- Strike one: The Fed not cutting this summer
- Strike two: Geopolitics
- Ball: Corporate earnings
Well, it’s baseball season, so here we go — in the bullish ballgame of the economy versus the market, I am currently seeing two strikes and a ball.
Strike one is the Fed likely not cutting this summer, which many bulls were counting on. I dare say, I don’t think we’ll see the first cut now until after the election. We need to start tweaking our investing swing to the policy pitch of “later and less,” with a terminal rate in sight that is likely higher than previously believed. I am thinking more like 4%, at least until we see our next recession. This really matters, both for bonds and for equity price-to-earnings (P/E) multiples. The fact that inflation has been above its target rate of 2% for around three years now, risks that at some perhaps sooner point the bond vigilantes will lose patience. It’s to be expected that above target inflation will rear its head every once in a while, but it’s mission critical that when it does rise that it be quashed quickly – a year or so is fine, three years is starting to look problematic. Keep in mind that over the last few weeks the yield on the ten-year note has been increasing, this at a time of heightened geopolitical uncertainty, when we’d normally expect to see a flight to quality and bond yields going lower. So, either the markets are relatively complacent on the geopolitics or, more likely in my view, the bond market is sending us its first signal that we need clarity, post the election, on the inflation fight, and also on addressing U.S. deficits and indebtedness. The truth is there’s just huge uncertainty out there right now, and it does concern me.
Strike two is the geopolitics. Investors shouldn’t downplay the seriousness of what is going on right now in the Middle East, and in Ukraine. And, as importantly, they should also think about the broader relationships and alliances that those conflicts are fostering, particularly perhaps when it comes to the relationship between the U.S. and China. It seems to me that trade tariffs, that were originally imposed by Trump, now have much more widespread and bipartisan support, and they pose a long-term threat to profits and productivity.
Ball. Just outside the strike zone for the time being is the ball of corporate earnings. Those higher rates I mentioned put yet more pressure on earnings, and on the already heady growth and valuations priced into equity markets. As I have said before, the stock market has been impressive largely because of tech, and some of the other pockets where one might look for opportunities — small caps, value stocks, non-tech large cap — have simply not delivered. It’s true that some features of the economy continue to be strong — unemployment is low, retail spending, manufacturing, and industrial production are all ok — but I still don’t see much profit generation outside of large cap tech, and I think earnings outlooks will soon err to the downside. My current thinking on the S&P 500 is rangebound between around 4700-5000 in the coming months up until the election.
Of course investors don’t have the luxury of watching this all play out from the stands with a hot dog in hand — they are very much in the game. So, how to play? Well, I think the S&P 500 is a little ahead of itself, so I think an underweight to equity makes sense at the moment, and an overweight to fixed income, particularly at the shorter end of the yield curve. This is a view we had before, and which we now refresh. Investment grade and high yield credit spreads remain tight, so I prefer municipal bonds for the taxable investor. We need an alternative to tech, and I quite like financials, but prefer healthcare, communications, and utilities. In the infrastructure allocation of an alternatives sleeve, that’s an area where I think an overweight allocation also makes sense.
Yes we’re at a pinch point in the game, but keep your nerve, watch your pitches, and swing judiciously. Remember why you play.
– David
