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Positioning Your Portfolio for a “W” Recovery Scenario

Portfolio positioning for a recovery scenario

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This article was originally published by Invesco.

In response to numerous client questions about portfolio positioning for a recovery scenario, we provide a historical perspective on stock market, sector, size, style and regional allocations. Also, we juxtapose typical recovery performance trends against recent price action. At present, we observe that some performance trends—for now, at least—do hint at a potential recovery, including the recent outperformance of stocks relative to bonds, cyclical sectors relative to defensive ones and small market capitalization stocks relative to their large counterparts. However, some other trends suggest it may be too soon to expect a durable change in leadership, namely in the form of growth continuing to outperform value and developed markets still outperforming their emerging competitors. Whether the recovery began a month ago or it begins a month or more from now, we help investors look across the valley to better times ahead and position their portfolios for optimistic, long-term outcomes.

1. Asset allocation – stocks outperform bonds (yes)

The first chapter of our “recovery playbook” covers the stock-to-bond ratio—a measure of investor risk-on positioning when the ratio is in an uptrend or risk-off positioning when it’s in a downtrend. Specifically, stocks—more aggressive, pro-cyclical assets—began persistently outperforming bonds—safer, income-oriented assets—near the last four economic recessions. Currently, stocks have been sharply beating bonds since the March 2020 low, which is consistent with the typical recovery performance trend. Figures 1 & 2. Stocks began persistently outperforming bonds near the last four economic recessions.
Source: Bloomberg L.P., Invesco, 05/21/20. Notes: Price indices. Cyclicals = Consumer Discretionary, Energy, Financials, Industrials, Information Technology and Materials. Defensives = Consumer Staples, Health Care, Telecommunication Services and Utilities. Shaded areas denote National Bureau of Economic Research (NBER)-defined US recessions. An investment cannot be made in an index. Past performance does not guarantee future results.

2. Sectors – cyclicals outperform defensives (yes)

Trends within the stock market also reflect the success or failure of the recovery trade. Intuitively, the economy-sensitive sectors of the stock market (e.g., consumer discretionary, energy, financials, industrials, information technology and materials) led the charge exiting the early-1980s, 1990s, 2000s and late-2000s business cycle downturns. Contrastingly, the defensive market segments (e.g., consumer staples, health care, telecommunication services and utilities) lagged in the same timeframe. Encouragingly, the cyclical-to-defensive ratio bottomed in March 2020 and cyclicals are generally behaving the way we’d expect in a recovery scenario. Figures 3 & 4. The economy-sensitive sectors of the stock market led the charge exiting the early-1980s, 1990s, 2000s and late-2000s business cycle downturns, whereas the defensive market segments lagged in the same timeframe.
Source: Bloomberg L.P., Invesco, 05/21/20. Notes: Price indices. Cyclicals = Consumer Discretionary, Energy, Financials, Industrials, Information Technology and Materials. Defensives = Consumer Staples, Health Care, Telecommunication Services and Utilities. Shaded areas denote NBER-defined US recessions. An investment cannot be made in an index. Past performance does not guarantee future results.

3. Size – small caps outperform large caps (yes)

In the past, equity portfolios with a small market capitalization tilt (favoring high-growth companies and riskier, less-liquid stocks) usually outperformed those with a large-cap bias (emphasizing stable, high-quality companies and liquid stocks) for several years into the recovery stage of the business cycle. Said differently, company size was a play on improving economic prospects. Initially, small caps gain traction in an environment of abundant central bank liquidity, improving credit conditions, tightening credit spreads, ebbing volatility, shrinking risk premia, as well as investors’ penchant for cyclicality and thirst for higher returns. Sound familiar? The next stage of small-cap outperformance may likely require the support of an expanding economy, rebounding corporate profits and declining default rates. As for large caps, they generally do well in the mid to late stages of the business cycle, but those times are clearly behind us. Figures 5 & 6. In the past, equity portfolios with a small market capitalization tilt usually outperformed those with a large-cap bias for several years into the recovery stage of the business cycle. Said differently, company size was a play on improving economic prospects.
Source: Bloomberg L.P., Invesco, 05/21/20. Notes: Price indices. Shaded areas denote NBER-defined US recessions. An investment cannot be made in an index. Past performance does not guarantee future results.

