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Stocks have lost ground since the summer, which followed a positive run that had gotten underway last fall. Driving this shift is worries about rising interest rates and the ‘higher-for-longer’ view of the Fed.Many in the market see the Fed tightening cycle as effectively behind us by now. These market participants see this improved Fed visibility as a big positive for stocks. This narrative is sanguine about the Fed, sees inflation as steadily heading in the right direction and views nothing egregious with valuations, given improved visibility for interest rates and a stable earnings outlook.Market bears see this optimistic view as without a solid basis and view the positive stock market gains of the first half of the year as nothing more than a bear-market rally in a long-term downtrend. This line of thinking sees inflation as far ‘stickier’, which requires the Fed to continue tightening for a while. Valuation worries also figure prominently in the bearish view of the market.The interplay of these competing views will determine how the market performs in the coming months and quarters. To that end, let’s examine the landscape of bullish and bearish arguments to help you make up your own mind.
Let’s talk about the Bull case first.Inflation & the Fed: The outlook for inflation and what that means for the path of interest rates and economic growth represent the biggest points of difference between market bulls and bears at this point in time. The bulls see favorable developments on the inflation question, with the steadily decelerating trend of the past year as confirmation of progress towards the Fed’s goal.It is hard to argue with the bulls’ view that the heightened post-lockdown demand in a number of product and service categories was bound to eventually normalize, with its attendant beneficial effect on prices. Related to the above argument are favorable developments on the supply side of the equation and reversal of China’s zero-Covid policies, with disruptions caused by the wars in Europe and the Middle East partly offsetting the gains.With interest rates already past the neutral level, investors are looking at incoming economic data through the prism of what it tells them about inflation and growth. The market correctly sees the Fed’s last rate hike as effectively concluding this tightening cycle even though the central bank can’t publicly acknowledge it.We see the seeming delay to the start of the eventual Fed easing cycle, the so-called ‘higher-for-longer’ Fed view, as nothing more than the central bank taking an insurance policy to ensure that the inflation problem is fully addressed.In other words, we are at the ‘pivot’ stage already, without the Fed explicitly telling us in so many words.The Economy’s Strong Foundation: The resilience of the U.S. economy in the face of the Fed’s extraordinary tightening cycle has surprised both market participants as well as the central bank. This strength notwithstanding, the U.S. economy’s growth trajectory is expected to moderate in response to the combined effects of higher interest rates, the runoff in the government’s Covid spending and some lingering logistical bottlenecks. This is beneficial to the central bank’s inflation fight, particularly the demand-driven part of pricing pressures, as we continue to see inflation readings.Many in the market are legitimately concerned about recession risks as a result of the unprecedented Fed tightening. While such risks are undoubtedly real, a recession is by no means the only, or even most likely, outcome for the U.S. economy. Underpinning this view is the rock-solid labor market characterized by strong hiring and a record low unemployment rate. It is hard to envision a recession without joblessness.The purchasing power of lower-income households has likely been eroded by inflationary pressures, as confirmed by a number of companies during their earnings calls. But household balance sheets in the aggregate are in excellent shape, with plenty of savings still left from the Covid days. This combination of labor market strength and ample savings cushion should help keep consumer spending in positive territory in the coming quarters.While questions remain about the economy’s growth trajectory over the next few quarters, estimates for the current period (2023 Q4) have been holding up a lot better than most could have imagined six to twelve months earlier.All in all, the strong pillars of the U.S. economic foundation run contrary to what are typically signs of trouble ahead on the horizon.Valuation & Earnings: Tied to the economic and interest rate outlook is the question of stock market valuations that have come down as the ‘higher-for-longer’ view of interest rates has taken hold.The S&P 500 index is currently trading at 18X forward 12-month earnings estimates. This is up from 15.5X at the end of September 2022 when the index started heading higher, but is down almost -11% over the last three months in response to higher rates.It is hard to consider this valuation level as excessive or stretched, particularly given aforementioned optimism on the Fed front.Granted there are parts of the market that have gotten rerated as the full effects of the Fed’s tightening cycle have diffused into the economy, resulting in cooling consumer and business demand and moderating economic growth. But not all sectors are exposed to the Fed-centric negativity in outlook to the same degree, as sensitivity to interest rates and the macroeconomy are much bigger drivers for some sectors than others.We have been seeing this division in earnings outlook in recent earnings reporting cycles, including the ongoing Q3 earnings season, with operators in the at-risk sectors unable to have adequate visibility in their business. But there are many other companies that continue to drive sales and earnings growth in this environment.We have seen many of these leaders from a variety of sectors and industries, including Technology, come out with strong quarterly results in recent days.Contrary to fears ahead of the start of the Q3 earnings results, the actual results are turning out to be fairly stable and resilient. Earnings estimates came down last year, but have notably stabilized since April this year and have actually started going up for a number of key sectors including Technology.While it is reasonable to expect some further downward adjustment to estimates for macroeconomic reasons, the overall earnings outlook is now largely in-line with the economic ground reality. In the absence of a nasty economic downturn, the earnings picture can actually serve as a tailwind for the stock market in an environment of diminishing Fed uncertainty.
