Resilience Amidst Growing Uncertainty

The U.S. economy has demonstrated surprising resilience amidst persistent inflation, historically high interest rates, and various political and geopolitical challenges. Market advances in the face of uncertainty is nothing new, but neither is investor complacency when things appear to be fine. While we certainly own our belief that the fastest rate hike cycle in history would have caused more economic pain than we have experienced thus far, we feel confident in our assessment that the strong momentum from artificial intelligence (AI) combined with significant fiscal stimulus pushed out the timing of a U.S. recession. The question we are grappling with now is if these “positive” surprises bought the Federal Reserve (Fed) enough time to achieve a rare soft landing. Time will tell but we know one thing for sure, the margin for error is razor thin going forward.

The U.S. Economy: Still Growing but at a Slower Pace

Despite stubborn inflation, multi-decade high interest rates, and a myriad of political and geopolitical issues, the U.S. economy has remained resilient relative to most other major global economies. Formidable growth in the U.S. has helped to support the global economy to date but it’s questionable how long this will last. For now, expectations remain rosy as highlighted by the International Monetary Fund’s (IMF) recently revised 2024 forecast for U.S. real economic growth of 2.7%. A meaningful pickup in the second half of the year is baked in the IMF’s forecast as first quarter growth came in light at 1.4%, a significant drop from 3.4% in Q4 2023 and 4.9% in Q3 2023. However, strong growth forecasts in the U.S. are at odds with leading economic indicators firmly in negative territory and unemployment (slowly) rising.

Given the strength of the economy, sticky inflation comes as no surprise. With that said, inflation reports over the past two months came in better than expected. Core CPI declined to 3.41% year-on-year and headline CPI a notch lower at 3.25%. Recent progress on inflation is noteworthy but the job still isn’t finished. With the economy slowing and inflation still well above the Fed’s 2% target, Jerome Powell and the rest of the FOMC is in a precarious situation. Keep interest rates higher for longer to ensure price stability and risk recession or cut rates early and risk inflation reigniting as it has in the past. With the U.S. presidential election just months away and other global central banks already cutting rates, at this point it’s anyone’s guess when the Fed will begin cutting rates and how aggressive they will be. Regardless, we caution the notion that any rate cuts would automatically translate into higher equity returns.

At the European Central Bank Forum on Central Banking in early July, Jerome Powell emphasized “a lot of progress” has been made on inflation while reiterating that he wanted “to be more confident that inflation is moving sustainably down” to its 2% target before starting to cut rates. He also noted an observation we’ve identified as a potential inflection point as the U.S. economy continues to march toward the next stage of the business cycle. The differential between job openings and unemployed workers is back to pre-pandemic levels indicating the labor market is now fully rebalanced. This implies that further softening of labor demand would hit actual jobs, not just open positions, and could therefore push up the unemployment rate more significantly. Given high household debt and low savings, a weak labor market would likely make it difficult to avoid some form of recession in the U.S.

U.S. Corporate Profitably in Focus

The mixed economic backdrop has seemingly had little effect on the equity market. With the S&P 500 up just over 15% in the first half of the year, performance has already outpaced even the most aggressive Wall Street forecasts. However, it remains true that market performance breadth is still lacking with a narrow group of companies carrying the load. The bifurcation of the haves and have nots has created the largest concentration in S&P 500 history (Top 10 holdings comprised of approximately 37% of the index).

In addition to the potential for Fed rate cuts, the boost from AI and a rebound in corporate earnings has contributed to strong performance in market cap-weighted U.S. Large Cap indices (e.g., S&P 500 and Russell 1000). Earnings growth for the most recent quarter once again surprised to the upside, even surpassing estimates from the beginning of the year. Analyst estimates hover around 10% earnings growth for 2024 and a further acceleration to the mid-teens in 2025. Worth noting is that Goldman Sachs has pointed out the six largest stocks in the index (Amazon, Apple, Google, Meta, Microsoft and Nvidia) are expected to grow earnings per share by 30% y/y, with the other 494 companies to grow by only 5%. Regardless, even with the positive outlook for corporate earnings, valuation multiples have expanded and currently rank in the top decile relative history.

Corporate profitability remains a bright spot and ever so important. Operating margins continue to rise and historically when they are rising, equities do not get into too much trouble. However, when margins begin to compress, organizational restructuring happens, and layoffs tend to follow. As highlighted above, softness in labor demand could affect the economy to a greater degree moving forward. At present, S&P 500 profit margins remain above the long-term average, appearing to have stabilized since mid-2023. Such persistently high profits are an impressive feat given the rising cost of labor and other inputs. Signs of margin compression is a signal we continue to monitor closely but as of now, the outlook appears to be stable.

Valuations Are Cheaper Abroad for A Reason

Angst about the political and geopolitical landscape is not just a U.S. problem. Look no further than France. Not so different than the U.S., budget deficit issues and high government debt relative to GDP has forced leadership to look for ways to become more fiscally responsible. One very unpopular solution included raising the retirement age from 62 to 64, which led to widespread protests across the country. This is perhaps not so different from how U.S. citizens would/will react to Social Security reform. Almost one year later, French President Emmanuel Macron’s falling popularity carried over to European Parliament elections resulting in his party’s heavy defeat. Shortly thereafter Macron shocked the markets by dissolving the government and calling for a snap election. The outcome was that France came close to having their first far-right government since World War II. With French equities selling off, credit spreads widening, and the Euro depreciating, the damage was mostly contained but additional pressure on French banks could become a big concern for the Eurozone broadly.

