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Will Santa Come Early?

A little over a month ago, various Federal Reserve officials directed a pause and started to signal that the US central bank might have reached its terminal destination in this rate hike cycle. These statements came with the caveat that short-term rates would stay “higher for longer”, but as history shows, once the Fed is done, it has usually been a matter of months before interest rates have been cut again. The one exception might just confirm the rule: it was 2006-2007, which was the lead up to the financial crisis. (Chart 1).

There’s an old metaphor attributed to Economist Milton Friedman that refers to aggressive central banks as the “fool in the shower”. In the same way that it takes time for hot and cold water to work their way through home plumbing to an older showerhead, so it takes time for monetary policy changes to work their way through the economy. When the fool realizes that the water is too cold, they turn on the hot water. However, the hot water takes a while to arrive, so the fool simply turns the hot water up all the way, eventually scalding themself. In other words, the Fed usually doesn’t know when its hiked enough until its hiked too much, leading to negative economic outcomes that force the central bank to pivot quickly.

Markets have already begun to pivot. Since the Fed’s signaling turned dovish, important financial conditions have backed off and cleared the way for a year-end rally. The 10-yr treasury yield, the price of oil, and the US dollar are three of the most important financial conditions we monitor. After resuming strength over the summer, all three have started to loosen (Chart 2), which has provided major support for equities. Investors are turning to the past decade’s big winners of excess liquidity, mega-cap tech stocks. The S&P 500 is up ~10% from its October low and has broken out of its downtrend from the summer.

The 10-yr treasury yield, the price of oil, and the US dollar are three of the most important financial conditions we monitor.

Chart 2 – Source: Bespoke Investment Group

While all that seems positive, ultimately, this is all following a typical late-cycle roadmap that will inevitably lead to recession. In fact, it is very on brand for stocks to melt up into a hard landing. Typically, stocks peak within six months before the onset of a recession. (Table 1) If the recession begins in the second half of 2024, as we expect, this provides a short runway for stocks to move higher.

Recessions

Table 1 – BCA Research

And It’s amazing how closely this year’s pattern for the S&P 500 has tracked its typical annual pattern. (Chart 3). If this were to continue, we may have a December to remember.

S&P 500 YTD Performance Vs Post WWII Average

Chart 3 – Source: Bespoke Investment Group

We have spoken in past commentaries about recession bells ringing for the second half of 2024, and our more pessimistic longer-term outlook for risk assets, but we believe this sets up a tactical opportunity. In the past month we have added to equity exposure following the October pullback, as we expect a final blow off rally before we inevitably position our portfolios more defensively.

Bottom Line

We do not believe this time is different, but this time is longer. A recession can be deferred (and has) but won’t be denied. A decline in bond yields, oil, and the USD from their recent highs should fuel a blow off risk rally into the end of the year, but risk assets should weaken in 2024.

Overall, our top-down asset allocation is overweight risk on a tactical timeline to take advantage of what we believe could be a year-end rally.

We will continue to monitor our portfolios as the facts change and will remain tactical as the situation evolves. We believe markets are at a point of inflection and will manage assets accordingly.

Recent Portfolio Changes

Global Tactical IncomeChanges to Holdings 11-07-2023

Global Tactical Model Exposure as of 11-21-2023

Global Tactical Model Allocations 11-21-2023

You can get more information by calling (800) 642-4276 or by emailing [email protected].
Best regards,
John A. Forlines III, Chief Investment Officer

John A. Forlines III, Chief Investment Officer


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