Let’s see what the Bears have to say in response.Endemic Inflation & Fed Tightening: Economic readings continue to show that the U.S. economy was still far too strong to ease the Fed’s inflation worries. While a big part of the economy’s recent growth momentum has been due to factors that tend to be volatile, there continues to be plenty of strength in household and business spending.The decline in inflation readings in recent months has resulted from pullback in commodity prices, the easing of logistical bottlenecks and moderation in demand for the ‘goods’ part of the economy. The much tougher part of the inflation fight is on the ‘services’ side of the economy. Given ongoing trends in wages, inflation is likely a lot stickier than most people assume.Many in the market believe that the Fed’s tough policy stance last year was meant to counteract the damage to its inflation-fighting credentials as a result of its earlier ‘transitory’ narrative. The current ‘higher-for-longer’ view of elevated rates confirms that the Fed simply can’t afford to declare a premature victory and risk the inflation scourge to reemerge.The Valuation Reality Check: A big driver of the stock market’s bull run in recent years was the Fed’s ability to flood the market with liquidity. The central bank achieved that by keeping interest rates at zero and buying a boat-load of U.S. treasury and mortgage-backed bonds that expanded its balance sheet to almost double the pre-Covid size.Fed tightening and the associated higher interest rates have a direct impact on the prices of all asset classes, stocks included. The ‘higher-for-longer’ view of interest rates in light of much stickier inflation means that investors need to adjust to an extended period of above-average interest rates.Everything else constant, investors will be required to use a higher discount rate, a function of interest rates, to value the future cash flows from the companies they want to invest in. This means lower values for stocks in a higher interest rate environment.The Growth Question: Since Fed rate hikes work with a lag, the central bank’s aggressive tightening moves since March 2022 likely haven’t fully seeped into the economy.Current projections of GDP growth for this year assume that the Fed is successful in executing a ‘soft landing’ for the U.S. economy. This favorable view has been strengthened by resilient GDP growth readings even as inflation has steadily come down.There is no basis for us to doubt this confidence in the central bank’s abilities, but we shouldn’t lose sight of history that tells us that economic growth typically falls victim to the Fed’s inflation-fighting efforts.The U.S. economy has undoubtedly proved stronger than many could have foreseen some time back, but this by no means guarantees that this positive run will continue forever.
Where Do I Stand?I am very skeptical of the bearish Fed tightening outlook and see this scenario as nothing more than a worst-case or low-probability event.My base case all along, saw the Fed moving from the then ‘stimulative’ policy stance to one that was only modestly ‘restrictive’. Following the already implemented rate hikes, the level of interest rates is at the ‘neutral’ policy level already, when Fed policy is neither ‘stimulating’ nor ‘restricting’ economic activities.Estimating an accurate level for ‘neutral’ policy is very difficult in real time, but many analysts believe that rates are already in ‘restrictive’ territory after the last hike.While another rate hike remains a possibility, we think they are most likely done tightening at this stage, particularly if incoming data continues to show progress on the inflation front. The recent jump in long-term treasury yields is already doing the tightening job for the central bank.This appears to be the most plausible scenario given the risks to growth as a result of premature tightening, a threat to the Fed’s second ‘full employment’ mandate.Regular readers of my earnings commentary know that the earnings picture continues to be resilient, with the steady downward revisions last year having brought them in-line with the economic ground reality. The market is starting to look past this year’s moderating earnings growth to next year’s growth recovery.There are reasonable questions about interest rates and the economy’s growth trajectory that are unlikely to be answered next week. But we do see investors eventually coming around to our view of inflation, earnings and the much more positive times ahead after a short period of volatility.More By This Author:Q3 Earnings Season Scorecard – Earnings Growth Turns Positive
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