Who is benefiting from the equity rally?

 

Bulls on parade

The rally in July was impressive. Equity markets rarely see such rapid and strong surges: US stocks rose by 9.1% (S&P 500), which was the largest July return in 30 years. This also compared well to performance in April 2020 (+12.7%) and November 2020 (+10.7%) and exceeded the March 2009 (+8.5%) and April 2009 (+9.4 %) totals.

It was an off-the-chart month for equities across most of the developed world, with the Eurostoxx climbing +7.3%. July’s performance was all the more impressive as, on this occasion, equities are not recovering from a recession-induced drawdown, as was the case in 2008 and 2020. This time around, markets have declined in an adjustment to the higher cost of capital, which suggests the sustainability of this recovery is questionable given the softer macroeconomic news flow.

In the month when bulls run the cobbled streets of Pamplona, animal spirits also charged through equity markets. We wonder who genuinely saw this shift coming. Like many investors, we are only just starting to re-risk our portfolios and are asking: who benefitted most last month?

 

July’s winners

Drawdown-insensitive investors and flexible speculators seem to be among the main beneficiaries of the rally, as shown by figures 1 and 2.

• Figure 1 illustrates the relationship between multi-asset funds’ historical drawdowns and their performance since 14 July 2022 until the end of the month, inclusive of our All Roads franchise. This chart shows one clear message: the funds which benefited from the rally are the ones holding high levels of market exposure, rather than having shrewdly called a bottom in the market. As a rule of thumb, strategies with -5% to -10% drawdowns posted a sub-2% rebound. Strategies with a drawdown from 10 to 20% recovered by about 3.5%, while strategies with even higher drawdowns exhibited a much larger participation. This suggests that such investors have not altered their asset mix during the downturn – respecting the 2020 mantra that ‘keeping exposure constant helps navigate downturns’. This also suggests that most of these institutional strategies do not see rising real yields as a global macro threat and that today’s valuations are a buying opportunity.

 

FIG 1. Multi-asset fund performance since 14 July 2022 vs their long-term drawdowns

Source: Bloomberg, LOIM as at August 2022. For illustrative purposes only. Past performance is not a guarantee of future results.

 

• Figure 2 shows the aggregated performance metrics for intra-day trend strategies (equity-based) versus daily cross-asset trend strategies. From the end of 2021 to mid-July 2022, both styles delivered a similarly negative return (once risk-adjusted). Since 14 July until the end of the month, daily strategies managed the market recovery poorly, losing a similar amount as they have since the beginning of the year. Intra-day strategies fared a lot better, rapidly catching the turn in market mood and significantly picking up on the strong equity rally that followed. This says a lot about the nature of July’s recovery: it was more of a ‘trader’s move’ than a fundamental trend that convinced investors to increase their dynamic exposure to equities. In simple terms, it was driven by sentiment rather than fundamentals, and it also reflected the re-risking of our own strategies, as we explain later.

 

FIG 2. Performance of intra-day and daily trend following strategies (risk-adjusted)

Source: Bloomberg, LOIM as at August 2022. For illustrative purposes only. Past performance is not a guarantee of future results.

 

The All Roads response

As puzzling as this context is, we cannot deny that our investment strategies are reacting to this new environment. Figure 3 illustrates how we have increased the market exposure of our flagship All Roads portfolio, with our cash allocation decreasing from an historical high of 65% down to 25%. Why are we re-risking our strategies now? Does it reflect an evolution in fundamentals or is it more of a technical effect? At this point of the cycle, such information is essential. As detailed in the Q3 issue of Simply put, there are three main factors which drive our re-risking strategy:

•    An evolution in the volatility and correlation structure of markets
•    Shifts in medium-term trends
•    Positive returns from global markets (the opportunity cost of not being sufficiently invested)

The increase in our exposure during July did not stem from the first two factors: we barely captured any significant changes in the covariance structure of markets lately and trends were steadily negative across the board. What has driven us to buy into these rising markets was the cost of not being invested (enough). Our risk-budgeting techniques include absolute drawdown management as well as relative drawdown management: the former cares about not losing more than our expected risk of loss (i.e. strategic budget), while the latter focuses on not participating enough in a rising market, which is an opportunity cost. 

To us, the July performance is yet another indication that sentiment is driving all and that we are still experiencing an market driven by animal spirits into which we are cautiously dipping our toes. In these moments of strong reversal, risks of further recovery and new losses become more balanced until we can capture signs indicating whether the recovery is durable or temporary. For us, caution is not all about being bearish: it is also about not being bullish enough (sometimes temporarily), too. As shown by our Nowcasters below, macro indicators are soft(er) and the jury has yet to confirm the next move.

Simply put, highly leveraged and high-frequency investors benefitted most from July’s rally. We are happy to reinvest marginally, but we still see evidence that sentiment is driving markets. For us, this is a reason to remain cautious.

 

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Macro/Nowcasting Corner

The most recent evolution of our proprietary Nowcasting indicators for world growth, world inflation surprises and world monetary-policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

The news flow coming from the US remained consistent with last week’s data: a macro deterioration is at the door and should not be overlooked. The manufacturing ISM was a fair indication of this. The main survey declined from 53 to 52.8 (expected at 52) but the ‘new orders’ component declined more than expected, moving from 49.2 to 48 (beyond expectations of 49). Similar readings were seen in March 2008 and such a decline is usually indicative of an upcoming deterioration of growth. For now, there is still dissent between the US employment market and these manufacturing surveys. Jobless claims have clearly bottomed and are now rising: this week they rose from 254,000 to 260,000. Yet, non-farm payrolls managed to surprise economists to the upside once again, bringing some relief to investors: the total number of US jobs created in July increased from 372,000 to 528,000, against the expectation of 250,000. The unemployment rate fell from 3.6% to 3.5%, decreasing to levels not seen since September 2019. Last but not least, the non-manufacturing ISM also showed how split macro indicators are: it was published at 56.7, which beat expectations of 53.5 and is higher than June’s estimate 55.3. No wonder investors are confused by the overall macro direction.

In Europe, retail sales declined by 1.2% versus expectations of zero, after increasing 0.2% the month before: this decline in retail sales is probably the first genuine sign of worsening macro conditions in the Eurozone. This is more interesting given the European Central Bank started hiking rates in July. Europe’s inflation problem remains intact, as the PPI index still showed a +36% progression year-over-year and +1% month-over-month – costs are still progressing and will weigh on the CPI.

In China, the PMI surveys were consistent with a domestic macro improvement but also with a slowdown in global trade. Notably, the Caixin China manufacturing PMI was down, from 51.7 to 50.4, while its service counterpart rose from 54.4 to 55.5. This interesting pattern was also evident earlier in the US and is definitely a trend to watch.

Our nowcasting indicators currently point to:

• A clear decline in global growth. The US and Eurozone are showing signs of decelerating growth momentum.
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere.
• Monetary policy is set to remain hawkish. Central bankers are likely to be more hawkish than expected.

 

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy). For illustrative purposes only