Bumpy Roads

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Geopolitics

In 2016, PBS published a column entitled “How Gold and Art Auctions Can Gauge Stock Market Confidence.” In it, economist and author Vikram Mansharamani asserted one of the world’s best indicators of overconfidence is the performance of a single stock: Sotheby’s. Peaks in the auction house’s stock price, he wrote, have historically coincided with financial and economic exuberance.

As it happens, Sotheby’s is no longer a publicly traded company (it chose not to IPO in 2023) and today, there are no auction houses listed on a public exchange. That said, Sotheby’s and other houses still report sales, and the trend entering 2024 among these auctioneers was notably positive. Artprice, the global leader in art market information, wrote in its year-end review “2023 stands out as the most dynamic year in the history of the global Art Market, with more than a million works put up for auction and 763,000 transactions.” Although the total value of transactions was lower than in 2022, the overall picture was one of robust activity and high confidence. So, it was a surprise when in the spring of this year, four of the world’s leading auction houses in New York reported a 22% year-over-year decline in art sales in New York.

The real shock, however, came a few weeks ago when Sotheby’s reported an 88% drop in its reported earnings and a 25% fall in auction sales for the first six months of the year. This plunge in activity was in sharp contrast to the S&P 500 index which had appreciated 14.48% through June, amid outsized speculative activity in names such as Nvidia and the rest of the so-called “Mag 7”. This begs the question: is such a disparity meaningful for investors and, if so, why? Mansharamani explains it best in his 2016 column:

“Not surprisingly, those that set new world record art prices tend to be those that have substantial personal resources — meaning they are usually very very rich. In short, those that pay $100mm+ for a painting are usually those that have much more than $100mm in net worth; such buyers are likely to be billionaires with significant corporate interests. Because of this connection between art buyers and corporate leadership, art markets serve as a useful indicator of corporate and global confidence. If the CEOs of major companies begin to see clouds on the economic horizon (through their corporate capacity), they are likely to scale back on their personal art buying.”

Mansharamani cautioned that tracking art prices is but one indicator in gauging economic and financial exuberance and best used in conjunction with other measures of social sentiment. At the time his original article was published, China had far less of an influence on global markets, and particularly the luxury goods market. Now, it comprises the world’s second largest art market, and a slowdown in Chinese purchases of art and other luxury goods markets will obviously carry greater impact. Still, the luxury industry’s current “slow down” is broad based and represents more than a dip in sales; it’s a barometer of changing consumer values and global economic health.

stock market

The stock market endured a bumpy month in August, ending in positive territory but not without some heartburn, especially early in the month. The S&P 500 finished up 2.28% for the month and is up year-to-date a robust 18.42%. The Nasdaq 100 gained 1.1% and is up 16.34% through the end of August. In contrast, the small-cap Russell 2000 fell -1.63%, but is still up 9.4% for the year.

Investors had to contend with several cross currents in August, ranging from currency risk (Japanese Yen) to weakness in labor markets, a slowing economy, the future direction of Fed policy, and the upcoming Presidential election. The lack of clarity resulted in an uptick in volatility in both stocks and bonds, with equities plummeting early in the month only to rebound strongly in the back half.

The month’s early weakness stemmed from surprisingly weak economic reports. Non-farm payrolls reported an increase of 114,000, far less than consensus estimates of ~190,000. On top of a light JOLTs survey, a meaningful uptick in unemployment claims and continued weak manufacturing numbers, concerns grew the long-predicted recession had finally arrived, with the Federal Reserve having waited too long to ease interest rates. The worsening fundamentals coincided with a pause in the multi-month AI bull narrative, as stories began circulating in the financial press questioning how quick the payoff from the billions of dollars being expended on AI hardware would be.

The combination of a surprise slowdown in labor markets and wavering tech leadership, along with overly bullish investor positioning coming into the month, produced a sudden downdraft in indices, with the Nasdaq 100 dropping more than 13% from its peak in July to the August trough and the S&P 500 falling almost -10%.

