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Silver linings emerge in market correction
In recent weeks global equity markets have shown weakness, and interest rates have once again advanced. We have seen this pattern of gyrations in stocks and interest rates since early 2022 – when the bear market began. In keeping with this prolonged pattern of gyrations, we have the same laundry list of concerns ranging from ongoing inflation, Federal Reserve policy, and concerns about economic growth. A few more recent worries to add to the list include the UAW strikes and a looming potential Washington shutdown as of this writing. At this point, we believe investor concerns regarding inflation, Federal Reserve policy, and economic growth are overdone, if not misplaced. Though the UAW strikes and Washington shutdown are concerning, we have seen both eventually get resolved in the past while not disrupting economies or markets. There is an adage on Wall Street that “markets climb walls of worry,” particularly at the beginning of bull markets. Though there have been many periods in the past two years when these worries justified being defensively postured, we would suggest that we are now at a stage where this is no longer the case. Let’s “unpack” our more optimistic view of global markets.
Federal Reserve Gets Closer to Their Goal – Rising Inflation and Interest Rates Less Concerning
The main impediment to global stock markets since the bear market began was the unwieldy inflation rate of over 9% and the Federal Reserve’s adamant fight against it, employing their policy of raising interest rates. As we have mentioned throughout the Fed’s war against inflation, stock prices will suffer – until inflation is brought closer to their target. Though investors are currently – once again – worried about inflation, interest rates, and Fed policy, we believe they are missing the most crucial fact about this data: The Federal Reserve’s goal is to get inflation closer to 2%, and we are almost there! In fact, given the lag effect of rising interest rates, inflation may trend below 3% in the next few months – removing Fed policy as a market concern.
Resilient Economic Growth and Corporate Profits
Almost all economists and market experts have been surprised by how resilient the global economy has been in the face of the aggressive campaign of hiking interest rates. In past periods of similar rate campaigns, economies have been tipped into recession. Though that is always a risk, it appears that it is less of one than previously considered. The most recently reported US economic data reflected a robust 2.1% annual growth rate – far from receding. Moreover, last quarter’s corporate profit reports were, in most cases, better than expected. One of the reasons that the US economy has remained resilient over the past 18 months of Fed hikes lies in the high level of US government spending, which has been significant and has served as a stimulus for the economy. This factor doesn’t look to be ending anytime soon, as Washington can’t seem to muster up the will or courage to reduce spending. We will watch all these economic factors and corporate profit reports closely as we enter the fourth quarter. However, so far, all have been surprisingly resilient.
Interest Rates Have Peaked or are Close to Peaking
Given that inflation is now close to the Fed’s target and trending lower, interest rates are close to their peak. Peak interest rates are good news for global stock markets as we progress into the fourth quarter and in the coming years. For bond investors, this may be the last window of opportunity to “lock in” the higher yields available in short, intermediate, and long-maturity fixed income. During their last meeting, The Fed expressed that they may have to raise rates one more time. However, since that meeting, the bond market has pushed rates higher and is doing most of this work on their behalf. The higher rates are another reason that The Fed’s raising rate campaign is likely finished or close to being finished. As we transition away from higher rates, bonds should perform well over the coming years with the combination of attractive yields and price appreciation as interest rates settle to somewhat lower levels.
The Fed, Interest Rates, US Debt & the Dollar, as well as the Upcoming Election
Higher US interest rates coupled with significant US debt is always a concern for our team. Although significantly high US debt levels have always been a concern, these factors have not disrupted the economy or markets. However, now that interest on this debt has doubled over the past 18 months, this is becoming more concerning. Part of our thesis for the Federal Reserve to end its policy of raising and possibly lowering rates in 2024 is related to reducing the cost of these interest payments. In addition, high interest rates have created a robust dollar, which doesn’t align with what Washington or our global trading partners wish to see. Lower rates will reduce the dollar’s strength more in line with political wishes. Speaking of politics, we are about to enter an election year. We will be watching this closely. From our experience, election years are less important to the overall stock market than sectors of it, i.e., policies that may affect healthcare or technology, as an example.
New Business Cycle and Bull Market Ahead!
Though stock markets may continue to be volatile this fall, we are close to a new business cycle and a real, broad-based bull market. This new business cycle will be characterized by higher interest rates and inflation than the previous cycle – but will still be very compelling for global equities and bonds. What interests our team is the price-earnings (P/E) ratio of most stocks, which is currently under 15. This P/E ratio is an attractive valuation as we are heading towards a new earnings reporting season in the fourth quarter. The recent correction in all stocks – particularly technology and artificial intelligence – invites investors to add to these sectors while prices are temporarily depressed.
Managing Potential Risks to Our More Optimistic View
As you know, we are always focused on managing the risk of catastrophic loss – even when we are optimistic. In that spirit, we will continue to manage the risk of your assets through the allocation of stocks in your portfolio, managing your sector exposure, and using carefully placed stop-loss orders. Another element of risk management that investors can now return to is the Federal Reserve’s ability to lower interest rates (since inflation is at more manageable levels) should some economic data worsen or unforeseen events occur.
We hope you find this Quarterly Strategy Update helpful, and if you have any questions or have experienced any significant changes in your finances, please let us know.
Thank you for your continued vote of confidence in our work
Your Main Street Research Team