Kensington Asset Management

Synchronizing Global Forces


Geopolitics

The Russia-Ukraine conflict recently passed the 500-day mark with both sides further entrenching themselves in battle amid little signs of immediate progress. At the same time, domestic pressure on Putin is increasing as the stalemate lingers, with casualties increasing and few signs of progress. This pressure was nowhere more evident than in the putsch staged by the Wagner mercenary group and its head Yevgeniy Prigozhin. While seemingly nothing of note came from the contretemps – Putin forgave and said it was all a misunderstanding – it was shocking to most experienced onlookers how public the aborted mutiny was and Putin’s almost conciliatory steps to end it.  In the meantime, the West agreed to deliver cluster munitions, long-range missiles, tanks and vehicles to the Ukraine, while holding off on extending an outright invitation to join NATO so as to minimize the risk of Russia escalating the conflict beyond the current theater. In retaliation, Russia halted the Black Sea grain deal that allows grain to flow from Ukraine to countries in Africa, the Middle East and Asia where hunger and high food prices are a growing security threat as more people find themselves pushed into poverty. 

Switching to China, the country continues to struggle economically, as it deals with structural imbalances in the form of an over-leveraged real estate sector and weak consumer demand on top of slowing export growth. Richard Koo, the highly regarded economist who coined the phrase “balance sheet recession” back in the 1990s, when describing the travails of Japan’s economy after its stock market bubble burst leading to years of sub-par growth, has recently said China is suffering from a similar malady: the enormous amount of debt taken on during the country’s real estate boom years is now acting as a significant drain on private demand as loan principal and interest is either repaid or canceled. Because of this, Koo is suggesting the Chinese government quickly step in and implement aggressive monetary and fiscal measures to stimulate demand or risk a repeat of Japan’s lost decade. China is in a fortunate position to do exactly this as inflation is falling rapidly (see chart below). At the same time, however, authorities are increasingly concerned about the weakness in the Yuan, so any policies to stimulate the economy must consider the impact on an already sliding currency. All this has been reflected in the relatively poor performance by China’s stock markets in the first half of 2023, with the Shanghai Composite Index gaining a lackluster 3.7%. 

Stock Market

Stocks rallied strongly in June with all the major indices registering mid single-digit gains: the Nasdaq 100and S&P 5002 nearly matched each other, up 6.49% and 6.47% respectively. For the first time in many months, the Russell 2000 Small Cap Index3 outperformed the large-cap indices, gaining 7.95%. Overseas bourses didn’t fare quite as well with the MSCI EAFE Index4 advancing 3.6% and the EURO STOXX 505 gaining 4.29%.

The strength in equities was due in large part to better than expected economic reports juxtaposed with an inflation backdrop that, while still elevated, is trending very much in the right direction. The ISM Services Purchasing Managers Index6 rebounded in June to 53.9, the strongest reading in four months and well above forecasts.  Core PCE, the Federal Reserve’s preferred measure of inflation, rose 4.6% YoY in May, far higher than their long-term target of 2% but still lower than consensus expectations of 4.7%.

Looking at more recent inflation data, however, the picture is much brighter. If one were to take the latest month’s Core-CPI report and annualize it, inflation actually came in at 1.9%, below the Fed’s 2% target for the first time since February 2021. Shelter inflation, which comprises 44% of Core-CPI, tends to lag changes in housing costs and is serving to inflate current overall inflation readings. If we were to remove these costs – which remain elevated at 4.4% – entirely from Core-CPI to obtain “super core” inflation, we can see in the graph below prices in the overall economy are actually experiencing a small deflation of 0.02% (m/m, annualized), the first such decline since January 2021.

“Super core” (blue), Core Services, ex-Shelter (red), and Shelter (green) (m/m, ann.)

One interesting data point accounting for why so many have wrongly called for a recession in the first half of 2023 is provided by the chart below. The stimulative impact of fiscal policy as seen in programs such as the Inflation Reduction Act has led to a boom in nonresidential investment, especially manufacturing. Together with government policies designed to encourage the on-shoring of American business, the result has been a boost to GDP growth even in the face of much higher interest rates and a slowdown in bank lending.  

Many investors are now wondering if we’re still in the bear market that began in 2022 or if we should characterize the current market as a new bull. As shown in the graph below bear-market rallies generally do not retrace more than half of their preceding declines.  As of June 30, 2023, the S&P 500 cap-weighted index has retraced approximately 65% of the 2022 decline, exceeding all previous bear-market rallies since the 1920s. From a purely technical standpoint, it’s becoming more and more evident October 2022 marked the bottom of the bear market. 

Looking forward, Q2 earnings season is upon us and it will be an important one as we now are some 15 months from the start of the Fed’s monetary tightening program. History indicates the impact of major tightening programs generally evidences itself 15-18 months out, so the drag on corporate earnings should start to show up beginning now. Of course, analysts’ earnings forecasts have adjusted accordingly with Q2 earnings expected to drop 8% year over year, but it is here where bulls and bears part company. Bulls believe earnings will begin rebounding in Q3 while bears believe earnings will continue declining in the last two quarters of 2023 leading to a retracement in overall markets. Corporate guidance provided by management for the rest of the year will be especially meaningful as a result.

