“…It’s just right.”

With the S&P 500 at highs for the year up almost 20% YTD and the Fed nearly complete in what has been an unprecedented rate increase cycle, investors have gotten what they hoped for so far…that the Fed got it “just right” and has been able to engineer what is potentially a “soft landing” or even no landing.

History has shown however, that while the market has been strong, recessions lag and tend to occur abruptly, while economic data is strong in the near term.

The consumer, which has generally been strong, is starting to show signs of weakness, and with credit still tightening and savings declining, there is still a likelihood of a weak economy going forward.

With the 25bps increase in rates last week, the consensus is now for maybe one more rate increase in the fall and the Fed being finished for this cycle. The debate will then become how fast the Fed cuts rates, which will also likely be data dependent, but will provide a cushion for the market and help minimize the downside in equities should the mild recession that is now expected occurs.

Europe has seen very weak growth. The ECB continues to increase rates despite the weak growth and slowdown in inflation, exacerbating a negative situation. The recession that was supposed to occur in the US is likely unfolding there and without the growth drivers the US has, will likely be negative for markets there over time. For China, while growth exiting COVID has been disappointing, the government is now taking action to ease tightening, offering support to the housing market and more importantly the technology sector. This “stimulus” should provide support on the downside for markets there.

Higher rates for longer. While inflation has cooled and various segments of the economy have showed signs of weakness, housing has remained fairly resilient despite the sharp increase in mortgage rates as many homeowners had already locked into low rates. With higher property prices, this could keep rents slightly elevated (though there has been some weakness) which would keep some inflation from weakening further.

Levered loans maturing. Levered loans are generally loans of lower rated credit quality. There are $27 billion of levered loans maturing in 2024 (not a lot); there are over $140 billion maturing in 2025. This will be an important area to watch as an uptick in defaults has historically been bad for markets.

Utilities. Elon Musk recently suggested that US consumption of electricity will triple by around 2045. While battery-powered vehicles will be a driver of this, interestingly, he also anticipates that a near-term shortage could stun the energy hungry development of Artificial Intelligence as well. So, potentially, there are now TWO long term drivers for the demand of electricity.

Broadening of the Market Rally. We have written extensively about the concentration of the rally being heavily weighted towards the top 10 largest stocks in the market. Our feeling is if the market is to continue to rise, it will likely be driven by a broadening of performance as valuations between large and smaller capitalization names are at historical highs. Additionally, while Artificial Intelligence (AI) has driven technology shares higher, the practical uses of it should benefit other sectors, especially consumer driven ones.

Longer Duration Fixed Income. We have been proponents of bonds as the higher yield has provided an opportunity to see how things play out, while getting paid a solid interest rate. With the end of the increase cycle here, the opportunity is now to move to longer duration fixed income investments as the eventual lower yields will lead to upside in the underlying investment as well in addition to the capturing the current high interest rates (the reverse of what happened in 2021).  

Overall, while the market rally has certainly been welcome and the economy has some potential drivers in Artificial Intelligence and Infrastructure upgrades, we would still maintain that a balanced approach is more prudent as there is an opportunity to take advantage of interest rates at levels not seen for almost 20 years and there are still potential dark clouds on the horizon now that investor sentiment is much more positive.