4. Style – value may outperform growth (no)

The value style of investing (which favors stocks with lower price-to-book ratios) was another leader coming out of the early-1980s, 1990s and 2000s recessions, but that wasn’t the case following the 2008-2009 recession. Why? Compelling valuation can be a good start to an investment thesis, but value isn’t enough on its own, in my opinion. Simply put, value requires an agent for change. When economic growth becomes relatively abundant and all boats are rising with the tide, investors have the latitude necessary to pursue value strategies. However, this cycle has generally been frustrating for value investors, owing largely to a constrained financial sector, and associated hostile and costly regulatory and legal environments. Contrastingly, the growth style of investing (which emphasizes stocks with higher forecasted earnings growth rates) and the information technology sector have been outperforming for 13 or more years—the longest growth cycle on record. Why? It may seem paradoxical, but growth investment strategies do better when economic growth is in short supply. In a structurally-impaired world, investors seem willing to pay up for earnings growth. Excessive growth and tech positioning raise further questions about the next potential shift toward value and financials. Both our strategic new-cycle dashboard and tactical list of market-bottom indicators argue it may be too soon for value to outperform. Importantly for financials, the yield curve—a market proxy for bank net interest margins—has steepened, but not enough to be consistent with past major stock market lows, in my opinion. Figures 7 & 8. The value style of investing was another leader coming out of the early-1980s, 1990s and 2000s recessions, but that wasn’t the case following the 2008-2009 recession. This cycle has generally been frustrating for value investors, owing largely to a constrained financial sector.
Source: Bloomberg L.P., Invesco, 05/21/20. Notes: Total return indices. Shaded areas denote NBER-defined US recessions. An investment cannot be made in an index. Past performance does not guarantee future results.

5. Regions – emerging markets outperform developed markets (no)

Developed market (DM) stocks represent the performance of companies based in the advanced countries of the world (e.g., the US, Japan, Germany, the UK, France). In the final throws of a business cycle, heading into a recession, investors flock to the perceived safety and stability of the major economies amidst slowing global growth, rising uncertainty, tightening monetary policy and a strengthening dollar. Sound familiar? Emerging market (EM) stocks capture corporate performance in the developing countries (e.g., China, India, Brazil, South Korea, Russia). Importantly, EM stocks bottomed in the depths of the last 3 US economic recessions—the final chapter of our “recovery playbook.” In our view, the outlook for Chinese and EM stocks may be better than many investors believe because of a combination of factors: 1) China’s ironclad response to the coronavirus and a flat case count; 2) a re-opened economy and rebounding business activity; 3) cheaper valuations; 4) unprecedented Federal Reserve support and a bearish technical setup for the US dollar; and 5) the relative outperformance of Chinese stocks year to date, which we believe should continue. Figures 9 & 10. Emerging market stocks bottomed in the depths of the last 3 US economic recessions—the final chapter of our “recovery playbook.” In our view, the outlook for Chinese and EM stocks may be better than many investors believe.
Source: Bloomberg L.P., Invesco, 05/21/20. Notes: Total return indices in US dollars. Shaded areas denote NBER-defined US recessions. An investment cannot be made in an index. Past performance does not guarantee future results.
All data sourced from Bloomberg L.P. as of 5/21/20 unless otherwise stated Important Information Blog Header Image: Maahoo Studio / Stocksy The S&P 500 Index is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. The Russell 2000® Index, a trademark/service mark of the Frank Russell Co.®,is an unmanaged index considered representative of small-cap stocks. The Russell 3000® Value Index is an unmanaged index considered representative of the US value stocks. The Russell 3000 Value Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co. The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 Emerging Markets (EM) countries. With 1,198 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in each country. The MSCI Developed Market Index, as represented by the MSCI World Index, is an unmanaged index considered representative of stocks of developed countries. An investment cannot be made into an index Past performance is no guarantee of future results. All investing involves risk, including risk of loss. The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues. Diversification does not guarantee a profit or eliminate the risk of loss The opinions referenced above are those of the authors as of May 21, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations. This does not constitute a recommendation of any investment strategy or product for a particular investor. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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Economics

Nearly Half Of Americans Making Six-Figures Living Paycheck To Paycheck

Nearly Half Of Americans Making Six-Figures Living Paycheck To Paycheck

Roughly 60% of Americans say they’re living paycheck to paycheck -…

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Nearly Half Of Americans Making Six-Figures Living Paycheck To Paycheck

Roughly 60% of Americans say they're living paycheck to paycheck - a figure which hasn't budged much overall from last year's 55% despite inflation hitting 40-year highs, according to a recent LendingClub report.

Even people earning six figures are feeling the strain, with 45% reporting living paycheck to paycheck vs. 38% last year, CNBC reports.

"More consumers living paycheck to paycheck indicates that many are continuing to lose their financial stability," said LendingClub financial health officer, Anuj Nayar.

