The Manley Macro Memo
Despite a surge in new Covid cases, inflation concerns, supply chain constraints, and labor shortages, the S&P 500 has advanced higher for seven consecutive months, which is its longest winning streak since January 2018.
- Despite a surge in new Covid cases, inflation concerns, supply chain constraints, and labor shortages, the S&P 500 reached a record high in August. The S&P 500 has advanced higher for seven consecutive months, which is its longest winning streak since January 2018.
- In August, the economy remained strong, and inflation remained near a multi-decade high. The unemployment rate dropped to 5.2%, the ISM Manufacturing PMI increased to a robust 59.9, and inflation rose by 5.3%. Despite the strong economy and surging inflation, the Fed continues to print $120 billion each month to buy financial assets. We remain concerned that the Fed is making a significant monetary mistake.
- We believe the market is susceptible to a sharp correction this fall. Despite the S&P 500's recent record close, the market's breadth remains poor, seasonality is negative, and there is uncertainty over the government's funding, the debt ceiling, the timing and magnitude of the Fed's QE taper, and the Q3 corporate earnings guidance. Additionally, China's economic slowdown and their significant regulatory increases could act as a negative catalyst.
- Thankfully, the number of new Covid cases is declining, and we expect this will lead to stronger than expected economic growth and inflation. In this environment, we expect interest rates will rise, and we continue to see a significant opportunity to invest in the economically sensitive value sectors of the market while avoiding the mega-cap tech stocks and the S&P 500. While we expect to profit from the reflationary rotation into the cyclical stocks, longer-term, we remain concerned about the impact rising interest rates and inflation will have on valuations and profit margins.
Despite a surge in new Covid cases, inflation concerns, supply chain constraints, and labor shortages, the S&P 500 reached a record high in August. The S&P 500 has advanced higher for seven consecutive months, which is its longest winning streak since January 2018.
The S&P 500 appreciated by 3.0% in August, while the NASDAQ 100 and the small-cap Russell 2000 rallied by 4.3% and 2.2%, respectively. Also, the MSCI EAFE index of international stocks increased by 1.5%, and the MSCI Emerging market index rose by 2.2%. The safe havens were flat -- the U.S. long-bond and gold fell by 0.3% and 0.1%, respectively. Additionally, the U.S. 10-year bond yield increased by 0.07% to 1.30%, and the yield curve (2-year to 10-year) steepened by 0.05% to 1.10%.
The primary catalyst for the market's advance was Fed Chairman Powell's dovish speech at the Jackson Hole Economic Symposium. Powell said the economy has met the test of "substantial further progress" toward the Fed's inflation objective, and the labor market has also made "clear progress." Additionally, he said, "if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year." The market rallied because Powell reiterated the Fed's belief that inflation is "transitory" and his suggestion that they were in no hurry to remove their emergency monetary measures (negative real rates and printing $120 billion each month to buy financial assets).
While the Fed gave the financial markets another dovish message and promised not to remove their emergency measures for the foreseeable future, the real economy remained robust in August. The unemployment rate dropped to 5.2%, inflation rose by 5.3%, and the ISM Manufacturing PMI accelerated to 59.9, which is near a multi-decade high.
We believe that the Fed is making a huge monetary mistake by overestimating its ability to control inflation and manage the financial markets. This summer, the surge in new Covid cases slowed many parts of the economy. Thankfully, the number of new Covid cases are declining. As the number of new cases drops this fall, we think the economy and inflation will accelerate, manifesting the Fed's profligate monetary policy.
In this economic environment of accelerating growth and inflation, we expect interest rates will rise, and the economically sensitive value sectors of the market (financials, industrials, and energy) will outperform. Additionally, we expect market volatility to increase, and if/when it becomes clear that the Fed made a monetary mistake, the markets will be vulnerable to significant decline.
In August, the Fed's dovish message led to a strong performance in the market's growth, value, and defensive sectors. The outperforming sectors were: Financials, Communications, Utilities, and Technology. Energy was the only declining sector due to the 7% decline in the price of oil.
We expect the Delta variant will continue to wane this fall and expect economic growth and inflation to accelerate. In this reflationary economic environment, we think interest rates will rise, and the value sectors of the market will outperform. Also, we believe the overvalued and over-loved growth sector will be vulnerable as rising inflation leads to margin compression, and higher interest rates cause valuation compression.
Our Model Portfolio:
The benchmark for our model portfolio is the Traditional Blend — 60% equity, 40% bonds. Our goal is to outperform the benchmark with less risk. To outperform, our investment portfolio is diversified and economically balanced. We eliminate laggards and tilt the portfolio toward our location in the business cycle. Finally, we risk-weight our positions to manage volatility.
We remain positioned for a reflationary economic environment (accelerating growth and inflation). We are concerned that significant monetary and fiscal policy errors could lead to an inflation problem as the delta virus abates, the global economy accelerates, and interest rates rise. Our core investments remain in the economically sensitive value sectors of the market (industrials, financials, and Energy), commodities, and TIP's (U.S. Treasury Inflation-Protected Securities). We remain underweight equities and fixed income duration and overweight commodities relative to our benchmark. We reduced our portfolio's risk level due to the value sector's underperformance and our short-term market concerns.
Our portfolio's annualized volatility is 10.0%, which is slightly less than our 60/40 benchmark
Current Risk-Weighted Model Portfolio:
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Our short-term (three-months) outlook is negative:
We believe that the market offers a poor short-term risk-reward because investors are complacent, and market breadth is deteriorating. While the S&P 500 reached a record high on September 2nd, the small-cap Russell 2000 and the Dow Transportation Average peaked on March 15th and May 10th. Additionally, most NYSE companies are below their 50-day moving average and in a correction. Divergences and narrowing market breadth typically presage a market correction. When investors are fearful, the market is oversold, and breadth begins to improve, we will increase our tactical risk exposure. Our short-term market outlook is negative.
Our long-term (more than four years) outlook is neutral:
We believe that the S&P 500 offers a poor risk-reward because it is extremely overvalued. Also, we are concerned about the long-term unintended consequence of the unprecedented monetary and fiscal policy that was used to combat the pandemic. Artificially low-interest rates and historic peacetime deficits have led to a record debt burden, which will become problematic as the economy grows, and interest rates normalize. We continue to see a significant opportunity to invest in the value sectors of the market while avoiding the mega-cap tech stocks and the S&P 500. While we expect to profit from the reflationary rotation into the cyclical stocks, longer-term, we remain concerned about the impact rising interest rates will have on stock valuations. Our Strategic Asset Allocation is underweight equities relative to our benchmark.
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Disclaimer: The material in this newsletter is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This newsletter is not a substitute for professional investment services. Past performance is no guarantee of future results, and there is no assurance that investment objectives will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.
J. Lawrence Manley, Jr., CFA