Equities Entering a New – and More Challenging – Stage

• The economy is set to normalize as fiscal and monetary ‘doping’ wanes. The U.S. economy has continued to defy recession calls, thanks in part to all the fiscal and monetary support it received after the pandemic. All that ‘doping’ led to a strong recovery, which the markets initially cheered, but eventually led to the unpleasant side effect of soaring inflation. Federal Reserve (Fed) officials responded aggressively to clamp down on inflation, lifting interest rates at their fastest pace in decades. The Fed’s medicine is working, with growth and inflation downshifting from 2022’s pace. And now that the ‘doping’ effects are wearing off, consumers are showing signs of fatigue (i.e., dwindling excess savings, higher debt servicing costs). Going forward, the economy will need to grow on its own merits, without all that artificial stimulus. The combination of higher interest rates, tighter credit conditions, and slowing job growth should steer the economy into a mild recession, starting in Q4 2023.
• The Fed is nearing the tightening cycle ‘finish line’. After 500 basis points (5%) of cumulative tightening over the last 15 months, the Fed is getting close to the finish line. Restrictive interest rates are having the desired effect – inflation is rapidly decelerating (4.0% YoY in May), growth appears to be slowing, and the labor market is becoming more balanced (i.e., rising jobless claims, declining quits rates, fewer job openings). While growth and inflation are moving in the right direction, Fed policymakers have maintained their tightening bias as inflation remains above their 2.0% target. Given the long and variable lags in monetary policy, Fed officials are slowing down the pace of tightening to see what impact higher rates are having on the economy. However, one more rate hike may still be needed, which will push the fed funds rate up from 5.25% to 5.5% by year-end. But as the disinflationary trend continues and growth decelerates to a 0.5-0.7% pace in 2024, a 4.0% fed funds rate is now in sight by year-end 2024.
• The next stage for interest rates is a ‘downhill glide’. Interest rates have endured a tumultuous climb, but as we near the peak in the fed funds rate, Treasury yields are set to enter the next stage. Slowing growth, declining inflation, and the prospect of less restrictive policy in 2024 suggest Treasury yields are poised for a downhill glide. In fact, we expect the 10-year Treasury yield to reach 3.25% by year-end as these economic trends become more visible in the official statistics. With the yield curve still deeply inverted and cash equivalents yielding above 5%, investors should be mindful of reinvestment risk (i.e., the possibility of reinvesting at a lower yield). The combination of healthy coupon yields and the opportunity for capital gains, once yields start to decline (as they typically do after the Fed concludes its tightening cycle), suggests it may be prudent to lock in longer maturity yields. A prolonged period of subdued growth could create challenges for lower-quality credits (i.e., high yield), therefore we prefer to play it safe and focus on high-quality bonds (i.e., Treasurys, investment grade corporates, and munis).
• Equities to enter a new, more challenging stage. Our out-of-consensus, positive outlook on the equity market at the beginning of the year has paid off, with the S&P 500 delivering a ~15% gain YTD and nearing our 4,400 year-end target earlier than we expected. As we discussed in prior Weekly Headings, we have become more cautious on the equity market in recent weeks. Our rationale for dialing back our optimism was due to the steady climb in bullish sentiment flagged in the AAII Investor Sentiment Survey and relative strength indicators moving into overbought territory. These technical indicators, combined with other Wall Street firms rushing to lift their year-end S&P 500 price targets in recent weeks, indicated that much of the good news had been priced in – suggesting the market had entered into a more vulnerable position, susceptible to disappointment. However, longer term, we remain optimistic and expect the S&P 500 will grind higher over the next twelve months to at least 4,600 as macro tailwinds (i.e., the Fed concludes its tightening cycle, declining interest rates, resilient margins, and record cash on the sidelines) provide a more supportive backdrop for equities.

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