The consumer price index, which measures the average change in prices for consumer goods and services, rose a higher-than-expected 8.3% in August, driven by increases in food, shelter and medical care costs.

Although real average hourly earnings also rose a seasonally adjusted 0.2% for the month, they remained down 2.8% from a year ago, which means those paychecks don’t stretch as far as they used to. -CNBC

Meanwhile, Bank of America found that 71% of workers say their income isn't keeping pace with inflation - resulting in a five-year low in terms of financial security.

"It is no secret that prices have been increasing for everyday Americans — not only in the goods and services they purchase but also in the interest rates they’re paying to fund their lives," said Nayar, who noted that people are relying more on credit cards and carry a higher monthly balance, making them financially vulnerable. "This can have detrimental consequences for someone who pays the minimum amount on their credit cards every month."

According to an Aug. 30 report from the Federal Reserve Bank of New York, credit card balances increased by $46 billion from last year, becoming the second-biggest source of overall debt last quarter.

And as Bloomberg noted last month, more US consumers are saddled with credit card debt for longer periods of time. According to a recent survey by CreditCards.com, 60% of credit card debtors have been holding this type of debt for at least a year, up 50% from a year ago, while those holding debt for over two years is up 40%, from 32%, according to the online credit card marketplace.

And while total credit-card balances remain slightly lower than pre-pandemic levels, inflation and rising interest rates are taking a toll on the already-stretched finances of US households.

About a quarter of respondents said day-to-day expenses are the primary reason why they carry a balance. Almost half cite an emergency or unexpected expense, including medical bills and home or car repair.

The Federal Reserve is likely to raise interest rates for the fifth time this year next week. Credit-card rates are typically directly tied to the Fed Funds rate, and their increase along with a softening economy may lead to higher delinquencies. 

Total consumer debt rose $23.8 billion in July to a record $4.64 trillion, according to data from the Federal Reserve. -Bloomberg

The Fed's figures include credit card and auto debt, as well as student loans, but does not factor in mortgage debt.

Tyler Durden Tue, 10/04/2022 - 20:25

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Spread & Containment

Plunging pound and crumbling confidence: How the new UK government stumbled into a political and financial crisis of its own making

Liz Truss took over as prime minister with an ambitious plan to cut taxes by the most since 1972 – investors balked after it wasn’t clear how she would…

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The hard hats likely came in handy recently for Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng. Stefan Rousseau/Pool Photo via AP

The new British government is off to a very rocky start – after stumbling through an economic and financial crisis of its own making.

Just a few weeks into its term on Sept. 23, 2022, Prime Minister Liz Truss’ government released a so-called mini-budget that proposed £161 billion – about US$184 billion at today’s rate – in new spending and the biggest tax cuts in half a century, with the benefits mainly going to Britain’s top earners. The aim was to jump-start growth in an economy on the verge of recession, but the government didn’t indicate how it would pay for it – or provide evidence that the spending and tax cuts would actually work.

Financial markets reacted badly, prompting interest rates to soar and the pound to plunge to the lowest level against the dollar since 1985. The Bank of England was forced to gobble up government bonds to avoid a financial crisis.

After days of defending the plan, the government did a U-turn of sorts on Oct. 3 by scrapping the most controversial component of the budget – elimination of its top 45% tax rate on high earners. This calmed markets, leading to a rally in the pound and government bonds.

As a finance professor who tracks markets closely, I believe at the heart of this mini-crisis over the mini-budget was a lack of confidence – and now a lack of credibility.

A looming recession

Truss’ government inherited a troubled economy.

Growth has been sluggish, with the latest quarterly figure at 0.2%. The Bank of England predicts the U.K. will soon enter a recession that could last until 2024. The latest data on U.K. manufacturing shows the sector is contracting.

Consumer confidence is at its lowest level ever as soaring inflation – currently at an annualized pace of 9.9% – drives up the cost of living, especially for food and fuel. At the same time, real, inflation-adjusted wages are falling by a record amount, or around 3%.

It’s important to note that many countries in the world, including the U.S. and in mainland Europe, are experiencing the same problems of low growth and high inflation. But rumblings in the background in the U.K. are also other weaknesses.

Since the financial crisis of 2008, the U.K. has suffered from lower productivity compared with other major economies. Business investment plateaued after Brexit in 2016 – when a slim majority of voters chose to leave the European Union – and remains significantly below pre-COVID-19 levels. And the U.K. also consistently runs a balance of payments deficit, which means the country imports a lot more goods and services than it exports, with a trade deficit of over 5% of gross domestic product.