Ultimately, the market found its footing when better than expected economic data arrived mid-month, soothing fears of an imminent recession. The Goldilocks narrative of not too hot, not too cold re-asserted itself but now with a twist: instead of investors worrying about an economy running too hot and continued sticky inflation, the focus shifted to concern about weakening labor markets and what that might portend for future aggregate demand and corporate earnings.

fixed income

The first few days of August saw a continuation of the waterfall decline in Treasury yields that began in the last week of July. The 10-year yield quickly falling to 3.80% on the second trading day of the month before stabilizing, eventually ending the month at 3.91%. The 10-Year Treasury ended up 1.40% for the month, the 30-year up 2.44%, and the 2-year 0.90%, as the entire yield curve reset lower. Corporates gained as well, with the Bloomberg US Corporate Investment Grade Index appreciating 1.57% and Bloomberg US Corporate High Yield Index up 1.63%.

Interest rates moved in tandem with inflation and employment data, both of which pointed to a slowing labor market and receding price pressures. What was perhaps most interesting about the price action was the behavior of lower quality credits. It’s almost obvious that an economy entering slowdown will see interest rates decline as the demand for money decreases. Spreads between risk-free Treasuries and lower grade credits can be expected to widen, as the ability of higher leveraged companies to service their debt turns more tenuous.

In August, rates did decline dramatically in reaction to a downward shift in labor demand but credit spreads hardly budged at all. In fact, as can be seen in the chart below, the lowest grade credits (CAA High Yield) paid no mind at all to what rates and equities were saying, with spreads counterintuitively declining over the course of the month.

This contradictory price behavior between stocks and lower quality bonds turned out to be temporary, as only one of the implicit directional bets investors were making would end up being right. A significant decline in both stock prices and risk-free interest rates only makes sense if the economy is entering into a slowdown of some magnitude. Under such a scenario, however, low grade credit spreads would be expected to widen, not narrow, and their refusal to do so strongly suggested the decline in equities early in the month was likely to be short-lived.

Federal Reserve and Monetary Policy

The Federal Reserve has embarked on a monetary easing program and the central question now is how low rates fall and for how long. The Fed Funds market is pricing in cuts of at least 75 basis points by the first quarter of 2025, while the US 2-year Treasury Note assumes the Fed will ultimately cut rates by 150 bps before rate neutrality is reached. It’s important to note that both Fed Funds and the 2-Year are notoriously volatile and only represent the market’s current best guess as to the Fed’s future direction, and by implication, that of the overall economy.

It is clear the Fed has shifted its dual mandate focus away from controlling inflation to the recent deterioration in labor markets and what it portends for future economic growth. The FOMC now wants to get out in front of any possible major slowdown and importantly, has the flexibility to do so. Inflation numbers have turned favorable with most measures of price inflation, outside of housing, at or near the 2% level. Housing itself, as measured by the Bureau of Labor, is a lagging price indicator and given the recent drop in new tenant rental prices, will at a minimum be supportive of lower inflation numbers in the months ahead.

Are we finally headed into recession and is now the time to become more risk-adverse? Or is this recent run of weak labor market data short-term in nature, and the economy will soon prove its resilience once again? There are valid arguments to be made on both sides. On the recession side, Jeffrey Gundlach in his Total Return webcast pointed to the Conference Board’s Month Over Month (MOM) Leading Economic Indicator, which shows only two positive contributors to the LEI, and both of those being financial based (stock prices and credit based). The remaining contributors, all of which are economic-based, are either neutral or negative.

He also points out the current unemployment rate is now clearly above its 36-month moving average, which has correctly foreshadowed recessions in the past (1990, 2001-2, 2008-10 and the pandemic driven 2020 recession).

Making the argument in favor of continued growth, former hedge fund manager Michael Kao asserts the US economy overall remains healthy – if bifurcated between the haves and have nots – and by moving too quickly to cut rates, the Fed risks re-igniting inflation. While there are pockets of weakness in the economy, Kao believes a full-blown recession is unlikely, principally because government fiscal programs continue to provide a major stimulus. The corporate and individual “haves” in the US economy remain cash flush with solid balance sheets and will continue to spend. Financial conditions continue to be quite easy as well, and the associated wealth effect of buoyant markets remains supportive of growth.

