OVOM Research: October 2024 Monthly Markets Outlook & Asset Allocation Strategy

Global Market Performance Heatmap: Chinese Equities & Precious Metals Lead

Monthly Macro Summary

US macroeconomic data this month was largely deflationary, as September’s ISM manufacturing PMI remained in contraction at 47.2 and the component readings of ISM’s monthly report. Employment plunged to 43.9, new orders modestly increased but still weak at 46.1, and prices paid fell significantly from 54.0 to 48.3. Consumer sentiment from the University of Michigan’s monthly survey is also continuing to hint at a recessionary and while up significantly to 67.9 from 50.0 – the lowest reading in the survey’s history – this remains lower than the trough of the Korean War recession, tech bust, C19 pandemic recession, and is at similar levels to the S&L crisis trough.

Notably, many leading indicators from the component readings of the ISM PMI & UMich consumer sentiment survey are historically correlated to US GDP and the S&P 500, as shown in several charts below. The majority of these charts highlights a disconnect between either US GDP or the S&P 500 being disconnected from those leading indicators and implying we might expect a slowdown in the coming quarters.

Aside from the continuing challenges and deflation we’ve seen in the US labor market, the past month’s CPI inflation data reaffirmed the same. Headline CPI inflation Y/Y came in at 2.5%, versus 2.5% expected and 2.9% in the prior month. Core CPI inflation Y/Y came in at 3.2%, in line with 3.2% expected and 3.2% prior month readings.

We think it’s notable that CPI inflation in the 2020’s is continuing to follow the path of CPI inflation in the 1970’s, primarily because of the Fed’s aggressive easing cycle. In the 1970’s, inflation bottomed as the Fed began cutting rates. In the 1970’s broader consumer prices rising – specifically oil prices – didn’t lead to US economic growth accelerating. To the contrary it led to recession and we see many similar macroeconomic risks present in the current cycle.

If the US labor market continues to soften, which is what we expect in the near & mid-term, coupled with rising consumer prices that could be a nightmare for risk assets. Outside of recent softening in JOLTS labor market data, as well as employment components in manufacturing and housing, annual US employment revisions generally provide a good idea of broader US labor market health. That would be unfortunate if that turns out to also be the case in the cycle, considering we recently saw annual US employment revisions come in at -818k, a figure not seen outside of the -902k during the 2008 GFC recession in any year dating back to the late 1970’s.

Despite the ongoing deflationary readings from historic leading economic & labor market indicators, US economic growth – via US GDP – has been quite strong. The final revision to 2Q24 US GDP came in recently at +3.0% Y/Y, versus 2.9% expected and 2.9% in the reading prior to the revision. It’s not that impressive relative to US economic growth since the C19 pandemic recovery began, however still quite impressive relative to longer-term averages. While we would certainly reiterate future inflationary risks and dangers with continuous deterioration in leading economic indicators, strong real economic growth (GDP) highlights our belief that the US economy is moving through a very thin ‘Goldilocks’ macro cycle.

Finally this past month marked the beginning of the US Fed’s easing cycle, which began with an aggressive 50bps rate cut. Therefore the total length of the Fed pause this cycle was 14 months (July 2023 FOMC – September 2024 FOMC), which is almost double the average time period between the US economy entering recession and the last Fed hike in prior cycle dating back to the late 1960’s. However that doesn’t mean the US economy is out of the woods yet, considering the onset of the 2007-08 GFC / Housing Bust began 18 months after the last Fed hike, not to mention in that cycle the US equity market peaked even later at 23 months after the last hike. If we do see a recession, at least from a timeline perspective we believe the current cycle could closely follow the 2007-08 GFC.

US Equity Market

US equity markets are all performing very well 2024 YTD, in fact the S&P 500 is having it’s best start through the first three quarters since 1997. Large-cap US equity market indices, specifically the NASDAQ Composite, NASDAQ 100, S&P 500, & Russell 1000 are all up over +20% 2024 YTD. Equal-weight indices and small-caps are up between +7.8% - 14.8% 2024 YTD. Sector level performance in the S&P 500 has broadened quite significantly from just the “Big Tech/AI” trade that dominated 2023 and much of 2024, however only Utilities and Communications Services are leading the S&P 500 composite. Financials, Industrials, & Information Technology follow closely behind and all three are up over +20% 2024 YTD.

Considering this streak of excellent performance combined with elevated levels of market risk, we expect investors to broadly begin considering reallocating some portion of their US equity market portfolio to other global equity market areas (particularly hedge funds). China’s recently announced economic stimulus plan may have come to the rescue, as a sustained revitalization of China’s economy is non-dispensable to broader emerging markets beginning a meaningful rebound. In the meantime Chinese stocks – whether you look at CSI 300, or an ETF like FXI (China Large-Cap Equities) – saw their best daily (as well as 5-day rolling) performance in its data history [chart below].?

China’s most aggressive round of economic stimulus since the C19 pandemic was led by the announcement of 2 trillion yuan (~$284.43) in new bond issuances. If this does lead to a sustained rebound in China’s economy and by extension China’s equity market, there could be very significant upside from here focusing on valuations. MSCI China is currently trading at 12.1x earnings, which is below its 10YR median of 12.7x [Trailing 12m P/E]. Not only is this valuation much more appealing than US equity market indices like the NASDAQ 100 currently trading at 43.7x earnings, but this is also significantly higher than its 10YR median of 30.6x [Trailing 12m P/E]. A historically inexpensive market that’s also underpriced future economic growth could result in exceptional returns in the current environment, so we’ll certainly be watching ongoing developments in China very closely.

