Soft Landing or Bumpy Ride?

Markets have moved toward a soft landing narrative, but risks remain and will likely fuel volatility.

Soft Landing or Bumpy Ride?: Summary

The soft landing narrative seems to have taken hold: revisions to GDP suggest that we have avoided a recession, and corporate earnings are beating expectations.
The case for weakness is equally compelling: the weakness of the consumer in combination with sticky inflation could prove a recipe for additional volatility.
The case for volatility remains strong: geopolitical conflict and bitter politics could outweigh a good earnings season with both influences ensuring that the markets will be volatile.

Market Performance as of February 29, 2024 | Source: Bloomberg

Market Review: Shifting Expectations

As economic revisions continued to trend up for 2024, the concerns about recession have largely been erased and U.S. equity markets have reflected the optimism in a blockbuster month, up 5.34% in February for large caps. Much of that performance was driven by a resurgence of growth performance consistent with optimism, which turned in a 7.3% performance versus 3.05% for value. Mid cap stocks also performed well at 5.93% with small caps lagging at 3.32%. That said, optimism for small caps built up over the month as the consensus for growth shifted.

International equities were hit by a moderately strengthening dollar over the course of February and that impact was far worse for European equity where economic expectations remain somewhat stagnant. European equities returned 1.49% in dollar terms, slightly behind the overall MSCI EAFE Index return of 1.86%. Japan remains the favorite in international investing, returning 2.91% in dollar terms. Emerging markets also turned in a strong return as China bounced this month with a 6.9% return versus 3.26% for the MSCI Emerging Markets Equity Index.

Another major shift in expectations took place in the Fed Funds Futures, now pricing in three rate cuts in 2024, in line with the Fed Dot Plot. In addition, the upward revisions to growth seem to have pushed the long end of the yield curve up, resulting in losses across the bond universe. Only high-yield credit debt bucked this trend while asset-backed credit was relatively flat as default expectations eased and the spread over treasury bonds fell, reflecting the lower risk expectations.

In real assets, commodity indices flagged in February. Though oil prices rose modestly over the month, the move was not enough to satisfy the expectations already priced into the futures curves. Precious metals and industrial metals also performed poorly, the former in response to waning inflation trends. However, industrial metals performance was a surprise as it is generally correlated to revisions in expectations for economic activity. Agriculture took the biggest hit this month as supply is looking to outstrip demand this growing season.

Going Forward: Soft Landing or Bumpy Ride?

The markets went from flux to full speed ahead. In the space of a few weeks, economists dramatically revised expectations for 2024 up to 2.1% for the full year and revised 2025 expectations down modestly, suggesting a very mild slow down to 1.7%. Meanwhile, expectations for the Consumer Price Index were revised down and then back up again for both 2024 and 2025, now currently at 2.7% and 2.4%, respectively. This suggests that investors are pricing in a soft landing while still conceding that inflation remains sticky. Expectations for Fed cuts have fallen into line with the Fed Dot Plot with Fed Funds Futures now pricing in three rate cuts in 2024 starting at the June meeting. The Fed has repeatedly communicated their willingness to be cautious before cutting rates to ensure that the inflation genie is indeed back in the bottle. The continued concern around inflation supports the “higher for longer” interest rate narrative that would accompany a slow reduction of rates. That said, unemployment is continuing to rise while wage growth continues to fall, setting up for the slowdown in growth expected in 2025. However, if the slowdown comes faster or inflation lingers for longer, the soft landing scenario may evaporate into a cloud of volatility.

The Case for Growth

Although wage growth is slowing down, it is still growing in real terms after accounting for inflation. Hourly earnings grew at 4.3%, year-over-year at month end while CPI grew at 3.1%, year-over-year. Assuming the growth narrative is right, then the S&P 500’s forward price-to-earnings ratio of 21x on a market-weighted basis and 17.7x on an equal-weighted basis could continue to expand. The breadth of the rally is starting to expand and the nature of the rally has moved toward higher-quality stocks with upward earnings revisions and stronger balance sheets. However, the yield curve is not set up for this with a long end that remains stubbornly too low. If this soft landing were to come to pass, we would have to see more of a lift at the long end to reflect the overall rosy expectations. The long end has so far moved down this month, not up, and this leaves the bond markets at risk of further pressure. All that said, the recent hiccup with NVDIA, whose blowout earnings reinvigorated Ai optimism, seems to have created a spark of upset in the equity markets, suggesting the yield curve outlook may be more correct.

