The Exuberant Investor

Investor sentiment can often flip from one extreme to another with bewildering speed.

Just a week ago, investors were clouded with panic about an impending market correction. Fast forward a few days, and the mood has shifted dramatically to one of exuberance again.

This rapid change is mirrored in our proprietary Risk Aversion Index (RAI), which leapt from the Normal Zone into the Exuberant Zone in a mere flash, aligning with spikes in other key indicators like the VIX.

Yet, this investor enthusiasm arrives at a precarious time.

Inflation stubbornly overshoots the Federal Reserve's 2% target, and the latest GDP figures for Q1 paint a picture of an economy that's growing slower than expected.

These are classic harbingers of stagflation—a troubling economic scenario where inflation and unemployment rise while economic growth stalls.

While I can't fault investors for embracing optimism, a bit more pragmatism is warranted until stagflation threats are definitively off the table.

Understanding the Shift in Sentiment

In the financial markets, sentiment can be as volatile as the stocks and bonds traded within them.

The swift transition from fear to exuberance often puzzles even seasoned investors. To comprehend this rapid change, it's important to consider the factors that influence market psychology.

Media Influence and Market Sentiment

One significant driver of sudden shifts in investor sentiment is the media. News outlets and financial analysts play a crucial role in shaping perceptions, often amplifying the impact of economic data and corporate earnings reports.

When the media pivots from highlighting risks to accentuating positive developments such as all-time highs in the S&P 500 and the latest AI innovations, investor sentiment can shift quickly. This response is also fueled by the natural human tendency to react strongly to new information, particularly when it contradicts recent fears or confirms hopeful speculations.

Market Psychology and Herd Behavior

Investor behavior often mirrors broader psychological patterns observed in other areas of human activity.

The concept of 'herd behavior' is prevalent in the markets, where investors may follow the lead of the majority without fully analyzing the underlying data.

This can lead to overreactions—both to the downside and the upside. When key indicators such as the RAI and VIX swing dramatically, it often reflects a herd response to perceived opportunities or threats, rather than a balanced assessment of the market conditions.

Measuring Investor Risk Aversion

Quantitative indicators like the RAI and VIX provide a framework for measuring market sentiment in a more structured way.

These tools help investors and analysts gauge the degree of risk aversion or appetite in the market.

A rapid move from normal to exuberant zones in these indices can signal that emotions are running high, which may not necessarily align with the economic fundamentals. This misalignment is particularly important to recognize in times when economic indicators suggest a different story.

Take our proprietary Risk Aversion Index as an example. From about the end of October 2023 to two weeks ago, the reading was in the Exuberant Zone. It then flipped into the Normal Zone for two weeks, but as of last Friday, we’re once again in the Exuberant Zone.

A flip-flopping of the data is not unusual but serves as a warning sign that investor sentiment remains fickle, especially at a time when expectations for a rate cut by the Federal Reserve have not materialized as inflationary trends remain stubbornly high.

Economic Indicators at Play

The recent investor exuberance must be weighed against the backdrop of significant economic indicators.

Persistent inflation and underwhelming first-quarter GDP growth in the U.S. present a complex scenario for market participants. Understanding these indicators is crucial for making informed investment decisions.

Persistent Inflation Challenges

Inflation remains a stubborn issue, exceeding the Federal Reserve's target of 2%.

The latest reading of the Consumer Price Index came in at 3.5%. Another measure of inflation, the Personal Consumption Expenditures (PCE) came in at 5.84%. Excluding the volatile Energy and Food sectors resulted in an inflation rate of 3.7%.

This sustained high level of inflation affects various aspects of the economy, from consumer purchasing power to corporate profit margins.

Investors need to consider the longevity of these inflationary pressures as they can erode real returns on investments.

Moreover, high inflation results in a lower probability that the Federal Reserve will cut rates in the near future.

Disappointing GDP Growth

The recent GDP figures, which came in lower than expected, signal a slowdown in economic activity. The advance estimate of GDP came in at 1.6% significantly below the 2.5% expectation.

This deceleration can be particularly concerning when coupled with high inflation, hinting at the risk of stagflation.

While the U.S. is not currently in a period of stagflation, the combination of slowing growth and persistent inflation warrants attention.

Investors should be cautious, as such economic conditions can lead to volatile market conditions and challenge conventional investment strategies.

The Stagflation Specter

The term 'stagflation' conjures images of the 1970s, when the world grappled with the dual issues of stagnant economic growth and rampant inflation.

Today, while we are not yet declaring a period of stagflation, the signals—slow GDP growth amidst persistent inflation—are troubling.

Investors must be cognizant of the small but real possibility of entering such a phase and understand its potential impacts on their portfolios.

Stagflation is an economic anomaly characterized by slow economic growth and rising prices. Historically, such periods have been difficult for both policy makers and investors, as the usual tools for combating inflation, like hiking interest rates, can exacerbate an economic slowdown.

In today's context, with the Federal Reserve already in a tightening cycle, the potential for stagflation adds a layer of complexity to their policy decisions and investor strategies.

Impact on Investment Portfolios

Looking back at previous periods of stagflation can offer some guide for investor positioning and asset allocation in such an environment.

