ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4?

Takeaway: The slowdown in both growth and inflation domestically requires investors to adopt a particularly defensive asset allocation.

Quad #4 Confirmation

During the week ended August 15th, our Tactical Asset Class Rotation Model (TACRM) generated a “high-conviction SELL” signal for Commodities and it followed that up by generating a “low-conviction SELL” signal for FX during the week ended August 29th. In our model, concomitant USD appreciation and commodity deflation is a clean-cut leading indicator for reported disinflation and that’s what you’re seeing with this morning’s US CPI print, which slowed from +2% YoY in JUL to +1.7% in AUG.

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - CPI

 

For the quarter-to-date, headline CPI is now averaging +1.85% on a YoY basis, which is down from an average of +2.1% in the 2nd quarter. On the growth front, a handful of key indicators have negatively inflected in the 3rd quarter as well:

 

  • #ConsumerSlowing: In contrast with the extremely positive trends in both consumer credit and survey data (e.g. Conference Board Consumer Confidence Index, NFIB Small Business Survey and ISM Non-Manufacturing Report), the ~70% of actual GDP that is Real PCE slowed to a +2% YoY pace in JUL, which is down sequentially and below its trailing 3M, 6M and 12M averages.
  • Median Consumer Woes & #HousingSlowdown’s Impact on Consumption: The dour trend in domestic consumption is in line with recent survey data from the Federal Reserve that shows ~40% of  US consumers are “just getting by” or “struggling to do so”. This is consistent with our groundbreaking work on the median consumer and the impact of all-time highs in key expenditure buckets, as well as our work on slowing home price appreciation, given that houses are the primary asset for most Americans.
  • Labor Market Deterioration: Consistent with the slowdown in the bulk of actual economic activity, we’ve seen the labor market cool off in recent months. Specifically, the seasonally adjusted MoM nominal growth rate of Nonfarm Payrolls slowed sequentially to +141k in AUG – a figure that is well shy of its trailing 3M, 6M and 12M averages. Moreover, the YoY rate of change in non-seasonally adjusted rolling Initial Jobless Claims ticked up to +7.3%, which is up sequentially and well above its trailing 3M and 6M averages.

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - RETAIL SALES

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - PAYROLLS

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - JOBLESS CLAIMS

 

Debating the Bull Case

We don’t highlight these metrics to cherry pick bad data in support of our existing views. Rather, we think it’s important to highlight the risk of #GrowthSlowing given where consensus expectations for growth remain – i.e. out to lunch. Moreover, the lack of dispersion among forecasts remains a key risk; everyone and their mother is convinced a high-growth US economic expansion is here to stay – 63 months into an economic expansion nonetheless!

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - Consensus GDP Estimates

 

Indeed, there’s admittedly a lot of green remaining on our US Economic Indicator Summary table and even our Housing Compendium has a fair amount more green on it that it has had in recent months. The key takeaway for us calling that is out is to highlight our fair and balanced analysis of the data, as well as to show that we are well aware that #GrowthSlowing is not a foregone conclusion for the investment community at large. Indeed, many investors might review the following tables and interpret the trend in domestic economic growth as positive and we’d be remiss to dismiss such claims at face value.

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - US Eco Summary

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - Housing Compendium

 

That being said, we’re also well aware of the fact that few others, if any, model economies the way we do (i.e. with a predictive tracking algorithm that combines differential calculus with real-time market and high-frequency economic data), so we’re comfortable being alone in the domestic #GrowthSlowing camp. We prefer forecasting accuracy over the safety of anchoring and our GIP model has, in fact, been deadly accurate in predicting the 2nd derivative of both Real GDP and CPI over the years.

 

Speaking of the model, there simply isn’t enough sequential momentum in the high-frequency economic data for Real GDP to surmount extremely difficult compares in 2H14, which is a conclusion supported by a compendium of financial market indicators – especially falling interest rates, though our math continues to show that #GrowthSlowing and fears of deflation in the Eurozone have also played a major factor in that trend as well.

