Key Research Takeaways from Baird Strategas

Asset Allocation

By: Nicholas Bohnsack, President and Head of Portfolio Strategy

We are watching global supply chains, inflation, and AI closely. We continue to include metals in our tactical allocations. Within equities we advise a measured rotation into more traditional Value corners of the market.

• Big questions. We are focused on three areas: 1) Is the Strait of Hormuz open and are global supply chains being fed at levels close to those seen prior to war in Iran? 2) Are inflationary pressures compounding or easing, and what action is being taken by global monetary policymakers? 3) Is there enough evidence of self-sustaining or scaled commercial applications of AI to resolve questions posed by the extreme readings of traditional fundamental barometers.
• Alternatives in focus. In recent years we increased exposure to Gold and precious/industrial metals with an Alternatives sleeve. Last November, we migrated to a 60/30/10 framework of stocks/bonds/alternatives. We believe an incremental approach to this shift is prudent given the impact on client portfolios (recent volatility in metals is case in point).
• Positioning dynamics. Our tactical conclusion is that the engine driving returns is changing. The next phase of the global equity cycle should favor companies that convert fiscal incentives, AI spending, defense budgets, energy scarcity, and infrastructure investment into cash flow (not solely companies whose valuations depend on multiple expansion). Growing instability beneath the index surface is troublesome. We recommend maintaining current levels of exposure but continue to reduce dependence on U.S. Mega-Cap Growth and advise measured rotation toward more traditional Value corners of the equity market and higher quality tranches within fixed income.

Technical and Market Strategy

By: Chris Verrone, Chief Market Strategist

The trend in global equities remains “up and to the right.” What began as a narrow melt-up this spring has gone broad. Share prices for 75% of S&P 500 stocks are above their 200-day moving average and the Russell 3000 advance/decline line confirms the new highs among the major indices.  

• Rotation. This remains a highly rotational market – since the peak in the momentum factor on June 22, most sectors have strengthened internally, particularly Healthcare and Financials. Money is moving within equities rather than exiting the asset class – hinting to us that a 4.75% 10-year yield is not competitive enough to pull money away from stocks in a 6.5% nominal growth environment.
• Financials. We can’t think of too many times in our career when a backdrop like we have today—global Banks stocks in gear and credit conditions benign (fresh tights for BB/BBB spreads last week)—has coincided with the market being on the cusp of having a big problem. We expect any seasonal or pre-midterm weakness to remain controlled and corrective.
• Leadership. As the tape has emerged from the momentum unwind of June and July, pay attention to what is and is not reclaiming the baton of leadership. The percent of Semiconductor stocks trading at 20-day highs (about 20% earlier this month) suggests a split response. Notably, the Utilities remain weak and have migrated to the bottom of our sector rankings. We don’t expect any leadership resurgence here.
• Rates. The trend in global rates also remains up, but the velocity of the move is controlled… believe it or not, this is one of the narrowest 18-month ranges for the 10-year yield ever. So far, higher rates have not upset credit conditions or been met with defensive leadership (we get more worried when this is the case).
• Sentiment. The biggest risk we see is the one right in front of us: so goes price, so goes attitude. Expectations as expressed through the package of sentiment data is getting more aggressive. With the weekly bull/bear ratio nearly 4 to 1 (a top decile reading), we have to be alert to when the market stops validating the excitement.
• Surprises. Two items to put on the radar are 1) some of the “weak links” aren’t so weak anymore. Concern persists on the private credit / alternative asset managers, but they’re acting better, and 2) we see signs of life from “the bottom of the K” – namely, lots of restaurants of all sizes breaking out (this wasn’t the case in the 2021/2022 inflation period).

ETF Research

By: Todd Sohn, Chief ETF Strategist

• Heavy inflows. The ETF ecosystem remains in full motion with over $2 trillion inflows and 900 new funds year-to-date. Both are well ahead of any historical precedents. Tactically, while July offered a reset for higher beta corners, flows showed no slowdown. Equity ETFs have averaged $6.5 billion per day since the June 2 market high, compared to sub-$3 billion during the March correction.
• Technology. Digging into the sector space, while corrective action reset High Beta relative Low Beta from its top decile of performance, this did not deter enthusiasm for Technology-related exposures. Tech ETFs have seen over $25 billion inflows since their recent high, nearly twice all other sectors combined. We would look to “low Tech / low correlation” areas such as Natural Resources, REITs, and the Low Volatility Factor to complement portfolios.
• Leverage. Keep a close eye on the resumption of levered activity. While Korean regulators tightened use of levered ETFs, U.S.-listed levered ETF notional value is again approaching $500 billion (a highwater mark). We suspect swap counterparties may begin to grow uncomfortable yet again (potentially soon).
• Where to? Away from leverage and Tech, the collapse of Beta for sectors such as Healthcare, Energy, and Financials is notable. Healthcare ETFs are seeing allocations return but are also coming off 3 years of heavy outflows. Energy flows have normalized following a spring sugar rush with the sector arguably a geopolitical hedge.

Fixed Income

By: Tom Tzitzouris, Head of Fixed Income Research

• Rinse and repeat. The Fed is getting closer to making a tightening move of some type in the next 4 months. At least that’s the market consensus, even after a weaker-than-expected jobs report and a relatively tame CPI print. These odds have come down in the last week, but the market still sees a hike coming before year-end. We’re not convinced a hike is coming, seeing it as more of a 50-50 bet (with, at worst, a slight bias towards a hike). This is important for bond markets between now and the next meeting, because if there’s any sign of an acceleration in inflation, the market is going to push up both short- and long-duration yields alike. This is one reason why we favor a slightly steeper curve from here. So Q3 is likely to be more about how expectations evolve rather than how the economy evolves, and unlike past periods, the bond market is going to have to set these expectations on its own – without the help of explicit forward guidance.
• Rates outlook. We favor minor steepening over the remainder of the year, with most of this move coming from reduced rate hike odds and lower term premia on the front end of the curve, rather than drastically higher long bond yields. For 10-year Treasury yields, we see a cap a smidge higher than current levels, around 4.80%, due in large part to our belief that a move to this level before midterms would trigger a Treasury response to push the yield lower. 20-year and 30-year yields have more flexibility to gravitate higher, but each of the long bond maturities will find the gravity of 10-year yields is still powerful enough to keep them tethered too. For the short end, we argue that one rate hike before year end is effectively a 50-50 bet, meaning that if the Fed delays or chooses not to move this year, 1-years through 3-years should give up a handful of basis points of yield, but not much more. Collectively, we’re left with a “weak bias lower” for the front end of the curve and a “weak bias higher” for the long end—and a resulting “weak bias towards a steeper curve”
• Credit spreads. Consistent with the stop-and-go economy over the next 12 months, we expect to see credit spreads wobble slightly higher between now and the end of 2026. Investment grade spreads should head slightly higher between now and year end, but with earnings growth still strong and the consumer still afloat, there’s only so much spreads can rise. In fact, any rise in spreads over the next 4 months is more likely to come from supply glut than from deteriorating credit quality, although 2027 may see more of both. High yield spreads are also likely to inch northwards this quarter, and a move back up to 300 basis points more likely than not, in our view. Here too, we suspect that spreads will be capped in both Q3 and Q4, but some portions of this space in weaker sectors and weaker balance sheets are likely to show growing distress, as represented by a bias towards a wider BB/CCC spread.