The US economy is less sensitive to higher interest rates due to a tight labor market, but stocks are still affected by short-term rates and a challenging earnings outlook.
Inflation can negatively impact corporates, causing margin compression and stagnation in profit growth, but a strong job market and savings act as backstops.
Market valuations are relatively moderate compared to previous cycles, with opportunities emerging in sectors like energy and consumer discretionary.
Deep dives
The impact of Fed policy on the US economy
The US economy is less sensitive to higher interest rates than in the past, thanks to a tight labor market and strong employment. However, stocks are still affected by short-term rates, and a challenging earnings outlook is expected. Inflation has caused margin compression and stagnation in profit growth, particularly in sectors like corporates and consumer goods. Valuations in the market are fair, with the technology sector facing short-term earnings challenges. Cash becomes an attractive alternative investment due to higher rates, and non-US equities appear undervalued compared to the US market.
History and market cycles
The 90s were characterized by stable economic environments and lower interest rates, leading to steady market growth. However, today's market has unique attributes, such as a less debt-heavy capital structure and a shifting focus on digital technology. The last 20 years have seen economic disruptions like the bursting of the internet bubble, September 11th, and the financial crisis. These events make it challenging to apply historical precedents to the current market environment, emphasizing the need for a logic problem-solving approach rather than relying solely on historical comparisons.
Inflation and its impact on corporates and consumers
Inflation can negatively impact corporates by causing margin compression, dwindling profit growth, and a midling economy, resulting in what is referred to as 'stagflation light.' Consumer sentiment is influenced by inflation, but a strong job market and savings act as backstops. While companies may gain pricing power during inflation, wage increases can squeeze profit margins. Different time frames and unique factors make historical comparisons difficult, emphasizing the need for a logic-based approach rather than assuming a replication of past periods.
The impact of rates and inflation on the market
Market valuations are affected by interest rates, but in the current environment, the impact is relatively moderate compared to previous cycles. The yield curve is expected to be inverted for a prolonged period, causing pessimism in the hedge fund community. However, economic growth is predicted to remain stable, with opportunities emerging in sectors like energy and consumer discretionary. Banks face mixed prospects, and small caps offer value. Overall, the market environment suggests an anemic economic backdrop with weak growth, low unemployment, and persistent but manageable inflation.
Future outlook: Customized portfolio analysis
A shift towards customized portfolio analysis is observed, where discussions focus on individual clients' portfolios and how they compare to peers. The work involves creating universes of managers and analyzing portfolio risk. The goal is to help clients understand their risk profile, identify non-consensus calls, and ensure their bets are well-positioned. This approach offers more tailored and valuable insights, enhancing client conversations and providing a foundation for informed decision-making.
With 3 decades in markets, Jon Golub’s career is split evenly between the buyside and sell-side. Reflecting on his early days in the industry, Jon notes the especially benign environment that characterized the 90’s, a period of post-Cold War geopolitical stability, with the trauma of 70’s inflation sufficiently in the rear view even as the tail wind of lower interest rates was still a positive force in markets. While analyzing time series of economic and financial data is a critical part of his team’s process, Jon is careful not to draw broad conclusions because in market cycles, “this time is actually different” probably applies more often than not. He points to the less debt heavy capital structure of key segments of the S&P 500 today versus decades ago as a ready example of the unique attributes of different time periods.
Our conversation shifts to Jon’s work as Chief US Equity Strategist and Head of Quantitative Research at Credit Suisse and his assessment of present day risks and opportunities. Here he makes the interesting point that the US economy is less sensitive to higher rates than it has been historically. But for stocks, the short rate does matter, especially in the context of what he expects to be a more challenging earnings outlook. He sees the impact of Fed policy at least partially blunted by a labor market that is even tighter than the headline unemployment rate suggests. Next, we talk about inflation and the various ways in which it impacts both corporates and the consumer. For the latter, inflation matters, but the healthy jobs market matters more, especially when set against the backstop of savings. For companies, margin compression, dwindling profit growth and a middling economy lead to what Jon characterizes as “stagflation light”. This less than rosy outlook is in the context of valuations that appear reasonably fair, especially when set against long term corporate bond yields.
I hope you enjoy this episode of the Alpha Exchange, my conversation with Jon Golub.
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