Time to rotate? If so, how?

After a rather eventful week in financial markets, many investors are wondering whether they should adjust portfolios – if at all. I will attempt to summarize what happened in recent weeks and offer some simple food for thought regarding potential rotation strategies.

First, a rare picture emerged on screens on July 11 with small caps rallying close to 3% while technology stocks dropping nearly 2% right after a better-than-expected June inflation print, boosting market confidence that the much-awaited cuts from the Fed would come soon. That trend continued throughout the rest of July. Small caps jumped 10% and technology stocks fell 5%. In turn, rate sensitive sectors like real estate and utilities rose 6-7%.

On Thursday, August 1, the July ISM manufacturing PMI – a very important leading indicator of the health of the overall economy – printed two points weaker-than-expected at 46.8 and accelerated a downward trend that had started in April. That marked four straight readings below the expansion-mode threshold of 50. The components were also weaker, particularly employment and new orders. Futures markets started pricing a probability of 32% that the Fed would deliver a cut of 50 basis points on September 18 – such probability was zero previously.

On Friday morning, employment data for July surprised to the downside too. Payrolls came in at 114,000 vs. expectations of 175,000. Prior readings were revised downwards, and unemployment rose two-tenths to 4.3%. Swiftly, futures moved to a Fed cut of 50 points in September with 70% probability.

Ironically, such dynamic took place only two days after the Fed had left rates unchanged on July 31. In fact, during the press conference, Chair Powell, while leaving the door wide open for a 25 point cut in September, said the committee was not thinking of a scenario of a 50-point cut.

Several banks have quickly adjusted their Fed forecasts over the weekend towards more and deeper cuts starting in September. Some even warn of the risk of an intra-meeting cut – probably far-fetched at this point but it is clear the Fed is now substantially behind the curve (some like J.P. Morgan argue that up to 100 points). Recall that the last time the Fed had to cut by 50 points in a surprise move was in March 2020…

Naturally, many asset classes traded in classic risk-off mode late last week. VIX spiked almost 10 points to 29, CDS on high grade credit surged like last October, equities bled (S&P -3%, Nasdaq -5%, semis -10%), the yield on 10-year treasuries dropped close to 40 basis points to 3.80% and the yield curve (2-year vs 10-year) is now nearly flat. The re-steepening of the yield curve after staying inverted for almost 16 months with front-end rates dropping quickly in response to weak economic data is a very dangerous development in terms of implied economic prospects.

The Mexican peso dropped by 4% and breached 19.0 – a level it scratched but failed to break post MORENA’s landslide win back in June. Conversely, the Japanese Yen rose 5% in the week following a bigger-than-expected 15-point hike by the Bank of Japan – the country is in a different monetary cycle than the rest of the world, but Japanese equities dropped 6% last week. Notably, gold continues to hit fresh record highs and copper was warning caution since mid-June.

Perhaps this episode will end up in only a brief growth scare and does no long-term wealth harm. However, investors should sit back and assess the interaction of the following factors: the aggregated price action across assets in recent weeks, the underlying economic trends of the past few months, the stage of the global economic cycle, the substantially narrow and concentrated leadership of the past year and a half in equities, high valuations and mixed earnings prospects, the uncertain geopolitical and political events ahead, and the typical volatility we tend to see around the summer season.

There are at least six frameworks that investors should consider regarding potential rotations in portfolios. Each one merits a deeper analysis, but I will stick to the key points for the sake of space and time.

1.????? Rotate within tech. It may be time to be more selective among AI plays, especially with mounting astronomical capex figures being reported with an uncertain path and timeline to profitability in many cases. The MAMA complex (Microsoft, Amazon, Meta and Alphabet) has increased combined capex by 50% year-on-year to $100bn in the first half of 2024. But semis just entered bear market territory and Nvidia just informed Microsoft about chip delays due to design flaws. Intel’s massive drop of 26% on Friday does not help either (it has different issues, though). It would be wise to let the space take a breather and tweak positions and look for entry points into stocks with the best combination of growth, valuation, diversified revenues streams, higher relative visibility on AI-driven returns, intensity of AI-related capex, among others.

2.????? Rotate within sectors. Defensives sectors and others like utilities, healthcare, med tech, and real estate are acting well. Balance valuation, secular growth, AI-leverage, demographic tailwinds and sensitivity to rates. Stick with high quality tech but diversify more broadly. Equities were just starting to branch out to more sector breadth and less concentrated leadership. If the soft landing case stays alive in the end, tech and semis should share some of the leadership with some cyclical stocks.

3.????? Rotate within regions. The quality and sophistication of tech and other features in the US remain unmatched globally by far, but some gradual tilt or diversification into secular growth regions like East Asia (e.g. India) and beneficiaries of the likely continuation of reshuffling of supply chains and a select spice of turnaround stories like Europe could help too. Some domestic stories in China may work. Japan, while a source of funds for now given significant outperformance, still has some positive structural advantages.

4.????? Rotate within styles. Solid growth features and visibility should continue to be a priority in screening stocks but given the stage of the cycle and the current environment, value stocks are starting to outperform. GARP (growth at a reasonable price) styles should pay off. Quality and sustainable growth dividend strategies could outperform momentum.

5.????? Rotate within size. Small caps came back with force last month only to give back a third of the July gains on Friday alone. Valuations help but, if they do come back, features like growth, quality and less fragile balance sheets will demand a premium. Renewed doubts on soft landing do not help smaller companies but should a red sweep materialize in November, lower taxes and regulation, coupled with a more aggressive stance on tariffs could help more domestic-focused companies vs. big multinational corporations.

6.????? Rotate across asset classes. Finally, tactical weight shifts across assets could pay off amid volatile markets. Duration outperformed last week finally but watch for structural challenges regarding debt and fiscal constraints in developed markets in relation to longer-dated fixed income. Probably the belly of the sovereign curve offers better risk reward still. High yield was already trading tight and is at particular risk now. Private markets may offer some protection to volatility in liquid markets, but some lower quality strategies may suffer too eventually. Global infrastructure funds are in vogue for a reason – they tend to offer more stable and visible cash flows in defensive industries while offering some sector diversification and even high quality AI and data center exposure if needed. Precious metals could continue to outperform at the expense of industrial commodities. And for those still in need to expand the asset allocation mix, alternatives will offer opportunities, especially secondaries amid potentially dry exit avenues in public markets. Manager due-diligence, deal structure and asset quality will be paramount.

Markets can stay highly fluid for longer. One week does not necessarily mark a trend or inflection point, but the recent price action does cast some doubts regarding the otherwise ubiquitous soft-landing narrative, has the potential to trigger unwinding of heavy positioning in many assets and is a perfect excuse to consider some rotations like those mentioned above. Yes, patience pays in the long run, but so does shrewdness through tactical moves at times like this.

In the end, the specter of outcomes is wide. This market episode may turn out to be either a window for what many have referred to as the “Great Rotation,” a chance to take profits on recent outperforming assets and tweak portfolios accordingly, or a great buying opportunity for fresh or idle money – like the $6 trillion or more sitting in money markets today.

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The comments above reflect my personal views and should be construed neither as stand-alone research nor investment recommendations.