Fixed Income

In contrast to the stock market, fixed income indices were mixed in June as interest rates moved higher. The benchmark 10-year Treasury lost -1.15%, the 5-year Treasury declined -1.32% while investment grade corporate credit fell -0.36%. At the same time, more credit sensitive sectors such as high yield and leveraged loans outperformed, with the Bloomberg High Yield Index7 gaining 1.67% and lower quality indices performing even better.

Credit spreads continued their downward trend in June.  Since peaking in March in the midst of the regional banking crisis, high yield spreads have come in close to 100 basis points and are approaching the lows in this cycle. Normally this long into a Fed tightening cycle, these spreads would be expected to widen in anticipation of a more difficult business environment ahead. However, spreads have done just the opposite, correctly signaling it is not yet time to worry about a hard landing in the economy.

Part of the reason for lower grade credits’ outperformance can be attributed to the Federal Reserve and the initiatives it put in place during the aforementioned banking crisis. In order to stop a run on small and regional banks due to depositors’ fears about the health of these banks’ capital bases, the Fed agreed to effectively swap cash for the deeply underwater fixed income securities held in these banks’ portfolios.  This re-liquified banks and together with the large Treasury’s General Account refunding going better than expected, was very supportive of corporate credit and asset classes in general.  

Federal Reserve and Monetary Policy

The Federal Open Market Committee (“FOMC”) paused their rate hiking program in June, with the rationale policy measures were beginning to take hold to slow inflation in the economy, plus a recognition the recent banking crisis might result in a pull back on lending acting to slow the economy further.  

Chairman Powell took pains to point out this pause was temporary and the FOMC would act to raise rates again if recent gains in reducing inflation were reversed. Here the news on both the consumer and industrial side of the economy has been encouraging. Of particular note are the ISM Purchasing Managers Index prices paid sub-indexes. While prices have been dropping over the past year on the manufacturing side of the economy, it’s only been relatively recently we have seen a noticeable slowdown in prices paid in the service sector, which is particularly welcome news given the dominant role services play in the overall U.S. economy.

At the same time prices are declining, consumer spending continues to be fairly healthy bolstered by strong wages. The average hourly earnings of employees grew 4.4% YoY in June, the same pace as in May, and disposable personal income growth posted a solid 8% YoY.   

Managed Income Strategy

As we noted last month, the US High Yield sector has recently been exhibiting rangebound activity. After a downtrend during the middle of the month, the sector began a strong positive trend, which was enough to bring the Managed Income model back to a “Risk-On” position at the conclusion of the month. In response to the “Risk-On” signal, the portfolio has been repositioned to include predominantly US High Yield, but also holds some diversifying positions, such as floating rate debt and investment grade corporate debt. We are encouraged that the high yield market could show further gains in the near term. Nevertheless, we remain vigilant and if prices reverse course, we will not hesitate to switch to a “Risk-Off” status if conditions warrant.

Dynamic Growth Strategy

Continued up trends across the equity markets, coupled with lower relative volatility, produced a “Risk- On” signal for Dynamic Growth very early in the month, and the Strategy remained positioned in a fully-invested position at month end as equity markets remained strong across the board. For the first time since the bear market began in late 2021, there are signs of broadening strength in equites. That’s an indication that the recovery that has been underway for the last few months could have further staying power. If so, Dynamic Growth should continue to benefit. The possibility of recession and higher interest rates in the medium to long term cannot be ruled out, but if a reversal of market conditions occurs, we will rely on the strategy’s “Risk-Off” metrics to go to a defensive position.

Active Advantage Strategy

The Active Advantage Strategy spent the month of June invested primarily in an opportunistic position, with approximately 20% of the portfolio invested in Nasdaq index instruments, with the remainder in cash. During the month, equities continued to rally, while fixed income remained rangebound. However, toward the end of the month, Active Advantage added on investment in US High Yield, at an approximate weighting of 20%. This resulted in a cash position of approximately 60% at the end of the month. Subsequent to the end of the month, the Active Advantage Strategy added incremental exposure, resulting in a fully invested position. As of this writing, Active Advantage is positioned in a more traditional “balanced” portfolio, with approximately 60% in equities and 40% in fixed income.  

Defender Strategy

As discussed last month, Kensington recently launched its fourth investment offering, the Kensington Defender Strategy (“Defender”). Defender is a tactical global allocation strategy that seeks capital preservation and total return through both capital appreciation and income. The Strategy uses a momentum-based approach to tactically shift its allocation across twelve asset classes, including domestic and international equities, real assets including real estate, commodities and gold, and fixed income securities. Additionally, the Strategy will shift defensively, allocating a portion or all of the portfolio to cash and Treasuries when global momentum trends weaken. Entering July, the Strategy increased its overall market exposure on strong global trends and maintains allocations across domestic, international and emerging market equities as well as gold.  


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