Stocks dropped to a one-month low last week and the reasons for the weakness couldn’t be clearer:
Disinflation has slowed materially and as a result the market is increasing Fed rate hike expectations, which is causing Treasury yields to surge and that’s pressuring stocks. To that point, stocks and bonds rallied in January on the ideas that 1) Inflation was declining (or disinflation), 2) The Fed was almost done with rate hikes and 3) There wouldn’t be a hard economic landing. Two of those three ideas have been refuted via the data of the past three weeks, and that’s why stocks have given back more than half of the YTD gains. Understand that I predicted that the next few months would be volatile as we digest the Fed’s next moves. This is to be expected.
Broadly speaking, for these declines to stop markets need to see data that shows inflation is again dropping and, in turn, the Fed is getting close to ending rate hikes. Until that happens, we should expect continued pressure on both stocks and bonds.
From a strategy standpoint, over the past several weeks we have pushed back against the budding optimism among investors that the Fed was close to done with rate hikes and the battle against inflation was close to being won. We have continued to be invested in dividend paying value stocks for a large part of our portfolios including the mutual funds. We have also added International stocks to our managed accounts to reflect a renewed interest in European stocks and emerging stocks.
The basis for that pushback was simple. Since the start of this hiking cycle a year ago, the market has consistently been too eager in pricing in an end to Fed rate hikes, taking any hint of a drop in inflation or slowing growth and extrapolating it out to be some catalyst that will cause the Fed to back off. That expectation has been wrong every single time (including most recently) and it won’t happen until the Fed sees more progress on inflation.
As such, we’ve remained defensive.
Now, it’s important that my skepticism towards the early rally not be confused with me being a perma-bear. I’m not! I’m far from it. There have been some important positives in the markets over the past several months: 1) Economic activity remains resilient, 2) Earnings have held up better than investors feared (at least so far), 3) Disinflation is occurring and the peak in inflation is behind us. and 4) The Fed is much closer to an end to rate hikes than a beginning. While those positives have occurred, investors remain far too eager to extrapolate one data point to imply an imminent end to Fed rate hikes and an economic soft landing and as long as that remains the case, I’ll remain skeptical of rallies above fair value.
That said, the S&P 500 has fallen into the upper end of what I consider “fair value.” As such, if investors found themselves underinvested and with major “Fear of Missing Out” when the S&P 500 was above 4,100, now is likely a solid time to begin to slowly increase exposure to stocks (and longer-dated bonds). I say that for this simple reason: Economic data has turned against the market (slower disinflation and strong growth) but that can easily change back and if/when it does, the rally will resume. I don’t expect it to happen this week (next week is the next big week of data) and I’m by no means saying the bottom is definitively in. However, any good analyst must make allowances for the other scenario occurring too, and the truth is there are positives occurring in the market, and a rally is not an impossible scenario.
Given the current set up, we continue to advocate for any equity allocations to go towards defensive sectors and value. The worst-case scenario for stocks is a recession that crushes growth and earnings. In that outcome, defensive sectors will likely handily outperform, and they should keep losses manageable. If/when a soft landing becomes more likely, we’ll happily abandon value and defensives and embrace growth and tech, but we are not yet at peak Fed hawkishness and as such I am wary of rising yields that will pressure growth and tech as it’s done for 15 months now.
Bottom line, stocks and bonds can bounce back but they need the following: 1) Signs of a resumption in the drop in inflation, 2) Stable economic growth (not too good or too bad) and 3) Fed rate hike expectations to stop rising. When that happens, stocks can rally, but until it does, we’ll remain defensive and cautious.
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