The separate oil shocks of the 1970s created two distinct stagflationary periods over that decade - characterized by high inflation, high unemployment, and low or negative economic growth.

During the first stagflationary period from 1973-1975, equity returns were muted and volatile - with the S&P 500 logging three separate double-digit declines and gaining just over 2% cumulatively during this stretch.

Meanwhile, bonds endured even steeper losses with the 10-year Treasury bond losing over a third of its value as consumer price inflation averaged around 9% over these three years.

Hard assets and commodities were the only places to hide, with gold bullion prices more than doubling amid double-digit inflation.

The second bout of stagflation in 1979-1982 was even more brutal for both stocks and bonds. The S&P 500 declined nearly 25% cumulatively over this four-year period while 10-year Treasury bondholders lost over 40% of their capital in nominal terms.

Even cash holdings suffered negative real returns as inflation topped out above 14% in 1980. Once again, hard assets like commodities and gold were the only places to refuge - with gold logging gains in excess of 100% from 1979-1980 as investors flocked to the "inflation hedge" trade.

One key takeaway from analyzing these historical stagflationary periods is that bonds suffered losses rivaling or even exceeding those of stocks - contrary to the popular narrative of bonds providing portfolio ballast in turbulent times.

The Implications for Investors

These economic indicators suggest a need for a more cautious investment approach.

While not our base case forecast, the prospect of stagflation materializing in the coming years can no longer be dismissed as a "tail risk" scenario. 

As such, investors may want to make portfolio adjustments as a hedge against this threat:

• Increase allocations to hard assets like commodities, commodity stocks, precious metals, and real assets/real estate that can act as inflation hedges.

• An allocation to TIPS (Treasury Inflation Protected Securities) also makes sense as the principal adjusts higher with inflation.

• Have ample dry powder in cash/short-term Treasuries to be opportunistic during risk-asset sell-offs if/when stagflationary forces intensify.

• Diversify globally as stagflation may impact countries differently based on policy responses, FX moves, and sector composition of equity markets.

Strategically preparing for stagflation involves recognizing the signs early and adjusting portfolios to be resilient under such conditions.

In navigating these challenging economic waters, investors must balance their exuberance with a sound understanding of underlying economic trends.

The Big Picture:

• Equities keep outperforming bonds. The dominance of US large-cap equities has been a key driver of the outperformance over the last decade.

• The best-performing asset class was Emerging Market Equities driven in part by a resurgence of the Chinese market. The MSCI China Index was up over 8% last week.

• The big losers last week were fixed income investors in particular those with international exposure.

• Cash is again outperforming bonds this year. Until there is more clarity as to the direction of Fed policy this situation is likely to persist.

• The investment environment has shifted to risk-on. Aggressive asset allocation strategies continue their outperformance. Investor risk aversion remains low by historical standards.

Economy:

• Last week saw increasing concerns over a slowing US economy. The Q1 GDP estimate came at 1.6% growth. The expectation was for 2.5% growth.

• The much-anticipated recession of 2023 never materialized, but a growth slowdown is bound to happen with an economy still adjusting to higher inflation, global supply chain shipping problems, and geopolitical tensions.

• Anecdotal evidence from recruiters also indicates a softer employment picture. Recent job reports have been strong but a change could be coming. The unemployment rate stands at 3.8%.

• Surveys indicate some caution by CEOs and CFOs in quarterly outlooks even though Q1 earnings have been strong.

• The other key concern besides growth regards the inflation outlook. Current measures are all north of 3% and have not budged in recent months. Break-even inflation rates in TIPS are going up. Inflation is trending in the wrong direction away from the Fed target of 2%.

Equities:

• More aggressive equity styles won out last week after the previous week’s beatdown. 

• The Russell 2000 eked out the S&P 500 by 0.1% last week but remains way behind for the year.

• Growth outperformed value once again as growth-oriented sectors such as Tech and Consumer Discretionary recovered from the prior week's losses.

• We’re past the halfway mark for Q4 earnings. According to Factset, this earnings season has been trending well above expectations. The percentage of S&P 500 companies reporting positive earnings surprises and the magnitude of earnings surprises are above their 10-year averages.

• On the international front, the Chinese equity market continues its rebound as investors become more confident about China's growth prospects. The housing market is, however, still in poor shape due to over-building and leverage concerns.

• Last week the MSCI China Index was up 8.2%, the best among major global markets. The index is now up 4.4% for the year significantly boosting the performance of emerging market strategies.

• Overall global equities are performing well this year with the MSCI ACWI Index (all countries) up 5.4% for the year in US dollars.

Bonds:

• The Federal Reserve is on this week with no eminent rate cuts on the horizon. The economy is still growing and inflation has remained sticky (> 3% ). There is no rational reason for the Fed to cut rates right now.

• Long-maturity bonds continue to lose money as interest rates have continued to rise. For example, in April, the 10-year US Treasury has risen 0.46%. The U.S. Treasury 20+ Year Bond Index (TLT) is down almost 10% year to date.

• In comparison, short-maturity strategies such as the U.S. Treasury Short Bond Index (SHV) are doing much better. The SHV ETF is up 1.41% for the year.

• Equity-oriented fixed-income strategies such as High Yield and Preferred outperformed last week.

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