February 02 2024

The New Colossus…With Feet of Clay

The beacon of the US economy is shining a bright light on the rest of the world. This week, Jan24 ISM manufacturing inches further out of contraction (49, 2 pts above consensus). Non-farm payrolls roared ahead, still very much driven by services. In parallel, earnings surprised again to the upside, half way through the season.

The equity rally broadened to the wider market, as noted in a marked improvement in market breadth since the trough of Oct23.

Yet, not everyone is shown Emma’s Golden Door, and some huddled masses yearning to breathe free are left out of the market rally. Typically, value and small caps are witnessing it from the sidelines. Concerns linger for rate-sensitive names, and investment pundits stick to their “quality” mainframe. In short, investors favor very much high profitability and strong competitive advantages.

By asset type, you still have strong discrepancies. As long as the USD stays strong, there is a reluctance to embrace foreign assets, whether in developed or emerging markets, not to mention the geopolitics we know.

Communication and Technology are still in the lead, whereas real estate and materials are good laggards. As doubters scan the economy for weaker links, they invariably fall down on commercial real estate, which is feared to harbor default rates that go beyond banks’ current provisioning. In my opinion, risk is contained to smaller regional banks and private credit funds, and is unlikely to reach systemic proportion.

With the FOMC speech out of the way, leaving us with a status quo on rates for now, “technicals” point to further rally in the coming 3 months. With improving or even stable financial conditions, and sturdy GDP growth, we can’t downplay that a lot of tailwind is building up. Party time, ain’t it?

Well not so fast. For one thing, the rush of corporate bond issue, breaking records in Jan24, is betraying a desperate thirst for funding, while burdening the supply side. Part of me is praising the CFOs’ clairvoyance, while the other part warns on more dire market conditions ahead.

Sale of investment grade (IG) bonds, both in Developed and EM, broke records in Jan24. As per Bank of America, IG companies are expected to issue $160bn more in Feb24, on top of a record-high $190bn in Jan24.

Here comes the feet of clay. The other thing is the unshakable legacy of “over-indebtedness, low-quality growth, and policy mistakes” in the words of Mohamed El-Erian. In short, companies, households and Governments are more leveraged overall, and they can’t count on rates going down as meaningfully as they did in the past. It means that accounting and fiscal discipline is a must. Credit-infused growth is no longer an option, as we already brought forward a lot of future growth by extremely lavish incentives.

Finding leaner growth paths is key, and we understand why everyone and her sister is looking at the promise of AI with bright shiny eyes. Now, we still have to deliver on the promise.

What’s the net for investment portfolios? As long as most market participants are bent on favoring “quality”, I assume that flows will continue to flock there, thus amplifying high multiples in equity, and compressing spreads in IG. This will go until the camel’s back breaks, as (a) I can’t imagine the economy running on the single leg of large cap quality, and (b) this trade will become far too crowded at some point.

Therefore, I’d keep squaring my duration as soon as US 10-year goes below 4%, and I’d take gains out of quality every so often, by rebalancing my portfolio. Too much of a good thing is not so good eventually.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments