Class Warfare

”This is a horrible suit, darling. You can’t be seen in this. Fifteen years ago, maybe, but now?”

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We have discussed the Nifty Fifty growth stocks in the 1970s, called “one-decision” stocks that would outperform over the long haul. It turned out they did not outperform, but in terms of asset class choices, U.S. equities have fit the “one-decision” description over the last 15 years.

During the second half of 2008 15 years ago, the S&P 500 began a tremendous rally against commodities (see green line below). Six months later, in Q1 2009, the S&P 500 began a tremendous rally against bonds (see blue line). Emerging market (EM) equities outperformed the S&P 500 for years, and continued until October 2010, before the asset class was trounced by U.S. stocks for the last 13 years (red line). Notably, the S&P has outperformed the China ETF FXI since global markets peaked in October 2007.

From the monthly chart above, commodities outperformed U.S. equities during a stretch from 2021 through the first half of 2022, but that trend has reversed too.

Additionally, any time a manager decided to allocate away from the U.S. to other developed markets, it has been a terrible mistake, as seen in the chart below:?

One last chart: Let’s examine a weekly EEM/SPY chart from 2005, which tends to display long trends:

There have been brief periods of EM equity outperformance since 2010, as highlighted by the circled areas, and 2017 through Q1 2018 saw the EEM ETF rally and then hold its own against U.S. large caps (see the rectangle above). However, as with other asset classes, it has been a one-decision dynamic: overweight U.S. equities.

So now, is the 13th time a charm? The underperformance in EEM over the last 13 years is indicative of a deflationary growth regime where credit spreads contract due to improving business conditions, but companies do not have pricing power, due to globalization. EEM tends to outperform during periods of inflationary growth. Oddly, only commodities responded to an inflationary growth scenario in 2021 and 2022, but there was no participation from EM equities due to China’s lockdown.

There is no denying China’s influence in driving the entire EM asset class. A bet on EM is a bet on China. We are watching EM versus the U.S. closely now. If our fundamental and technical models turn, we will be advocating for a major change in trend.

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A Note About the Nasdaq Rebalance

The third “special rebalance” in 25 years triggered on July 3 when the market capitalization of the top six stocks in the NASDAQ exceeded 48%. On July 24th, the rebalance will drop that group’s weight, which was 51% on July 3, down to 40%, a reduction of 20%. When this rebalance happened in May 2011, it coincided with a 20% selloff into October 2011. When this rebalance occurred in December 1998, there was no negative impact on the rally off the EM-crisis lows that started in October 1998.

We remain concerned about this rebalance for a few reasons, but the one that really bothers us is that volatility has a seasonal tendency to bottom in July and move up into October. Volatility-balanced funds are currently overweight equities, hence outflows could become a significant trigger event. The 3-month realized volatility level is extremely low, with only three returns that are greater than 1.5% over the past three months. That means volatility control funds will be dumping stocks quickly into any daily selloff that is greater than 1.5%. Additionally, the CTA community will pile on top of the selling if this NASDAQ rebalance of mega cap tech stocks sparks a market correction.

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CPI: Enjoy It While You Can

The inflation data looks good, until you really start looking. The CPI data sparked tremendous investor enthusiasm that inflation is, in fact, cooling down to the point where the Fed can step away from its hiking campaign:

First, the inflation numbers released Wednesday morning for headline and core (excluding food and energy) were both below expectations. Used cars had been pushing up goods CPI, and they fell a hefty 0.5% from last month. Shelter and rent (housing related) inflation has not fallen as expected, but most believe it is simply a matter of time before it joins used cars in pushing inflation down toward the Fed’s 2% goal. To get into the weeds, new leases had started to come down, but they are recorded into CPI data with a lag, which has formed the favorable view that housing will no longer contribute to higher inflation. However, new leases have started to firm up again. We believe this false hope that turns into disappointment based on the reality of sticky inflation will spread to other areas in the inflation report.

Second, Core Services ex-housing was flat for the month, and the market perceives that the Fed weighs that number very heavily in their policy decisions. We believe the data flow will support the Federal Open Market Committee’s (FOMC) forecast calling for two more rate hikes, perhaps more.

Upon closer inspection, we are concerned that yesterday’s celebration is misplaced. We believe that within a few months, inflation can hook back up again based on energy prices. Lower energy prices have fed through a wide array of industries and have been in the background helping drive down goods inflation. Even if energy prices stabilize, the beneficial aspects of the drop in energy prices will evaporate, and CPI can ascend again, which will scrap the reason driving so many to add risk to their portfolios in the hope that inflation has peaked.

Pave’s CIO downloaded the components of the inflation data on the Bureau of Labor and Statistics website, and noticed some interesting things:

Looking at the major components of inflation, he found that energy, while having a relatively small 7.5% weighting in the CPI calculation is down -16.6% y/y, and fuels are down over -25% y/y. Shelter, with roughly three times the weight of energy, is running at 7.8%, and its key component, owners’ equivalent rent, is also at 7.8% annual inflation. These key categories of energy deflation and shelter inflation stand in contrast to headline inflation across all categories at a 3.0% annualized rate and excluding food and energy, at a 4.8% rate.

We noticed that the largest energy datapoint over the last 2 years fell out of the calculation for June 2023, and the second largest number will be coming off the July CPI number released in August. Assuming no change in energy inflation, as these large readings fall out of the calculation, their year-over-year deflationary impact will be sliced in half for the August report and could cause an increase of 0.5% in the headline reading. That report is released before the September FOMC.

If energy happens to rise, not only will its impact on headline inflation be higher, but it will flow through other categories such as airlines, increasing inflation in the core data. It is not surprising that airline fares have fallen -17.5%, tracking fuel prices. Airline fares will see inflationary base effects similar to energy prices. Note that the August report comes out a week before the September 20 FOMC meeting.

Additionally, we think the Fed realizes their rate hikes will have a lagged effect, and labor demand and spending will continue to keep services inflation too high in the near term. Wednesday’s CPI number has superficially bolstered perceptions of a soft landing, but the potential for a hard landing is very much alive.

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Peter Corey

PavePro Team

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