Nobody would blame you for suggesting market sentiment outran the fundamentals during the opening weeks of 2023.
Then again, a lot hangs on your definition of “fundamentals.”
Some macro fundamentals have been solid indeed. Look no further than Europe averting a recession (miracles do happen, apparently), blockbuster jobs data in the US and ongoing evidence to suggest that, all sarcasm aside, the disinflation process has begun, and should continue, even as the question of where inflation will ultimately settle remains uncomfortable and unresolved.
Seen in that light, it’s not terribly difficult to explain better market outcomes, and given how under-positioned institutional investors and other “pro” cohorts were headed into 2023, the “chase and grab” that helped propel the Nasdaq 100 to a blockbuster January (to cite one example) was predictable — in hindsight. Readers accustomed to my brand of humor will appreciate the paradox inherent in backward-looking foresight.
On the other hand, though, the likes of Morgan Stanley’s Mike Wilson have a point. Earnings growth is negative on a YoY basis, and margin compression is virtually assured from here. A 50-year low in US unemployment screams “late cycle,” and although pandemic distortions and the prospect of structural labor shortages certainly suggest hiring (and, by extension, consumption) could remain resilient for the foreseeable future, “resilient” needn’t mean blowout prints like the NFP headline and Wednesday’s blockbuster read on US retail sales.
The chart below shows Goldman’s risk appetite indicator. On the far right-hand side, you can see how detached it is from PMIs.
More important, perhaps, than the disconnect is the level. At 0.7, the indicator isn’t too far from extreme readings associated with poor return asymmetries.
In a new note, the bank’s Christian Mueller-Glissmann and Cecilia Mariotti distinguished between three “interrelated and overlapping cycles.” There are structural cycles, which are secular trends (or assumptions about them), there are business cycles and then there are “shorter cycles in risk appetite and sentiment, which are often triggered by growth or rate shocks.”
For Mueller-Glissmann, 2023’s early rally was an example of a sentiment cycle. The US business cycle, by contrast, “remains late,” he said, citing the rock-bottom jobless rate and suggesting that the “runway appears limited globally despite some room to grow in China.”
As for the structural cycle, that’s where the concern is — or, maybe it’s better to say that’s where the concern should be, assuming we have indeed undergone an epochal macro shift. Mueller-Glissmann cautioned on structural headwinds including “higher inflation risk and uncertainty on long-term growth prospects.”
If you’d be inclined to ask whether the combination of structural headwinds and a late-cycle dynamic in the US could present a challenge to risk sentiment, the answers are “yes” but also “no.”
“No” in the sense that, as Goldman put it, “risk appetite can increase and stay at elevated levels for prolonged periods as long as the macro backdrop remains supportive.”
But “yes” because… well, because eventually that conjuncture is either pernicious or we mischaracterized something. Headwinds are just headwinds unless and until they abate, and if “late”-cycle means anything, it’s that a turn is coming.
More to Goldman’s point, there is a threshold on the bank’s RAI beyond which history suggests returns will be lower and drawdowns larger. The table gives you a sense of where those thresholds are.
As you can see, we’re still in the “green zone” currently, with the RAI at 0.7.
If the animal spirits keep stirring though, the situation could get dicey pretty quickly. “With rising RAI levels, the market is becoming more vulnerable to negative growth or rate shocks,” Goldman went on, before driving the point home.
“A rising RAI is particularly concerning in the context of a late-cycle position in the US,” Mueller-Glissmann wrote, adding that “just before the Tech Bubble burst and the GFC, the RAI was above 1.”
