What are the biggest factors influencing the current economic climate?
Obviously, in 2022, it was all about inflation and Fed policy. The market did not have a good grasp of the terminal rate and when it would be reached. Bond volatility shot up and created volatility across all asset classes. 2023 saw a benign disinflation. There was some inflation surprise in Q1, but it appears to have been front-loaded in the quarter. We think that the disinflation process will resume as this year progresses. The bond market has been far less volatile, and we have a good grasp of Fed policy and what will change their trajectory.
The biggest factor today is the labor market. As evidenced by the mosaic of employment reports for March and April, the labor market has been inching closer to balance, though it remains somewhat tight relative to history. What we are experiencing right now is an economic cycle whereby corporate profits are on the upswing, so layoffs are low. If people have jobs, they tend to spend, further feeding future profits. We are unsure what will break that cycle, but we should remember that expansions do not typically die of old age; rather, an external shock to the system tends to disrupt the cycle.
As the labor market comes into balance, you begin to lose the cushion to absorb a shock as it becomes more difficult for unemployed persons to find a new job. So, we’re paying particular attention to the overall tightness of the labor market.
How do you see these factors impacting the investment landscape in the near future (6-12 months)?
Starting with stocks, this is a bull market until proven otherwise. We experienced an economic scare in 2022 that resulted in the second bear market of this pandemic recession/expansion cycle. It is not unprecedented, but it is rare to get a third bear market in the absence of a recession. We believe the strongest bull market returns are likely behind us, as 2023 was largely driven by multiple expansions. Typically, you would see a downshift in return as the main driver of returns becomes expanding profits. It also would not be abnormal to see valuations come down a bit, even with rising share prices, as fundamentals play catch up.
For the bond market, we see fair value on 10-year Treasurys as they capped around the October high of about 5%. Fair value is driven by Fed rate expectations, global rates, and core inflation. All three of these have the potential of easing in the next 6-12 months. In the absence of a recession, we expect it is unlikely that fair value will fall much below 4%. As for an intra-equity theme, we are overweight small caps in our portfolio strategy. Small caps, which have become negatively correlated with interest rates, are projected to grow earnings faster than large caps by Q1 2025 and are relatively attractive from a valuation perspective.
What’s a news headline you are keeping an eye on?
We have to keep an eye on geopolitical developments. The global improvement in inflation has occurred along with stability in the broad commodity complex. Consumers were able to absorb the first bout of inflation due to excess pandemic savings. With wage growth moderating and excess savings dwindling, we do not believe another strong inflationary impulse would end in such a benign fashion. If commodities surge again, that could prove too much for the consumer to bear, resulting in a recession. So, of course, we’re cognizant of developments in the Middle East.
Domestically, we need to watch the way that our government approaches the national debt. If austerity becomes the preferred option to begin working the debt down, then there is a chance U.S. economic growth stagnates for a long period of time, especially if private capital is not willing and ready to fill the gap in government spending.
Additionally, what will trade policy look like in the next four years?
Of course, our trade with China is a big part of the story, but the USMCA comes up for review in 2026. If one of the three parties is unhappy, the agreement may not be renewed. That is something that will come up under any administration. So, in the near term, we’re keeping an eye on the Middle East and, in the longer run, the way we approach the national debt and trade policies.