In other words, investors were already predisposed to view the long-term trajectory of the U.K. economy and the British pound in a negative light.

An ambitious agenda

Truss, who became prime minister on Sept. 6, 2022, also didn’t have a strong start politically.

The government of Boris Johnson lost the confidence of his party and the electorate after a series of scandals, including accusations he mishandled sexual abuse allegations and revelations about parties being held in government offices while the country was in lockdown.

Truss was not the preferred candidate of lawmakers in her own Conservative Party, who had the task of submitting two choices for the wider party membership to vote on. The rest of the party – dues-paying members of the general public – chose Truss. The lack of support from Conservative members of Parliament meant she wasn’t in a position of strength coming into the job.

Nonetheless, the new cabinet had an ambitious agenda of cutting taxes and deregulating energy and business.

Some of the decisions, laid out in the mini-budget, were expected, such as subsidies limiting higher energy prices, reversing an increase in social security taxes and a planned increase in the corporate tax rate.

But others, notably a plan to abolish the 45% tax rate on incomes over £150,000, were not anticipated by markets. Since there were no explicit spending cuts cited, funding for the £161 billion package was expected to come from selling more debt. There was also the threat that this would be paid for, in part, by lower welfare payments at a time when poorer Britons are suffering from the soaring cost of living. The fear of welfare cuts is putting more pressure on the Truss government.

a man in a brown stocking hat inspects souvenirs near a bunch of UK flags and other trinkets
The cost of living crisis in the U.K. has everyone looking for deals where they can. AP Photo/Kirsty Wigglesworth

A collapse in confidence

Even as the new U.K. Chancellor of the Exchequer Kwasi Kwarteng was presenting the mini-budget on Sept. 23, the British pound was already getting hammered. It sank from $1.13 the day before the proposal to as low as $1.03 in intraday trading on Sept. 26. Yields on 10-year government bonds, known as gilts, jumped from about 3.5% to 4.5% – the highest level since 2008 – in the same period.

The jump in rates prompted mortgage lenders to suspend deals with new customers, eventually offering them again at significantly higher borrowing costs. There were fears that this would lead to a crash in the housing market.

In addition, the drop in gilt prices led to a crisis in pension funds, putting them at risk of insolvency.

Many members of Truss’ party voiced opposition to the high levels of borrowing likely necessary to finance the tax cuts and spending and said they would vote against the package.

The International Monetary Fund, which bailed out the U.K. in 1976, even offered its figurative two cents on the tax cuts, urging the government to “reevaluate” the plan. The comments further spooked investors.

To prevent a broader crisis in financial markets, the Bank of England stepped in and pledged to purchase up to £65 billion in government bonds.

Besides causing investors to lose faith, the crisis also severely dented the public’s confidence in the U.K. government. The latest polls showed the opposition Labour Party enjoying a 24-point lead, on average, over the Conservatives.

So the government likely had little choice but to reverse course and drop the most controversial part of the plan, the abolition of the 45% tax rate. The pound recovered its losses. The recovery in gilts was more modest, with bonds still trading at elevated levels.

Putting this all together, less than a month into the job, Truss has lost confidence – and credibility – with international investors, voters and her own party. And all this over a “mini-budget” – the full budget isn’t due until November 2022. It suggests the U.K.‘s troubles are far from over, a view echoed by credit rating agencies.

David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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Economics

Roubini: The Stagflationary Debt Crisis Is Here

Roubini: The Stagflationary Debt Crisis Is Here

Authored by Nouriel Roubini via Project Syndicate,

The Great Moderation has given way to…

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Roubini: The Stagflationary Debt Crisis Is Here

Authored by Nouriel Roubini via Project Syndicate,

The Great Moderation has given way to the Great Stagflation, which will be characterized by instability and a confluence of slow-motion negative supply shocks. US and global equities are already back in a bear market, and the scale of the crisis that awaits has not even been fully priced in yet.

For a year now, I have argued that the increase in inflation would be persistent, that its causes include not only bad policies but also negative supply shocks, and that central banks’ attempt to fight it would cause a hard economic landing. When the recession comes, I warned, it will be severe and protracted, with widespread financial distress and debt crises. Notwithstanding their hawkish talk, central bankers, caught in a debt trap, may still wimp out and settle for above-target inflation. Any portfolio of risky equities and less risky fixed-income bonds will lose money on the bonds, owing to higher inflation and inflation expectations.

