How to read market signals (and what these stock and bond fundies see now)

All investors want (need) an edge and macro signals are one way to achieve this. Some are pure sentiment – for example, the Bitcoin price is up 80% in 2023 so far. 

"Fundamentalists" instead focus on profits, inflation and rates. These are some of the topics also considered by Livewire’s Hans Lee and his guests in the regular “Signal or Noise” video series. 

In the following wire, I've spoken to a couple of fund managers who invest in two disparate asset classes: stocks and bonds.

• From the equity funds camp: Aaron Binsted, portfolio manager at Lazard Asset Management.
• On the bonds side of the discussion: Stuart Dear, head of fixed income at Schroders Australia.

What signals are you watching most closely right now, and what are they telling you?

As a bottom-up, fundamental investor, Binsted says the most important signal for his team is the level of sustainable/core earnings for companies. In other words, the multiple it attributes to those earnings, and how this differs from the market view. (“Multiple” refers to a ratio that is calculated by dividing the market or estimated value of an asset by a specific financial statement item – in this case, earnings.)

“Our long-run view shouldn’t change much week to week or quarter to quarter. That said, you are always testing your view and looking for opportunities,” he says.

A few ‘signals’ of interest currently are:

• The extent of the slowdown in discretionary spending.
• Any evidence this is leaking from the known “impact zone” of discretionary retail into other parts of the economy.
• The crude oil market. “We’re beginning to see the reduction in oil exports from Russia and Saudi Arabia while demand has been solid. The progression into H2 2023 will be interesting,” says Binsted.
• Commodity prices. Binsted explains that some commodities, such as iron ore, have been robust despite an influx of weak data from China. The big question, he says, remains: “Is the shoe yet to drop, or is something else going on?”

What's on this bond manager’s radar?

Stuart Dear emphasises Schroders’ credentials as an “asset allocation-based, predominantly fundamental fixed-income investor.”

For him, three of the most important considerations are:

• bond prices (valuations);
• growth, inflation and the trajectory of monetary policy; and
• investor sentiment, but to a lesser degree.

“Right now, we’re getting reasonably positive valuation signals in fixed income, because we had the big backup in yields last year,” Dear says.

“We’re also watching the economic cycle very closely. That’s so we can see whether growth and inflation are rolling over and whether there’s enough priced into markets for central bank hikes,” he says, noting that most markets are priced for one, maybe two, more rate rises.

The cyclical surprise

Dear explains one of the most confounding things for markets right now is the delay of the cyclical downturn – it’s been anticipated for months but hasn’t yet materialised.

“Some of the traditional indicators of recession haven’t worked particularly well yet. Things like the slope of the US yield curve, which is inverted and everyone’s been talking about for ages,” he says

How do such indicators fit into your process?

Lazard's internal valuations (those developed in-house) are the key drivers of portfolio construction, with the following just a teaser for what is an almost endless list:

• price movements of stocks, bonds and commodities;
• broker upgrades/downgrades;
• changes in industry competitive dynamics and corporate strategy;
• technological changes;
• insider transactions;
• economic data points.
• central bank policy.

Binsted says most of it will be noise, but there can be the "occasional gold nugget or a few disparate data points that cumulatively can confirm or challenge a view." 

"It is a real skill of judgement to know when a data point matters or not."

“Recession isn’t imminent”

Further to Dear’s point about economic indicators not currently playing by the usual rules, he says there’s one his team uses that’s been helpful.

The Taylor Rule is an interest rate forecasting model invented by economist John Taylor in 1992. It suggests how central banks should change interest rates to account for inflation and other economic conditions. Schroders has adapted this for its own purposes so that it’s even more zeroed in on inflation.

“That’s done a really good job of signalling where the US Fed Funds Rate is likely to go. It’s saying the funds rate has more or less peaked,” says Dear.

“But it’s not calling for a big cut in the Fed funds rate just yet. So, we’re not really getting the signal that recession is imminent.”

You can read more about the Taylor rule here. In addition, Schroders has built a model to help determine whether a recession is coming, and when. It comprises 24 indicators that are each good indicators of a recession, “whenever their data series' get above a threshold level,” Dear says.

“Some have longer lead times, which indicate the economy is overheating. For example, sales of heavy truck sales – when these are high, it’s usually a sign that economies are overheating and, assuming hikes follow, the recession will come in 12 to 24 months.”

There are also shorter-term market-based indicators – such as the VIX going up or the S&P falling by a certain amount over a six-month window.

What is this telling Schroders now?

“About two-thirds of the 24 indicators are flagging recession, but most of those are in the monetary zone – things like falling M2 and inversion of the yield curve. These have a six to 12-month lead time, emphasising Dear's earlier point that recession, should it occur, is still some time away.

Which equity sectors are most appealing over the next six to 12 months?

The equity guy in the room, Lazard’s Binsted, remains “very positive on insurance and energy”.

Why? It’s tied to the premium cycle, which remains strong (in other words, you know how your insurance costs have been ticking up lately? That’s great for the profits of the companies collecting them – such as Medibank, NIB, QBE, and others).

“We will see claims and reinsurance speed bumps, but premium growth is the key medium-term driver,” Binsted says.

And he emphasises that premiums are driven particularly by industry dynamics. “So, this earnings momentum, combined with attractive valuations, is not dependent on a strong consumer, as just one example,” Binsted says.

And what about fixed income?

“Our preference is for high-quality fixed income and you’ve got good value on offer…to earn between 5% and 6%, which is decent. But there’s also potential for capital gain and that comes mainly on the rates side,” Schroders’ Dear says.

He, therefore, sees an opportunity in interest rate exposure, particularly in markets where central banks are “fully priced” for the inflation risk of the country.

“We’re getting more confident that’s the case in Australia now. We’ve been expecting the RBA needing to tighten more because it’s been slow compared to the US, for example, and inflation here is coming later,” Dear says.

“The market’s still got one or two more hikes from the RBA priced-in, and we think that’s probably about right.”

Dear holds a similar view on US interest rates, with the market anticipating the Fed will hike once or twice more. But in the US, “we prefer inflation-linked bonds rather than nominal bonds in that short end," he says.

“And in terms of credit, we have an up-in-quality stance, preferring investment-grade over high-yield. And we prefer Australia…where spreads [the gap between government and corporate yields] are quite wide."

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Follow my profile to catch the conclusion of this series, where our contributors will dig further into how they're positioned, including some specific names on their radars.