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Still Dancing, Near The Exit

As we noted in April, the prevailing bias has been skewed to the belief that we are in a “crash up” phase in risk assets. Over the past year, the S&P500 has gained 31% and the MSCI World index 25%. Approximately 80% of the returns have been driven by valuation expansion. Stated differently, most of the return has been driven by perceptions of risk rather than earnings. US Credit markets have also performed well, investment grade spreads are within a few basis points of the tight in 2021 before the Fed commenced the rate hike cycle. Similarly, high yield spreads and implied equity volatility have compressed back close to cycle lows. Of course, these factors are reflexive and self-reinforcing.

From our perch, the macro news flow overnight was only a marginal dovish surprise. The core CPI surprised by 0.2% to the dovish side on a year-on-year basis. Headline inflation was in-line with consensus. However, retail sales, especially the “control group” which is used to estimate GDP, surprised materially to the downside. The big picture point for markets is that the data improved the odds that the Federal Reserve might deliver a rate cut before the election in November. As we have noted previously, core services inflation (ex-housing) is high and re-accelerating. Moreover, our pipeline inflation pressure index has also re-accelerated. Our sense is that it is still premature for the Fed to contemplate cutting the funds rate. However, our role as a fund manager is not to argue what the Fed should do, but rather what they are likely to do.

As we have emphasized for some time, the US equity risk premium, credit premium and implied equity volatility are extremely compressed relative to history. That is never an immediate sell-signal. However, it does suggest something about the probability of forward-looking returns. The US equity markets have also already priced a meaningful recovery in earnings. EPS growth implied by the S&P500 is implying a full recovery back to cycle highs. That is probably not consistent with sustained disinflation and meaningful rate cuts.

The good news is that Asia and emerging markets have already experienced a much deeper and more elongated bear market. The exposure in our main Asia Pacific Fund still trades at 11 times earnings, has net cash on balance sheet and above average implied growth. The key point is that there is still considerable upside for returns on a longer time horizon. We don’t often share the performance widely, however our main strategy is up ~13% year to date (unofficial) which is around 7% ahead of EM/Asia equities.

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