How do these predictions stack up? First, Team Transitory clearly lost to Team Persistent in the inflation debate. On top of excessively loose monetary, fiscal, and credit policies, negative supply shocks caused price growth to surge. COVID-19 lockdowns led to supply bottlenecks, including for labor. China’s “zero-COVID” policy created even more problems for global supply chains. Russia’s invasion of Ukraine sent shockwaves through energy and other commodity markets. And the broader sanctions regime – not least the weaponization of the US dollar and other currencies – has further balkanized the global economy, with “friend-shoring” and trade and immigration restrictions accelerating the trend toward deglobalization.

Everyone now recognizes that these persistent negative supply shocks have contributed to inflation, and the European Central Bank, the Bank of England, and the US Federal Reserve have begun to acknowledge that a soft landing will be exceedingly difficult to pull off. Fed Chair Jerome Powell now speaks of a “softish landing” with at least “some pain.” Meanwhile, a hard-landing scenario is becoming the consensus among market analysts, economists, and investors.

It is much harder to achieve a soft landing under conditions of stagflationary negative supply shocks than it is when the economy is overheating because of excessive demand. Since World War II, there has never been a case where the Fed achieved a soft landing with inflation above 5% (it is currently above 8%) and unemployment below 5% (it is currently 3.7%). And if a hard landing is the baseline for the United States, it is even more likely in Europe, owing to the Russian energy shock, China’s slowdown, and the ECB falling even further behind the curve relative to the Fed.

Are we already in a recession? Not yet, but the US did report negative growth in the first half of the year, and most forward-looking indicators of economic activity in advanced economies point to a sharp slowdown that will grow even worse with monetary-policy tightening. A hard landing by year’s end should be regarded as the baseline scenario.

While many other analysts now agree, they seem to think that the coming recession will be short and shallow, whereas I have cautioned against such relative optimism, stressing the risk of a severe and protracted stagflationary debt crisis. And now, the latest distress in financial markets – including bond and credit markets – has reinforced my view that central banks’ efforts to bring inflation back down to target will cause both an economic and a financial crash.

I have also long argued that central banks, regardless of their tough talk, will feel immense pressure to reverse their tightening once the scenario of a hard economic landing and a financial crash materializes. Early signs of wimping out are already discernible in the United Kingdom. Faced with the market reaction to the new government’s reckless fiscal stimulus, the BOE has launched an emergency quantitative-easing (QE) program to buy up government bonds (the yields on which have spiked).

Monetary policy is increasingly subject to fiscal capture. Recall that a similar turnaround occurred in the first quarter of 2019, when the Fed stopped its quantitative-tightening (QT) program and started pursuing a mix of backdoor QE and policy-rate cuts – after previously signaling continued rate hikes and QT – at the first sign of mild financial pressures and a growth slowdown. Central banks will talk tough; but there is good reason to doubt their willingness to do “whatever it takes” to return inflation to its target rate in a world of excessive debt with risks of an economic and financial crash.

Moreover, there are early signs that the Great Moderation has given way to the Great Stagflation, which will be characterized by instability and a confluence of slow-motion negative supply shocks. In addition to the disruptions mentioned above, these shocks could include societal aging in many key economies (a problem made worse by immigration restrictions); Sino-American decoupling; a “geopolitical depression” and breakdown of multilateralism; new variants of COVID-19 and new outbreaks, such as monkeypox; the increasingly damaging consequences of climate change; cyberwarfare; and fiscal policies to boost wages and workers’ power.

Where does that leave the traditional 60/40 portfolio? I previously argued that the negative correlation between bond and equity prices would break down as inflation rises, and indeed it has. Between January and June of this year, US (and global) equity indices fell by over 20% while long-term bond yields rose from 1.5% to 3.5%, leading to massive losses on both equities and bonds (positive price correlation).

Moreover, bond yields fell during the market rally between July and mid-August (which I correctly predicted would be a dead-cat bounce), thus maintaining the positive price correlation; and since mid-August, equities have continued their sharp fall while bond yields have gone much higher. As higher inflation has led to tighter monetary policy, a balanced bear market for both equities and bonds has emerged.

But US and global equities have not yet fully priced in even a mild and short hard landing. Equities will fall by about 30% in a mild recession, and by 40% or more in the severe stagflationary debt crisis that I have predicted for the global economy. Signs of strain in debt markets are mounting: sovereign spreads and long-term bond rates are rising, and high-yield spreads are increasing sharply; leveraged-loan and collateralized-loan-obligation markets are shutting down; highly indebted firms, shadow banks, households, governments, and countries are entering debt distress.

The crisis is here.

Tyler Durden Tue, 10/04/2022 - 17:25

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