The past two months over the northern hemisphere summer have been extraordinary for markets. The euphoria of the AI boom contributed to an impulsive fear-of-missing out into equities. That was followed by an equally rapid and emotional correction in the second half of July and early August, likely amplified by an unwind of the correlated yen carry trade. Prior to the correction, positioning and consensus beliefs had become very crowded long equities (especially mega-cap technology and AI), short JPY and short volatility. While it is not straightforward to measure, most common positioning metrics were at or near the 100th percentile. The recovery in the second half of August has also been impulsive, rapid, and emotional, taking the global risk proxy back to just under the all-time-high.
From a fundamental standpoint, US markets are priced for the optimal combination of disinflation, aggressive Fed easing, growth near trend, acceleration in earnings and benign credit conditions. As Gerard Minack noted recently, while any one of those outcomes might happen, it is unlikely that they will all happen together. From our perch, the additional context is the absence of risk compensation in equities and credit. The equity risk premium, or difference between the earnings yield and the 10-year Treasury yield is only 1% and the most compressed since 2005. At the same time, the credit risk premium or high yield bond spread is at trough levels. You must squint hard to see the August episode in credit, despite the large spike in implied equity volatility (chart 1).
Chart 1
Markets anticipate everything will go right as the Fed pivots from inflation to growth and supporting the labour market (the other side of the dual mandate). Inflation is expected to moderate towards the 2% target on core PCE by mid-2025. Concurrently, GDP growth is anticipated to slow, but only to trend. Concurrently, the slowdown in growth is not expected to prevent an acceleration in EPS for the broader market excluding mega-cap technology stocks. Historically, achieving all these outcomes at the same time would be rare. As we have noted in the past, there have been 12 cycles since 1957, only 2 (1966 and 1995) have been “soft landings.” In most cycles, once there has been a rise in the unemployment rate by 1% from the trough, the economy experiences a recession. The US unemployment rate is up by 0.9% from a trough of 3.4% in the current cycle.
As we have noted previously, equities typically experience a non-trivial drawdown following the first Fed rate cut. Clearly the sample of episodes is modest. However, 1990/1991, 2000/2001 and 2007/2008 rate cutting cycles were not bullish for equities. Although the initial impulsive response to the first rate cut on September 18, 2007, was a meaningful rally, equities soon pivoted to the deterioration in growth and credit conditions. The experience was similar in the 2001 episode (chart 2).
Chart 2
We don’t know how the cycle or macro conditions will evolve over the next 12 months. There is a non-trivial risk of a renewed fiscal impulse next year with a new US Administration that could support the cycle. Although that might have renewed challenging implications for the path of inflation and interest rates. What we do know is that US equity and credit risk compensation is poor and the probability of the best-of-all outcomes is low. This suggests having moderate aggregate risk exposure and a focus on quality (balance sheet strength and cash on cash returns) in portfolios. We fear another drawdown phase over the coming weeks into October.
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