January ends & February begins with confounding price action in financial markets. Flows continue accruing to the few but largest market cap tech stocks. Meanwhile the most economically-sensitive smaller cap stocks continue underperforming despite still-solid economic data. Perversely, the better data while supportive to earnings, tends to push Yields higher which the markets discount as a increased risk to small caps and other cyclically sensitive market proxies. Additionally, of the eleven S&P 500 sectors, only two – Tech and Communications – are outperforming this year.

The disparity in breadth is typical in a regime of “safety trades” into an economic slowdown. Such narrowing reflects fewer and fewer options for investor flows which are competing versus still elevated short-term cash rates north of 5%. What’s atypical in recent months is the further narrowing of the market coincides with data, such as payrolls, unemployment claims, and GDP that effectively undermine recession. Yet the market positioning has yet to unwind its recession concerns. Rightfully so considering the trusted pool of leading indicators including yield curve inversion, contracting ISM manufacturing cycle, declining employment breadth, soured capital expenditures, curtailed lending and corporate margin pressures to name a few.

The disparity continues widening between the data-fueled narrative of economic strength and the market’s positioning for economic stress. Given the volatility of the data and its revision tendencies, we side with market signals which continue to flash warning signs. However, such signs, like resurgent banking stress or tighter overnight funding markets, do tend to catch the attention of fiscal and monetary authorities which respond through the financial plumbing system counter to the stated policy. For example, while the Federal Reserve has maintained policy rates near multi-decade highs and it continues to shrink its balance sheet size, it is expanding its balance sheet capacity by adding liquidity to the financial system. Such liquidity is a support to risk assets, treasury markets and it allows refinancing of debt to continue which is generally what matters most in a debt laden economy with a limited need for new borrowing.

Such nuances are not lost on our process of asset allocation which require an understanding of the narrative and the mechanics of both the economy and markets. Given banking flare ups associated with commercial real estate markdowns, we doubt the Fed can maintain its policy tightness for too much longer. Given election year considerations, we doubt politicians will exert any fiscal restraint. Thus, we are watching stubbornly high interest rates with great…interest. US borrowing is remarkably high by peacetime and cyclical standards. We wonder if the bond market may revolt to any pro- or counter-cyclical spending given the incredibly high starting point of deficits relative to GDP.