The Case for a Cold Shower

The challenge to the case for growth is that it rests solidly on the consumer and the wage growth story. The challenge there is that consumers have spent well in excess of their pandemic savings and wage windfalls and have racked up significant levels of credit card debt, which at current interest rates carry hefty interest costs. Not only are credit card debt levels up, but 30-day and 90-day delinquencies are also sharply up, suggesting that consumers are getting out beyond their skis. Though not yet at the extreme levels experienced during the Great Financial Crisis (GFC), we are seeing levels at the top of the range established post-GFC. To make matters worse, the hotter-than-expected Producer Price Index read for January could be a canary in the coal mine for a hotter Consumer Price Index and the potential for the Fed to continue to push off the beginning of rate cuts. If the overstretched consumer starts to slow with no support from the Fed, the much-dreaded R word could come back into the mix.

The Case for Volatility

Like most things, the answer may lie somewhere in between the best and worst scenarios. However, the pressure for upside and downside outcomes comes from many directions, suggesting that regardless of the end destination, the journey could be bumpy. Upside pressure is primarily backward-looking but does impact sentiment greatly through the string of solid earnings, particularly across retail as we have seen. NVDIA aside, the outlook and momentum for AI does not seem to be abating and is very likely to be transformational over time, which may support further expansion than what seems rational at the moment. To the downside, we continue to see conflict, politics and looming regional bank crisis as sources of tail risk. Though hardly making headlines, Congress quietly passed yet another continuing bill to avoid a government shutdown. This has become overly normalized, and given the bitterness of U.S. politics, the potential for a disruptive political showdown going into the election is a distinct possibility. What could really upset the apple cart would be the commercial real estate debt sitting the regional banks desperately awaiting rate cuts that may be delayed, which could kick off a more significant bout of volatility.

Net View

The revised outlook for growth leaves us with a neutral portfolio view while our expectation for continued volatility supports hedging equity risk assets.

Past performance is not an indication of future performance. The information provided in this newsletter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. There is a risk of loss from investments in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor's financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.

The information contained herein reflects Lido’s views as of the date of this newsletter. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. Lido has obtained the information provided herein from various third-party sources believed to be reliable but such information is not guaranteed. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Lido is not responsible for the consequences of any decisions or actions taken as a result of information provided in this newsletter and does not warrant or guarantee the accuracy or completeness of this information.

Index Definitions:

MSCI ACWI covers approximately 85% of the global investable equity opportunity set. The index is based on the MSCI Global Investable Market Indexes (GIMI) Methodology—a comprehensive and consistent approach to index construction that allows for meaningful global views across all market capitalization size, sector and style segments and combinations.

MSCI EAFE Index measures international equity performance and is comprised of the developed markets outside of North America: Europe, Australasia, and the Far East. (Source: MSCI)

MSCI Emerging Markets Index is a free float Adjusted market capitalization designed to measure equity performance in global emerging markets and covers 800+ securities across 23 markets and represents about 13% of world market cap. (Source: MSCI)

The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). (Source: Barclay’s)

The BofA Merrill Lynch U.S. High Yield Master II Index value, which tracks the performance of U.S. dollar denominated below investment grade rated corporate debt publicly issued in the U.S. domestic market. (Source: BofA Merrill Lynch)

The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. (Source Russell)

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. (Source Russell)

The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. (Source: Russell)

The S&P 500® is a market value weighted index that includes the 500 leading U.S. based companies and captures approximately 80% coverage of available market capitalization. (Source: S&P Dow Jones)

Dow Jones Industrial Average™ was introduced in May 1896, is a price-weighted measure of 30 U.S. blue-chip companies. (Source: S&P Dow Jones)

MSCI AC World Ex U.S.: A market-capitalization-weighted index maintained by Morgan Stanley Capital International (MSCI) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI All Country World Index Ex-U.S. includes both developed and emerging markets. (Source: MSCI)

Barclays U.S. Universal: Unmanaged index comprising U.S. dollar-denominated, taxable bonds that are rated investment grade or below investment grade. (Source: Barclay’s)

HFRX Global Hedge Fund: The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies falling within four principal strategies: equity hedge, event driven, macro/CTA, and relative value arbitrage. (Source: HFRX)

The Alerian MLP Infrastructure Index is a composite of energy infrastructure Master Limited Partnerships (MLPs). The capped, float-adjusted, capitalization-weighted index has 25 constituents that earn the majority of their cash flow from the transportation, storage, and processing of energy commodities. (Source: Alerian)

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Soft Landing or Bumpy Ride?