June 20, 2023

Mixed economic data over the past couple weeks continued to support the soft landing narrative that has underpinned the market’s advance.  Economic growth is slowing, but still holding up better than previously expected.  Meanwhile, inflation is cooling, but not enough to put the Fed at ease.  Ongoing solid job and wage gains, along with excess pandemic-era savings, continue to support resilient consumer spending and inflation.

Last week, the Fed delivered on its well-telegraphed June “skip” as Chairman Powell brokered a compromise between the hawks and the doves, holding tight on the interest rate for now while signaling the possibility of at least two additional hikes via its Summary of Economic Projections (SEP).  Hawks are concerned that core inflation hasn’t really slowed much despite +500 basis points of rate hikes combined with Quantitative Tightening (QT) over the past year.  The doves, leery of how much tightening has already been done along with banks restricting credit in the aftermath of the regional bank crisis, want more time to see the impact.

The market’s rise and growing investor complacency seem to suggest more investors are buying into the “immaculate disinflation” story (the latest iteration of “this time is different”), with two increasingly non-consensus views emerging:  either (a) growth and inflation remain stronger for longer, requiring the Fed to take interest rates above 6%, or (b) growth and inflation slow materially in the months ahead, causing profit margins and earnings per share to collapse.  Neither outcome would be positive for the market in our view.

It is our belief that bank credit tightening will begin to adversely impact the labor market, especially considering small businesses – the primary engine of job growth in the U.S. – are heavily dependent upon bank loans to finance expansion.  When the job market does weaken, the Fed is unlikely to be in a position to quickly come to the rescue due to stubborn inflation, potentially exacerbating the downturn.  This is what is different than at any time over the past 30 years.

Market gains this year have been powered by an extremely narrow group of mega cap technology stocks.  A recent Bernstein analysis showed that the amount of concentration has been historic; the gains have been almost entirely driven by price-to-earnings (P/E) multiple expansion; and subsequent returns for the leaders are likely to be below average as we’ve seen historically following similar periods.

We continue to hold the view that market risk remains elevated with stock valuations full, earnings estimates at risk, investor sentiment increasingly bullish, and market liquidity set to decline as the Fed resumes QT and the Treasury issues over $1 trillion in new securities in coming months.  We have also entered the typically weak seasonal trading period between June and November.