Tight Spot

Tight Spot was an outdoor installation by David Byrne, sponsored by Pace gallery for two weeks at the end of September 2011. It featured a giant inflated globe, pinched under the High Line in West Chelsea on 25th Street. As ambience, Byrne had a pulsing beat play from subwoofers. A heartbeat of sorts. Spectacular, ominous, foreboding, humbling, human.

I’m surprised investors have been able to shrug off escalating aggression in the Middle East. As direct military engagement ratchets up, a tight spot is exactly where we find ourselves. Known unknowns can only be brushed off for so long.

The current market headline grabber was the U.S. September employment report. Positive prints exceeded all expectations. Those came with upward revisions to July and August data as well. The narrative of a Fed behind the curve in the face of a weakening labor market was just turned on its head. That took the froth off expectations for a 50bps cut in November.

My fair value target for 10-year U.S. Treasury bond yields holds at 3.75%, +/-25bps. We’re bouncing around the top end of that range. The recent yield increase we’ve seen reflects an economy on solid ground, not one facing imminent recession. It also reflects an unwind of the flight to safety bonds benefited from as tension in the Middle East quickly escalated. We may find ourselves back there again.

We trimmed back the equities we bought in the early August sell-off. We’re being disciplined, holding risk reins tight. I’m constructive on the outlook, in particular for the U.S. But I’m paying close attention to the known unknowns given valuation levels. Geopolitics and U.S. elections are center stage.

Escalating violence will continue to alarm risk-takers. It should. Safe havens initially rallied but not to a degree that screamed alarm. Longer-dated U.S. Treasuries stand out as a sentiment tipping point of sorts. U.S. Government bond yields continue to lean into Fed easing and economic strength. Also, the defeat of lingering ‘recessionistas.’

Energy prices too can serve as sentiment indicator. Oil prices are jumpy, but we haven’t seen the marked move up we saw when Russia invaded Ukraine. We run the risk of a repeat should things in the Middle East spiral. With the U.S. Strategic Petroleum Reserve at about half its capacity and global crude inventories below last year’s levels according to Bloomberg, a run of the ‘scaries’ may readily give a boost to prices.

The European Central Bank’s President Christine Lagarde squarely put rate cuts on the table for October. The Bank of England’s Andrew Bailey too signaled proactive policy rate cuts ahead. With the Fed seemingly intent to cut at its meeting in November, risk assets are doing their best to hold onto a loosening monetary policy narrative. It provides running room for growth.

I’ll point out that rising geopolitical tail risk and an environment where G-7 central banks, not to mention China, seem aligned on easing takes pressure off the dollar. Tail risk adds upside to the dollar in another flight to safety.

We’re neutral the dollar across portfolios, having been overweight earlier this year. We’re fully invested in bonds, targeting specific pockets on the curve and credit markets. On an absolute basis we are neutral duration, with offsetting short and longer maturity positioning to manage volatility.

Core bonds are playing their reinstated role as a risk diversifier in a multi-asset portfolio. It seems ‘too cute’ when I hear pundit calls for ultra long (or short) duration. We’re playing pockets across the yield curve, offsetting positions to navigate what I expect will continue to be very bumpy markets.

We’re intentionally not taking big tactical bets right now. Our largest risk position is in investment grade and extended credit across developed and emerging markets. That feels like the right place to be with investor sentiment, tail risk and valuation levels each in a very tight spot.

Disclaimer

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