Investment wise we believe is some blue sky and clear sailing with two months before the next Fed meet, states Jay Pelosky of TPW Advisory.

We have made it through the Covid rapids with its inflation spikes and aggressive CB responses. The US economy is growing close to potential with Q2 GDP just the latest example of hard data outperforming poor sentiment-driven surveys. As inflation and recession risks recede the Fed is done tightening with the ECB close behind. Bond market pricing is finally in line with reality and Chair Powell’s view that 2% inflation is unlikely before 2025 validates the higher for longer thesis, eliminates the overtighten till it breaks risk, and sets the stage for some blue sky investment thinking.

In speaking with a client earlier this week, we discussed whether one should be spending that blue sky time thinking about what could go wrong and how to hedge or allocate more time and portfolio allocation to what could go right. It’s always good to have an idea about downside risks and where one could be wrong but today we think there is more upside in thinking about what could go right over the coming six-12 months. 

At TPW Advisory we always try and maintain our focus forward, believing that’s what markets do and we need to do the same if we are to be competitive with our market BM. Near term, we look for manufacturing to rebound, both in the US and globally. This has been the weak link with services carrying the load across the US and Europe while manufacturing stagnates. Well, now we are approaching the end of the destocking process (in goods and raw materials—oil, copper) and setting the stage for manufacturing to recover and help drive the early cycle of global economic recovery.

Already some straws in the wind are supportive—German manufacturing orders appear to have bottomed as have S Korean exports (bellwether for global cycle) while US trucking’s Outbound Tender Volume Index (OTVI) hits its highs for the year in what is normally a slow period. Transports have broken out, triggering a Dow Theory buy signal. 

Carson Group reports that the Philly Fed manufacturing survey showed a huge jump in future activity (growth over e next six months). Largest back-to-back increase since March '91. That ended the '90/'91 recession btw. Finally, July’s US S&P Global Manufacturing PMI came in at 49 vs a forecast 46—now it's not above 50 (yet) but it's moving in the right direction.

Central Banks are wrapping things up in the US and EU while the BOJ starts to move off YCC as Japan finally senses victory in its 440-year fight against deflation. What comes next is the Birth of the New as we wrote some months ago—Pres. Biden’s New Industrial Policy coupled with the EU’s similar efforts while Japan defeats deflation and China seeks to stimulate a domestic demand-driven economic recovery. 

We are not going back to the low growth 2010-20 period but rather moving forward to a high nominal growth world driven by a global cap ex boom to meet the climate and tech challenges.

That global cap ex boom is underway as competition intensifies across the TrTri-Polarorld’s three main regions on both the Climate and technology fronts. This competition is healthy and will serve to deepen regional integration in each of the three main regions: Asia, Europe, and the Americas. It’s interesting to note that China is ahead in Climate while the US has the AI edge.

At the end (or the beginning) of the day, what we care about as investors is what comes next for markets. We wrote about rotation two months ago and that’s just what we have seen, emblematic of bull market behavior. Q2 earnings have been informative in two ways for us—first t, the banking scare of three-four months ago was just that, a scare, as demonstrated by both big and small bank Q2 results. Second, the Big tech AI moat is no joke as both META and Alphabet laid out their cap ex plans with serious bi big-boloney. The AI Innovation cycle is real and will deepen productivity and cap inflation in the coming cycle a la the 2H of the 1990s analog has been working off.

We remain tethered to our investment mantra: Fed done = USD down = ROW equity and Commodity Outperform. We have enjoyed a rolling rotation in our non-US equity exposure from a heavy European OW last year to a focus on Japan early this year and on to EM where we have building positions in both debt and equity over the past several months. MS notes EU equity trades at a 16 yr. relative low to the US on a forward PE basis.

In this blue sky period, we want to press some of our bets, mainly in Japan, EM equity, and Commodities. We want to go out to the periphery – the periphery in terms of equity markets = EM and the periphery in terms of assets = Commodities. Commodities are breaking out—GSG, WTI, Copper, etc., validating the no-recession thesis, even as broad commodities sit at roughly 220-year lows vs US equity. Inventories—of copper, oil, of EEV-related minerals, are at low or rock-bottom levels as we begin a new global growth cycle. 

Meanwhile, as we noted last week, the latest 3M #s from BofA suggest the most selling of commodities in roughly 13 years. JPM notes Commodities price in the biggest risk of recession of any asset class calling it “cheap on multiple short-term and long-term valuation metrics”.

EM equity has made no headway on a nominal basis for 16 years sitting as it does at levels seen in 2007 and 2012 according to EM expert and buddy Jean Van De Walle. That just doesn’t make sense to me. EM equity likewise sits at very low levels relative to US equity and offers a whole host of appealing characteristics: commodity exposure, rate cut cycle leadership, totally under-owned very cheap relative to history, etc., etc.

Two EM markets in particular stand out to us: China and Brazil. China is universally hated even as the 2nd biggest economy in the globe grows at 5%, more than double the US or Europe. The Govt is busy making friends with its tech leaders as it seeks to shift from an investment and export-led growth economy to a domestic demand-driven one. China tech is cheap on a relative basis—as we suggested a few Musings ago shifting some US tech winnings into China tech makes a lot of sense. 

Brazil is growing faster than expected with a huge trade surplus that underpins its currency. This combo will allow it to lead the new rate-cutting cycle thereby reducing the highest real rates in the world (8-9%) and boosting the domestic economy while it benefits from the global commodity demand pick-up we expect. 

Japan rounds out the Big Three markets for us—the end of YCC is super bullish for equities as it is likely to bring some money back home, helping the Yen appreciate (among the cheapest currencies in the world, roughly 50% undervalued) while domestic investors shift out of bonds into stocks as JGBs join the DM sovereign bond bear market. Cheap FX, cheap stocks (roughly 20% of TOPIX sells for less than cash on balance sheet—yes you read that right) equal opportunity.

So what’s next for TPW and our clients? We aim to take advantage of the blue sky and the birth of the new to expand our existing positions in EM debt and equity together with commodities. I had the pleasure of joining the BTV Surveillance team this morning minus Tom Keene who was on vaca and I laid this thesis out to Jon and Lisa.  Jon paused and then said Jay it would have been easier to just ask you what you don’t like—and of course, he was right—but let’s remember the only way to perform this year has been to be optimistic on risk assets with ACWI up 16% YTD, GSG now up 4% while Barclays AGG is flat.

We think it will pay over the coming six-12 months to remain positive and to use pullbacks to either get more involved or boost allocations into EM equity and Comm. That’s what’s next.

Learn more about Jay Pelosky here.