Trade Notice: BlackRock Standard Model 7/20/2023

Key Takeaways:

• Take profits on winners and recalibrate stock & bond bets for potential changes in market trends, reallocating risk across equity regions and styles, credit and rates

• Move overweight US stocks with a preference for lower octane growth and midcap companies, trimming tech as market breadth potentially widens

• Balance US growth stock bets with an increase in value bets in Europe, as the respective paths of inflation and central bank policy in these regions diverge

• Take advantage of the recent (but possibly short-lived) surge in real yields by adding to Treasury Inflation Protected Securities

• Seek to enhance portfolio yield and move up in overall credit quality, barbelling short- and long-duration nominal Treasuries and rotating out of high yield bonds

Trade Rationale:

• Stocks have climbed a formidable wall of worry since March. Events that would have whipsawed markets and maybe even instigated a recession in the past, were instead treated as only mildly irritating speed bumps. Banking crisis? ‘No big deal.’ Congress flirting with default? *Yawn*. Another series of Fed hikes with short-term rates potentially kissing 6%? ‘Bring it on!’ A pleasantly surprising run, heroically led by a narrow set of stocks: the ‘Magnificent 7’ tech giants. Following this dramatic outperformance by those with outsized exposure to the A.I. boom, we’re reducing our tech overweight. We expect risk-assets to take a breather in Q3 and for the drivers of return to broaden to YTD laggards, like midcaps.
• Does all this mean we’re out of the woods? Not necessarily. In our view, while the worst ‘unknown unknowns’ emanating from the bank failures now appear to be off the table and cuts in lending appear less than severe, stocks have been partially propped up by one-time infusions of liquidity – from the Fed’s emergency bank lending program and the US Treasury’s General Account (TGA) balance drawdown – which are now reversing. Between March and June, these infusions more than offset the Fed’s on-going quantitative tightening (QT). But that’s behind us now and commercial bank reserves at the Fed are falling again. We think this is likely to cause some market indigestion later in Q3. This explains our cuts to liquidity-sensitive assets like emerging market stocks and lower quality credit.
• Nonetheless, we do believe the odds of recession are lower than 4 months ago. This reflects the lingering power of ‘revenge spending’ by consumers, fueled by post-pandemic pent-up demand and excess savings. But the economy’s impressive resilience may also make the endgame battle against inflation trickier than the 9%-3% freefall in CPI the last 12 months. The Fed appears committed to flexing its rate-hiking and QT muscles into the final rounds of this fight, and Treasury markets have re-priced accordingly (perhaps even overshooting). We’re taking advantage of this surge to add yield via floating rate Treasuries and TIPS, which we see as having higher than normal real yields, complemented with long-term Treasuries. This barbell strategy may help guard against the cumulative effects of Fed tightening potentially proving to be excessive vs an already weakened foe, bringing to fruition what so many have been calling for the last 18 months: the R word.