensitive to high interest rates, not only because of size but also due to the high representation of banks and real estate components. Rates stabilizing at a high level may accompany the Russell 2000 rally.

USD weakness also means that USD-denominated assets look cheaper, typically commodities. This one is tricky. While commodities look set for a bear market rally, a lot of the forward price is pegged to the continued strength of the global economy, especially China. There, stimulus is widely expected, but failing to materially come in. Besides, commodity index (BCOM) is still trading 30% over pre-covid level, which is probably a lingering after-effect of global supply chain disruption, but also looks still lofty vis-à-vis growth expectations, and downbeat manufacturing activity.

If you still follow me at this point, I won’t bet the horse on a massive rally in commodities prices.

What could go wrong then? For starter, a further rally in equity, while enjoyable in the short-term means that future equity premiums get squeezed. Long-term portfolio holders should prop up their portfolio with private assets and their higher expected return. BCG, in their Jun23 Wealth report, expect US real assets to overperform by 1.6% CAGR from 22 to 2027.

Next, earnings have been very supportive of the current rally, and we’ll monitor with attention the 2Q23 season. Elsewhere, credit spreads look tighter than longer average, and could widen should the persistence of high rates hit in the margins of highly-leveraged companies. Last but not least, the US consumer needs to remain employed, credit-worthy, and happy.

And for now, according to U-Mich sentiment in Jun23, it seems to look happier everyday.

Stay safe out there and enjoy the summer !

About –

360 Advisory LLC is a Boston-based RIA managing investments