We wanted to provide a brief update on market conditions in light of the sell-off in stocks that began late last week and has carried through today.
The downturn in stocks follows the release of fresh economic data that portends a potentially weaker economic outlook and the possibility that the Fed has waited too long to begin interest rate cuts. This represents a shift from the soft-landing view that has underpinned the markets for the better part of the past year.
Clearly, a couple disappointing data points do not ensure the imminent onset of a recession, but the very strong returns over the past 9 months have left little room for error. The pickup in volatility is not all that surprising. Our inclination is that the sell-off in stocks is more of a reset to a market that was near-term overextended. Our own macro work has been seeing cracks in economic activity and employment trends for some time now, though we also see some support coming from broadening corporate profitability and the stimulative effects of lower interest rates.
There are other coincident factors that are adding to the current angst, specifically: (1) A reversal in the Yen exchange rate causing severe weakness in the Japanese and Global markets; (2) more scrutiny on select mega-cap growth stocks to justify their sizeable capital expenditures on artificial intelligence and at the same time, sustain their earnings growth trends; (3) geopolitical pressure ramping up around Iran’s retaliation toward Israel; (4) Warren Buffet raising yet more cash and halving his long-held stake in Apple; (5) political uncertainty ahead of the November U.S. election; and (6) entering a seasonally weaker time of the year for stocks.
With uncertainties now elevated, what should we expect from here? The spike in the volatility index tells us this bumpy environment will be with us for a while. As we typically see at inflection points, markets will overplay the importance of each new piece of economic data. In particular, new information that sheds light on the labor market will likely have an outsized influence on stock prices. The measure of job strength, however, is more complex than any one statistic, often making it challenging to identify actual trends.
From an investment strategy perspective, there has been a notable shift away from the Mag 7 favored tech stocks since quarter-end. This initially sparked a lift in the prices of small-cap stocks; more lately those gains have faded due to renewed recession fears and fund flows have been redirected toward more defensive sectors that pay higher dividends. This volatility creates opportunities to improve portfolio holdings in solid companies who are on the selling end of these short-term swings. This will be our primary focus.
At this same time, bonds have staged a massive rally. Interest rates have pulled back on the prospect of a slowing economy and more interest rate cuts than previously expected. Fed Chair Powell has signaled this will begin with their September meeting. The bond market is now pricing in a 50-basis point rate cut at that time, followed by another 50-75 basis points before year-end. That said, we’ve seen the bond market overshoot on expected rate cuts multiple times in this cycle.
More relevant for investors is that unlike the weakness investors experienced in 2022, when bonds declined right along with stocks, they are now are providing strong support to balanced portfolios.
We will keep you updated as we go through this heightened volatility while the economy transitions to lower interest rates and markets adjust their expectations to an economic landing of some magnitude. Even with the strong gains of the past 3 quarters, we know this abrupt decline in stock prices is disconcerting.
Please give us a call if you would like to discuss any of this further.
The Meritage Investment Team