Commodities & Precious Metals

We’ve attributed a “triple threat” of economic challenges, which are fundamentally driving our bullish macroeconomic outlook for precious metals, to a longer-term bullish thesis for precious metals:

• Public debt crisis similar to peak following WWII in 1940’s
• Inflation potentially bottoming with incoming Fed cuts (exactly what happened in 1970’s stagflation-era)
• Historically elevated risk asset valuations similar to peak’s preceding 1930’s Great Depression & 2000’s tech bust.

We also found changes in gold prices do have some correlation in changes to broader consumer prices (inflation). The historic relationship is far from perfect and there are some time intervals where it can vary quite considerably, which we feel is worth noting because we remain bullish on precious metals; inflation notwithstanding. More specifically – as the chart below demonstrates – gold prices rising have preceded broader consumer price changes. Despite demand dynamics for gold and precious metals varying quite considerably from daily consumer prices, which we believe will bode well for gold in the current cycle.

When we talk about commodities in this cycle, there’s an important characteristic to distinguish between price pressures on precious metals and assets like crude oil and the US Dollar. If we do see more deflation in the pipeline, as one of the charts below demonstrates we would expect yields, crude oil, & the USD to all continue moving lower along with inflation. Conversely falling yields have historically been very bullish for precious metals and even though it’s still early in the current easing cycle, silver and gold prices have responded positively to yields/rates falling.

Lastly we think it’s notable that in prior precious metals “supercycles” we’ve always seen gold lead, but silver followed and outperformed gold on a relative basis both post 1970’s stagflation GFC & 2007-08 GFC and we’re seeing a very similar dynamic unfolding today. In addition to historic performance, silver has more upside today as it’s still considerably lower than its ATH, while gold is trading at fresh ATHs and breaking new milestones on a regular basis lately. Even if the path followed in this cycle doesn’t overlap with the two mentioned above, silver remains underpriced relative to gold, so if we expect gold prices to continue rising we should expect silver to continue moving upward from that fundamental relationship alone.

Asset Allocation Strategy

Given everything discussed above we believe the US economy has benefitted from a ‘Goldilocks’ regime through most of 2024 thus far, where prices come down while economic growth continues rising. However our macroeconomic models – based on leading indicators – continues to highlight an elevated risk of ‘disinflation’ turning into deflation and US economic growth could slow down from here. That assessment could change given the onset of the Fed’s recent easing cycle, but the lag at which monetary policy operates suggests it could be some time until we see lower interest rates positively impacting the business cycle.

Nonetheless, below are detailed returns in both US equity and fixed income markets from recent Fed cutting cycles. From this data it’s clear that historically fixed income has benefitted most in the next 12 months with 0 down years since 1980, which we don’t find surprising given that bond prices are historically derived from i) inflation and ii) interest rates. Lower Fed Funds rates naturally pushing US Treasury yields lower and in turn bond prices rise on a relative basis. While some have called this dynamic into question due to concerns over uniquely high US Treasury issuance levels, we don’t think that will overpower significantly lower interest rates. With positive fixed income performance back in the picture, multi-asset portfolio’s could be poised for longer-term outperformance from here.

With all that said, we believe it’s very prudent to maintain a multi-asset strategy with asset allocation focused to areas of each market that have positive underlying fundamentals. That strategy led us to identifying the Communications Services & Utilities sectors of the S&P 500 and we’re very pleased they’ve been the top 2 performing segments 2024 YTD. We’re also confident we’re finally at the point in the cycle where we should see fixed income market performance reverse, which has really been the only laggard to our multi-asset portfolio. All-in-all, we maintain our ongoing asset allocation strategy: 35% Equities, 30% Fixed Income, 30% Precious Metals & Commodities, & 5% Unique Ideas.

The dynamics in the fixed income market appear relatively straightforward for us and despite equities performing quite well in our portfolio, that’s likely where we may look to make changes in upcoming months. As we mentioned above, we like what’s happening in China now with the economic stimulus, which could cause us to reconsider allocating capital to emerging markets. We’re also interested in US equities that are historically interest rate sensitive and may have been suffering from higher rates to this point, like Real Estate, Materials, & Small-Caps.

Thank you as always for taking the time to read and participate in my monthly markets’ newsletter. Hope you enjoyed this month’s update and if you have any questions, feedback, concerns, etc., please don’t hesitate to email me at:

[email protected]

Best of luck to all market participants this upcoming week, month, & year!

Disclaimer: The information and publications are not meant to be, and do not constitute, financial, investment, trading, or similar advice. The material supplied is not intended to be used in making decisions to buy or sell securities, or financial products of any kind. We highly encourage you to do your own research before investing.

Disclaimer: Returns from ETFs do not match the index they’re meant to track on a 1:1 scale. ETFs contain shares of securities comprising a given market metric an ETF is tracking and the composition of the ETF is often not identical to the index its tracking. For example, SPY (SPDR S&P 500 ETF) tracks the S&P 500. A committee ultimately agrees on the companies from the S&P 500 included in the ETF, using guidelines including liquidity, profitability, & balance.