Aesop’s fable “The Boy Who Cried Wolf” teaches a simple lesson: do not lie or else no one will believe you when you are telling the truth. It’s an easy enough story to apply if you are the boy, but what if you are one of the villagers? At what point do you stop taking the cries of wolf seriously? Hindsight makes it easy, but if you put yourselves in the villagers’ shoes, knowing the threat of a wolf was a real threat, but the boy had proven to be an unreliable messenger, it’s tough to know how you would have responded.
If you haven’t already guessed it, the boy represents the financial media and economists, and the villagers represent the rest of us. In early 2022, the calls for recession began and while some have reversed course, there are still plenty calling for a recession today. Inflation has fallen significantly since 2022 and the stock market is much higher, but risks remain, and depending on which commentator you listen to, the presidential election, geopolitics, inflation reacceleration, Fed policy, unemployment, and the government debt have all been cited as reasons why we should be worried. My hope is to look at where we are and where we are headed to better understand if there really is a wolf this time.
Let’s start with the two areas the Fed is most focused on: inflation and unemployment. When I wrote last quarter, inflation was just under 3.5%, and has since come down to approximately 3%. The last three months have been particularly encouraging, as the early year reacceleration of inflation has slowed, and we are seeing disinflation in areas such as shelter. This bodes well for increased progress on inflation, even if it will take further progress to reach the Fed’s target of 2%. Meanwhile, unemployment made its low of 3.4% in April of last year, then climbed to 3.9% when I wrote the last commentary, and now has climbed further to 4.1%. If you disregard the trend of each, you still have a low unemployment rate historically and an inflation rate that is about in line with the historical average, but still a little above the Fed’s target.
Up until now, the Fed has been rightly laser-focused on inflation, as it has been well above their mandate and unemployment has been low. However, in Powell’s testimony before Congress, it became clear that the Fed is starting to take notice of the upward trend in unemployment, and with inflation falling, the Fed can afford to be focused on labor risks as well as the price risk. Add to that slowing wage growth and slowing jobs growth, and you have a labor market situation that is not as rosy as it was a few months ago. If the Fed deems that the risk of rising unemployment outweighs the risk of inflation, they will move to cut rates. Our expectation is to see at least one cut this year, or, in our opinion, more likely two. The best-case scenario is that the Fed can loosen monetary policy slightly to help the employment side, without loosening too much to cause inflation to flare up again. We think out of fear of inflation’s reacceleration, the Fed risks the policy mistake of a continued rise in the unemployment rate. We will come back to our level of concern about that scenario.
One of the reasons for optimism is the state of corporations right now. CEO confidence is rising, companies’ cash on their balance sheets is rising, and we have had consecutive quarters of better-than-expected earnings to start the year. The companies that make up the S&P 500 grew their earnings in the second quarter by 10% year-over-year.
Another positive development since my last note is that interest rates have fallen with inflation and the expectation that Fed cuts may be coming soon. This has allowed bond returns to improve with the US Agg Bond Index improving – from down approximately 1.5% three months ago, to up nearly 1%.
It’s been a bizarre year in the stock market so far. The S&P is up 16%, but if you look under the surface, it hasn’t been a great year all around. The largest companies, particularly the ones with an AI focus, have had a tremendous year, but across the board only two of eleven sectors are outperforming the S&P, and Real Estate is still negative on the year. Additionally, from a market capitalization standpoint, it has been the greatest divergence in performance since 1998, with small-cap stocks roughly flat on the year. Our view is that the path forward for the market will require a broadening of the rally beyond the largest tech stocks, but that process will cause some near-term volatility and potentially a bit of correction. We would see a correction that leads to a broad market rally as a very healthy thing.
Since it’s July of an election year, I would be remiss if I ended this letter without briefly talking about the election. There are a few policy items that do matter to markets. The primary one is the sunsetting of the Tax Cut and Jobs Act of 2017 and the differences in the candidates on how they address that. There will be a lot of rhetoric on both sides leading up to the election but in our view, this is the short-term issue that matters the most in the election.
When you are investing in markets in election years, historically it has been more important to understand election market seasonality than it has been to guess the winner of the election correctly. Over 83% of election years have been positive for the S&P 500 since 1926 and returns have been higher than in non-election years. As for how much it matters who wins, when a Democrat was in office and a Democrat won, the average return was 11%. When a Democrat was in office and a Republican won, the average return was 12.9%. However, those positive returns haven’t historically been spread evenly throughout the year. The two best times for the stock market in an election year have historically been between Memorial Day and Labor Day, and between Election Day and the end of the year. The worst time for the market in election years has been between Labor Day and Election Day. This year, the market has followed the historical election year pattern very closely. We will be more cautious on the market in the months leading up to Election Day, as the market doesn’t like uncertainty and there will be plenty of headlines giving us whiplash in the days leading up to the election. However, once the uncertainty is behind us, the market tends to rally even if the expected candidate doesn’t win. In 2016, Hillary Clinton was the favorite to win, but on election night, as it appeared that Donald Trump was going to pull the upset victory, the markets dropped 5% at the thought of uncertainty bringing many commentators out to predict a dire recession and market sell-off. However, when markets opened in the morning, the market had rallied and was higher than it was going into the election, when it expected Hillary Clinton to win. The market went on to have an extremely positive finish to the year and it had a similarly positive finish to the year in 2020 when Joe Biden won the presidency. So, expect volatility, dire headlines, and perhaps a drop in the markets leading up to the election but on the other side, if history is any guide, expect a far more positive outcome than many were expecting, no matter who wins.
In summary, we think stock market rotation and election seasonality may create a bumpy ride for the next few months. We will likely get a little more defensive in our positioning in the coming weeks for the short term, reducing some of our exposure to the areas of the market that have had a great year so far, and adding some exposure to some of the more defensive sectors and asset classes. We remain long-term bullish and think the economy is in very good shape and have no reason to see an imminent end to this bull market, even if there is some short-term choppiness. Finally, we will be closely watching the labor market and the Fed’s actions to see if a policy mistake is made. At this point, we are not concerned about the risk of a recession given the health of the consumer, the labor market, and the health of companies’ balance sheets, but if the labor market continues to deteriorate and the Fed doesn’t act, we may change our tune in the coming months.
So that leaves us with the question of what to do with the cries of wolf. We think the current cries of wolf are overstated but we’ll be keeping our eyes peeled in the coming months.
As always, feel free to reach out with questions.
Christian
