Update on Recent Market Volatility and Portfolios

This morning saw stock markets sell off globally, with indices declining and volatility spiking (S&P 500 opening down 4.2%, NASDAQ opening down 5.4%, Nikkei declining 12.4%, Euro Stoxx 50 opening down 2.2%, and the VIX reaching 66, its highest level since June 2020). Below is an update on volatility drivers, our views, and portfolio positioning. Overall, our view has remained consistent amid a dynamic market narrative that has shifted from inflation being far too hot in the first quarter to a soft landing being assured —as recently as last month — with some chance of continued above trend growth, and now to an imminent recession. Our outlook since the end of 2023 has been for lower inflation, falling interest rates, and a consistent slowdown in economic growth. We believe recent data is consistent with this view and are attuned to risks to economic growth, which seem to have increased somewhat; however, the market’s recent (over)reaction does not change our analysis:

• Labor market: The employment report last Friday, although providing more evidence of labor market softening, is not consistent with a severe contraction in economic growth, given the addition of 114,000 jobs. Most of the rise in the unemployment rate was due to an increase in labor force participation, not solely because demand for labor is collapsing. Current private employment growth of about 1.3% at a 3-month annualized rate is not typical of recessionary periods. We highlighted several nuances in the labor market data in last Friday’s Weekly Investment Update – another is the impact of Hurricane Beryl, which could have made the report worse than would otherwise have been the case. While the Bureau of Labor Statistics claimed that “Hurricane Beryl had no discernible effect on the national employment and unemployment data for July,” 436,000 employees were absent from work due to bad weather in July, considerably higher than the historical average of 32,000 for the month.
• The economy: A “soft landing” isn’t a straight line. Sometimes it may seem as though economic conditions are stronger (e.g., as seen a couple of months ago) or weaker (e.g., today), but ultimately a contained slowdown remains our base case. High-frequency data suggests consumer demand is stable, with restaurant bookings, TSA air travel data, and credit card spending on solid footing. The New York Fed's Q3 GDP Nowcast dropped 0.6% following last week's manufacturing and employment negative surprises, though it continues to run above trend growth.
• Corporate earnings: While some companies highlighted a weakening consumer amid continued bifurcation between the lower and higher end consumer, others noted continued overall strength (e.g., MasterCard reporting steady U.S. trends in July). Despite somewhat softer results, companies such as Starbucks and McDonald's traded higher, suggesting that a certain amount of bad news was already reflected in the share prices prior to their earnings reports. The blended Q2 S&P 500 earnings growth rate moved up to 11.5% year-over-year from 8.9% at the end of Q1, as profit margins continue to be supported by cost efficiencies. We recognize that cost cutting cannot protect earnings indefinitely, but current sales expectations should be enough to support reasonably solid earnings growth in the coming quarters.
• Credit markets: While credit spreads were not immune to volatility across other asset classes, relative losses remained muted by comparison. Reflecting the general risk-off environment, high yield credit spreads increased 53 basis points last week to 3.59% on Friday. However, absolute spread levels remain at the lower end of their range over the past three years and well below levels consistent with recessionary conditions. Default rates in U.S. high yield rated companies fell to 1.78% in July, an 18-month low.
• Interest rates: The bond market has quickly priced in 50 basis points of cuts in September. Although the Fed did not cut rates in July, there is ample room to adjust policy as needed. Easier monetary policy outside of a recession should ultimately be supportive of stocks.
• Equity market technicals: While the speed of recent equity market moves may be jarring, strong upward momentum is intact. Near-term support on the S&P 500 is at the upward sloping 200-day moving price average at 5,010. We believe there hasn’t been a material shift in underlying company fundamentals. We also note there are signs of oversold conditions as the market recouped some of this morning's losses during the day's trading hours as stocks seem to be finding some buyers and support.

Broad Perspective

Although equity drawdowns can be uncomfortable, history shows that they are not unusual. Since 1986, equity market returns have averaged 10.1% per year, while the average drawdown within each calendar year is 14.1%. Moreover, while the VIX reached its highest level since June 2020, it is important to note that following a spike in volatility, 6-month forward returns can be positive. Additionally, since VIX volatility peaked this morning, volatility has subsided ~70% in the afternoon.

The current decline in yields suggests that either inflation is falling more rapidly than expectations, the growth backdrop has significantly deteriorated, or the federal funds rate is too elevated. Given that the Atlanta Fed’s GDPNow estimate is still 2.5% for the third quarter and S&P earnings for the second quarter are up over 11% year-over-year, we believe the risk that the federal funds rate is too elevated should not be discounted versus an assumption of rapidly deteriorating fundamentals.

Bessemer Positioning

Bessemer portfolios maintain an overweight to the U.S., which has been faring well relative to its international counterparts. Specifically, Europe and Japan had a notable selloff relative to the U.S., with Asia overall reaching its highest volatility since 2008. Bessemer portfolios maintain an underweight to Asia versus benchmarks.

On a sector basis, while we generally favor quality growth, we are not significantly overweight the technology sector (23.9% vs. the benchmark weight of 23.5%). Our two largest overweights are healthcare and industrials, while we are also slightly underweight communication services. Moreover, we continue to avoid more speculative areas of the market – e.g., bitcoin, which is down ~25% from recent highs.

We recently increased exposure to more defensive equity sectors that we believe will benefit relatively from the current market volatility and expected lower interest rates. We also recently moved out of a more volatile subadvisor that is exposed to more high-growth and speculative technology companies.

We believe our long duration bond positioning should benefit as our view that interest rates should be cut sooner rather than later begins to materialize. Lastly, we have maintained reduced exposure to credit risk, which is helping to drive relative outperformance.

We continue to monitor the economy and markets and will be in touch with additional communications. Please contact your client advisor with any questions you may have.