This debate is unlikely to be resolved soon, particularly since a change in Executive and Legislative branches is on the horizon. It does seem reasonable to assume the economy is unlikely to reaccelerate in the near term until there is greater clarity around the impact of economic policies being put in place under a new Administration, whoever that may be.

Managed Income – Manager Commentary

As was the case in July, investment-grade corporates and longer duration bonds led the way, with yields falling yet again throughout the month. The high yield market was rattled by unemployment news, as well as a selloff on August 5 related to concerns the Bank of Japan would be raising interest rates. After a swift pullback, high yield rallied for the remainder of the month.

The Managed Income model remains Risk-On despite this abrupt bout of volatility. The portfolio management team used the pullback on August 5 to shed some higher quality senior loan positions and add to high yield positioning. We believe we are nearing the end of the cycle for high yield; however, this does not necessarily mean a Risk-Off signal is imminent, as current conditions could persist into the next few months. We remain focused on mitigating price volatility, while taking advantage of the current yield of our positions. In the event we do see a deterioration in US High Yield, which would lead to a Risk-Off signal, the portfolio management team has begun adding higher quality multisector bond positions, which are expected to benefit from falling yields as we move toward September’s rate decision.

Dynamic Growth – Manager Commentary

Large cap equities began August with a significant pullback following poor jobs data, which was then exacerbated by fears of the Bank of Japan raising rates, sparking a panic over the first weekend of the month. The CBOE Volatility Index (VIX), also known as the “fear gauge,” spiked as high as a reading of 65, before retreating below its long-term median of 17.95 just six trading sessions later.

The Dynamic Growth model remained in a Risk-On state until the conclusion of the week of August 5. The model’s defensive indicators stepped in to move into cash equivalents, as such wide trading ranges are often a harbinger of increased market volatility in the weeks to come. However, equities ultimately advanced for the remainder of the month, with all major indices finishing positive. This was an example of a classical “whipsaw” trade: absorbing a drawdown yet moving to the sideline and missing the recovery. Such sequences are not unusual for a trend-following strategy. Above all else, our mantra is to protect against periods of outsized probability for loss. While such reversals do happen, we believe adherence to our long-term process is paramount to achieving Dynamic Growth’s investment objectives. Looking ahead, we believe September and October will bring more volatility, as market participants weigh the Federal Reserve’s interest rate decision alongside possible indicators of slowing economic growth.

Active Advantage – Manager commentary

The Active Advantage model remains positioned in a fully Risk-On state, with a balanced posture across fixed income and equities. During the month of August, Active Advantage shed some growth equity exposure after the volatility bout in the first week of the month. For the fixed income portion of the portfolio, the portfolio management team continued to add investment grade corporates and high yield exposure.

Heading into a higher-than-average area of market volatility from a seasonal perspective, we continue to look for opportunities to increase the duration of our bond portfolio, as stock-bond correlations continue to turn negative again with inflation declining. Our goal is to provide investors with access to a risk-managed balanced portfolio designed to guard against a downturn, should equity markets continue to retreat from the all-time highs established in mid-July.

Defender – Manager commentary

August proved to be a tough month for tactical allocations, as various markets and assets classes moved in different directions. The volatility was continually being driven by mixed economic data, interest rate uncertainty, geopolitical tensions, and narrow market breadth. Despite these challenges, the Kensington Defender Strategy posted just a slight negative return for the month, slightly underperforming its benchmark.

August’s market dynamics were influenced by a complex combination of factors. The Federal Reserve’s signals on the potential rate cuts in September varied, coupled with inflation concerns, created uncertainty among investors. Additionally, the tech sector’s recent rally showed signs of cooling, contributing to market fluctuations. However, assets classes such as Gold, Fixed Income, and Real Estate exhibited relative resilience, benefiting from their defensive characteristics, and adding positive returns to the strategy. The detractors from performance were some of the international markets, such as Japan, Europe, and Emerging Markets. While a few mid-month changes helped mitigate the risks, the Defender strategy continues to emphasize quality risk-adjusted returns while generating long-term growth.

As we move forward, we remain optimistic about the Strategy’s performance in the coming months. Given the ongoing macroeconomic uncertainties, we believe Defender is well-positioned to provide investor capital with deeper downside protection while providing steady growth opportunities.

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