Investing cautiously and not against in ways that might run contrary to the US central bank policy gave rise to the adage “Don’t Fight The Fed”! Despite that, a section of investors seem to wage this fight unequivocally. Although the Fed offered explicit guidance that continued monetary tightening may be needed to subdue inflation, investors seem to have ignored how such policy action could further weigh on the economy and corporate profits. Instead, they have sent US stocks rallying on the apparent conviction that inflation will quickly fall to the Fed’s target of 2% and that the central bank will soon turn to cutting interest rates.
The rebound has sent valuations to extreme levels again, with the SPX now priced at 18.5 times forward earnings. But is this confidence justified? Is inflation truly controlled and will the US economy come out of this tightening cycle with only a scratch? Morgan Stanley’s Global Investment Committee believes investors should recognize that this is a period of profound uncertainty. Three developments amplify my concerns:
- Opaque Economic Outlook
Consumers are spending down their savings and running up credit card balances at a time when corporate layoffs have begun in some sectors. Even as service sectors remain strong, manufacturing new-order rates continue to decline, suggesting weaker demand for goods. Some investors expect the economic recovery in China to rescue the US economy from steeper decline, but if US growth rebounds, that could put upward pressure back on prices and prompt the Fed to keep rates higher for longer, in turn weighing on asset prices.
- Perturbed Corporate Profits
The consensus estimate for SPX company earnings this year is higher than likely at $224 per share. This relatively sanguine forecast is based on 2020-2022 trends, which seems to ignore the fact that economic growth has been extremely distorted in those recent years: For the past 10 quarters, US nominal GDP has run between 9% and 14%, versus the long-run trend of 4-5%, and SPX operating margins have averaged 14.5-16.5%, versus the 25-year average of 12.5%. The tendency for performance to revert to a long-term average could bring about a negative year-over-year change in earnings growth, known as a “profits recession.”
- Labor Market Positivity
Despite gathering headlines on layoffs, the US labor market has remained strong overall, as measured by large numbers of new job openings and a recent 53-year low in the unemployment rate. A resilient jobs market could help the economy achieve a “soft landing” if robust real wages support consumption. The conundrum, however, is that strong wages and spending would likely add to inflationary pressures and thus provide little rationale or incentive for the Fed to cut rates.
Inflation has likely peaked and the bulk of Fed tightening is probably behind us. But remember that policy operates with a lag, and uncertainty around the economy, earnings and jobs matters. It is a confusing time that demands hedging one’s portfolio positioning. To that end, investors should focus on income generation while this cyclical period of maximum uncertainty plays out. Lean into short to intermediate term Treasuries, municipals, investment-grade corporate bonds and dividend-growth stocks.
The Fed hiked interest rates for the eighth time earlier this month and warned of ongoing increases needed to bring down inflation. That same week, the jobs report for January showed the US unemployment rate fell to a 53 year low. This is powering wage gains and, in turn, boosting consumer spending, which might explain why consumer prices in the US rose more than expected last month. The Fed has two responsibilities: keep employment full and inflation around a stable 2%. But the central bank can only do half a victory lap because January’s jobs and inflation reports painted two very different pictures. The first was an absolute blowout: 517,000 jobs added (more than double the month before and shattering economists’ estimates of 187,000), a 53-year low in the unemployment rate, and strong wage growth that was higher than expected.
But while promising for workers, the jobs report was probably too hot for the Fed’s liking. The central bank has been aggressively increasing interest rates in an effort to dampen consumer demand and bring down inflation. Problem is, inflation isn’t coming down as fast as hoped. Data this week showed consumer prices increased by 6.4% in January compared to the same time last year. That was only slightly lower than the 6.5% pace recorded the month before, and economists had expected a bigger deceleration to 6.2%. On a month-on-month basis, consumer prices climbed by 0.5% in January – the most in three months and a steep acceleration from December’s 0.1%.
One of the reasons why inflation isn’t falling fast enough goes back to the red-hot labor market, which has bolstered wages and allowed many Americans to keep on spending – even as borrowing costs rise and inflation stays elevated. In fact, separate data this week showed retail sales increased 3% last month from the one before – their biggest gain in nearly two years and easily topping forecasts of 1.9%. Those numbers aren’t adjusted for inflation, meaning that consumer spending outpaced the 0.5% increase in consumer prices for the month by two and a half percentage points.
Inflation is likely to stay high for a while. On top of a blistering labor market, China’s reopening could fuel inflation in the US and the world over. Bloomberg Economics, for one, reckons China’s economic growth will almost double this year to 5.8%, and that could lift global inflation by close to a full percentage point toward the end of 2023. But even putting the labor market and China aside, history tells us that spikes in inflation take a long time to disappear. A study by Research Affiliates looked at surges in 14 developed countries over the past 50 years: when inflation crosses above 8% (the level reached by most of the developed world last year), falling back to 3% usually takes six to 20 years, with a median of over ten years.
2. Interest rates will probably climb to a higher peak than previously thought.
But that doesn’t guarantee a repeat tumble for stocks. That’s because the marginal impact on stock valuations of a one percentage point increase in rates is far less when you start at today’s levels of around 5% in the US, versus when you start from zero. Put differently, rates rising from 0% to 1% hits stock valuations way harder than rates going from 5% to 6%.
The US securities regulator proposed new rules this week that would force investment advisors to secure clients’ crypto assets with qualified custodians. The idea is to build better safeguards around investors’ assets and comes after the collapse of several high-profile crypto companies last year, which revealed that customer funds were not as safe as had been advertised.
Hence the title of my article! Have a great month making and taking right investment decisions or at least try!
Risk warning – As with all investing, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance and the contents of this outlook is not a reliable indicator of future performance. This article/print is protected through international copyright & print laws and may not be reproduced, distributed or copied without exclusive permission from the writer.
Geoffrey Muns is an Independent Financial Advisor and Planner certified from the UK, US and UAE based out of Dubai for the past 20 years. He also works in the PE/VC space and is a seasoned investment banker having worked with international banks and investment firms in the region. You may contact him at email@example.com