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - UNITED STATES

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - UST 10Y

 

For the 3rd quarter in particular, we see Real GDP growth in a range of +1.6% YoY to +1.8% YoY. If it comes in exactly at the midpoint of that range, that would translate to +1.3% on a QoQ SAAR basis – i.e. less than half the rate of the Bloomberg consensus forecast of +3%. We get the advance estimate for 3Q14 GDP on October 30th.

 

Quad #4 = A Dovish Fed

With both economic growth and reported inflation slowing domestically, we are now in a markedly different economic environment than what we saw in the second quarter and we continue to expect a marginally dovish response from the Federal Reserve – particularly relative to near-consensus expectations of a tightening cycle commencing in 2H15.

 

In fact, we’d argue today’s FOMC statement was decidedly dovish:

 

  • They lowered their 2014 and 2015 Real GDP growth projections to +2.0 to +2.2% and +2.6% to +3.0%, respectively, from +2.1% to +2.3% and +3% to +3.2% in JUN.
  • They narrowed their forecast for 2015 PCE Core Price Inflation to +1.6% to +1.9% from +1.5% to +2.0% in JUN.
  • They failed to remove the “considerable time” language in their guidance on the level of the Fed Funds Rate post the end of their existing large-scale asset purchase programs.

 

The one hawkish takeaway that initially had the bond market spooked was that 14 FOMC members now see “policy firming” in 2015, which was up from 12 in JUN. Since 2015 growth and inflation data is a long ways away from being reported, however, we think such projections are, at best, useless. The only thing we actually know about 2015 is that the Fed will continue to be data dependent, and if the growth and inflation data continues to slow, there’s little chance of “policy firming” on par with their current expectations.

 

Adjust Your Asset Allocation Accordingly

From an asset allocation perspective, our GIP model would suggest Quad #4 requires a defensive allocation and we think few investors are prepared for that. If, however, you’ve been following our research, you undoubtedly are adequately prepared for Quad #4 (refer to our August 8th presentation titled, “Are You Prepared For Quad #4?” for more details).

 

In the table below, we show historical quarterly performance of various asset classes according to our GIP model quadrants. It’s worth noting that we anchor on history (i.e. historical performance), math and investor psychology in our tactical asset allocation process, rather than on feel and valuation. In fact, we’d argue valuation has little place in the tactical asset allocation process and, at best, should be reserved for the strategic asset allocation process – which is seldom the focus of our research.

 

While our team boasts an impressive number of Ivy League degrees, nowhere in our Yale or Princeton curriculum did we learn how to be smarter than the market or acquire enough hubris to think that we are. While stubbornly telling the market it’s wrong at valuing a security might work in the art of stock picking, it has little place in global macro investing, in our opinion.

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - GIP Model Backtest Trailing 10Y

 

Summary Investment Conclusions

As you can see, we think investors should be in bonds and defensive, bond-like equity exposure and out of both the domestic growth style factor(s) and inflation hedges.

 

On the long side we continue like:

 

  1. iShares 20+ Year Treasury Bond ETF (TLT)
  2. Utilities Select Sector SPDR Fund (XLU)
  3. Health Care Select Sector SPDR Fund (XLV)

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - TLT

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - XLU

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - XLV

 

And on the short side, we continue to like:

 

  1. iShares Russell 2000 ETF (IWM)
  2. SPDR S&P Regional Banking ETF (KRE)
  3. iShares US Home Construction ETF (ITB)

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - R2K

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - XLF

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - XLY

 

Please note that Quad #4 is not a good economic environment for REIT securities. Even though we’ve been recommending the Vanguard REIT ETF (VNQ) on the long side for several months as part of our slow-growth yield-chasing playbook, we now feel it is prudent for investors to cut or dramatically reduce their exposure to this asset class.

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - VNQ

 

This is especially true if the weakness in commodities portends a Quad #4 setup for the fourth quarter as well. While that is not something we are currently forecasting given the ease of CPI compares in the 4th quarter, the probability of this occurrence is certainly rising according to TACRM:

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - TACRM ACRM Delta

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - TACRM ACRM Percentile

 

ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? - TACRM CRB

 

Feel free to email us with any follow-up questions. Enjoy your respective afternoons!

 

DD

 

Darius Dale

Associate: Macro Team


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