Elsewhere in Europe, turmoil in the United Kingdom (UK) has upended political stability in recent time. The Labour Party’s Keir Starmer defeated Rishi Sunak by a landslide. Starmer will be the fourth UK prime minister in just two years and the first non-Conservative Party leader in fourteen years. The UK has been struggling economically since exiting the European Union and more recently teetering on the edge of recession. Unlike the elections in France, general market and currency reaction was limited. Despite relatively low valuations, European equities need a catalyst to regain investor interest. Growth across the region is weak and many countries are dealing with their own fiscal issues. For investors searching for opportunities outside of the U.S., Asia may be a better long-term option, but selectiveness is critical.

Looking farther East, there is no shortage of reasons to be nervous about China. Outside of political pressure from both former President Trump and President Biden, US policymakers continue to push for supply chain resiliency over supply chain efficiency. Reducing reliance on China lies at the heart of this trend, with the US imposing export controls on key technologies, rebuilding domestic semiconductor supply chains, and working with allies and partners to coordinate on export controls and to build reliable supply chains for critical minerals, other key technologies, and pharmaceuticals. As such, US imports from China, as a percentage of total imports, stand at their lowest level since 2004. While lingering issues related to real estate and aging demographics remain, it’s fair to wonder where the bottom is for the world’s second largest economy, particularly when considering that it is still growing faster than most of the developed world, albeit at a slowing pace. With nearly $5 trillion lost in the equity markets between mainland China and the Hong Kong stock exchanges over a 3-year span, a lot of the known negative issues seem to be priced in. At less than half the valuation multiple of the U.S., selective pockets in China appear to be attractive. If history is a guide, valuations this low have led to outsized returns for those brave enough to participate.

U.S. Politics & Government Spending

For the first time in 35 years the US debt servicing cost is increasing. Higher inflation leads to higher interest rates and higher interest rates lead to a higher debt servicing cost. Due to several years of low rates in the U.S., the federal government pays a relatively low average monthly interest rate just above 3.25%. A concerning issue is that significant Treasury issuance to fill the gap between revenue and spending, combined with high rates, is pushing the average payment higher every month that passes. Currently net interest costs account for 17% of tax revenues and the federal deficit is running close to 7% of GDP, approximately double the historical average.

In early June, the Congressional Budget Office (CBO) revised their 2024 deficit projection from $1.6 trillion to ~$2 trillion along with adjusting revisions further through 2029. With budget deficits projected to hover around the $2 trillion mark for the foreseeable future (absent a recession), it’s clear that something needs to change. Flexibility from the government to respond to a crisis and/or provide additional fiscal stimulus to boost the economy may be limited for the foreseeable future. For those who remember discussions about Modern Monetary Theory (MMT), we are effectively living it now.

Perhaps we are biased as investors, but given that current deficit trajectories are unsustainable, we believe the budget deficit should be the core issue regarding the upcoming presidential election. Unfortunately, it’s not. The unique nature of this election is depriving voters from the opportunity to hear actionable plans on how best to deal with the issue before it crowds future growth. The reality is that neither presidential candidate can claim fiscal responsibility during their time in office so not talking about it is probably the best strategy for now. The “good news” for the immediate future is the S&P 500 has increased in every presidential re-election year since 1944 by an average of 15.8%. That is 13 straight presidential re-election years, which includes years with recessions, like 2020. In addition, historically S&P 500 performance in presidential re-election years is stronger than in open election years by 13% on average. This likely happens because presidents use the tools available to them to impact the economy ahead of their bid for re-election.

Though November 5th is quickly approaching, a lot can still happen from now until then. As it stands now, and following the first presidential debate, the Republican party has a lot of momentum. Concerns about President Biden’s health and his ability to lead the nation the next four years is now a bi-partisan issue. We won’t opine on whether President Biden is replaced as the Democratic nominee, but some popular names being mentioned are Gretchen Whitmer, Josh Shapiro, Gavin Newsom, and, to a lesser degree, Kamala Harris. The Supreme Court’s ruling on presidential immunity also favored former President Trump’s chances to regain office, effectively eliminating any pre-election legal distractions. From an investment perspective, we cannot discount the growing chance of a total red wave where Republicans control Congress and the executive branch (with continued majority representation in the Supreme Court). Portfolio repositioning ahead of an election is not something we normally consider worthwhile but given the circumstances, it is something we are evaluating closely at this time.

Diversification is Important During Uncertain Times

There will inevitably be surprises that shock the markets that no one saw coming. When valuations are high and risks apparent, such as they are now, we naturally worry about the potential for a negative surprise that could set off the next Tech Bubble (2001) or Great Financial Crisis (2007-2009). However, it’s important to remember that not all surprises are bad. Last year, the positive market surprise was the exuberance around AI, which certainly played an important role in powering stocks and the economy further. Still, there seems to be a widening gap between the volatility and the performance of the average stock and the stock market as a whole. A broadening out of performance across the market would greatly benefit client portfolios. In our view, adding diversification is a logical choice to benefit from the potential market broadening or buffer downside risk if the economy were to slow faster than expected.

For now, what we know is that U.S. economic conditions remain mixed with slightly more positives than negatives. Globally, the picture is less positive with a handful of bright spots. The Fed may cut rates later this year, but a continuation of the bull market will hinge on corporate profitability holding up. Compared to historical standards, valuations across equities, fixed income, and real estate are generally stretched, and in some cases to the extreme. With rising uncertainty surrounding the election and massive debt refinancing cliffs lingering across commercial real estate, corporations, and the federal government, caution is still warranted despite rising tides since markets bottomed out in October 2022.

Our focus is to position our client’s assets based on their long-term investment objectives and risk appetite, while adjusting for our best estimation of what we expect across asset classes in the short to medium term. We expect to make further adjustments to our investment strategies in the coming months. As always, we welcome the opportunity to discuss our perspective and portfolio positioning with you.