Markets shrugged off a seemingly dire correction in early August and rallied back to all-time highs. Despite weakness in the labour market and manufacturing, overall economic data continues to underpin the soft-landing narrative. A potential ‘Goldilocks’ outcome has been bolstered with actions taken by the U.S. Federal Reserve and People’s Bank of China. The problem for investors, however, is that a soft landing is fully priced in, while equities remain expensive. As it stands, we believe buying pullbacks remains the best course of action.
Executive Summary
As the last quarter got underway, we viewed the set-up for equities as unattractive. While markets continued to march higher in early July, they swooned dramatically at the beginning of August, before staging a strong reversal. This correction felt different than the one in the preceding quarter. The CBOE Volatility Index (VIX), for example, spiked to levels last seen near the start of the global pandemic.
The ground under the soft-landing narrative started to give way when the U.S. unemployment rate jumped over 50 basis points from the previous year. In the past 50 years, a jump of this magnitude has always corresponded to a recession. The U.S. Federal Reserve (the Fed) responded by shifting its focus away from just fighting inflation to gearing up to deal as well with rising unemployment rates. Investors seemed to begin to remember that the start of a Fed cutting cycle has not always been a source of comfort historically, because the first cut is often (although not always) associated with an economic contraction.
But as quickly as the market panic surged, it abated. Despite their brief flirtation with a recession narrative, investors seem to be overwhelmingly in “Goldilocks” mode. Underscoring this is the Bank of America/Merrill Lynch’s September fund manager survey, which showed that 79% of respondents believe the global economy is headed for a soft landing. The percentage of fund managers believing that the world is headed for a hard landing has remained relatively constant for the last three months. Increasing faith in a soft landing – up 11% since July – is the result of many “no landing” adherents capitulating to the majority view.
And there is an improving case to be made for an economic soft landing as we enter the fourth quarter. U.S. retail sales for August came in stronger than expected. A month-over-month sales increase of 0.1% beat consensus estimates for a 0.2% decline. Sales ex-gasoline and autos have now increased for the last four months. Meanwhile, “control group sales,” which are used in the calculation of GDP, rose 5.7% from June to August, which is the fastest pace since August 2023, according to Bloomberg.1 Given how important the consumer is to the U.S. economy, this improvement is worth noting.
Further increasing the odds of a soft landing are actions by key central banks. Japan seems to have pressed pause on its tightening campaign, after seeing the yen spike and risk assets plunge following its early August rate hike. Meanwhile, Chinese authorities unleashed a comprehensive economic stimulus package aimed at reviving the country’s sluggish economy. Most importantly, perhaps, the Fed put is back. The U.S. central bank expects to cut rates by another 50 basis points this year, and a further 100 basis points by the end of 2025.2 While this will likely support the domestic economy, the Fed’s actions should also take some of the pressure off countries (such as Canada) that have been more exposed to rising rates.
While the case for a soft landing has strengthened, risks of a hard landing do remain. The yield curve, for example, has “un-inverted,” as historically it has happened just before a recession. We’re also seeing the lagged effects of tight monetary policy: in addition to small business optimism remaining at low levels, Chapter 11 filings are on an ominous ascent. Manufacturing, for its part, has turned lower after a brief reprieve during the first half of the year. This weakness may be a warning sign for market bulls, as downturns in manufacturing tend to coincide with falling equities.
The U.S. presidential election poses risks to the economy, no matter who is victorious. If Donald Trump wins, his promised tariffs on Chinese goods could result in materially higher U.S. inflation. And if Kamala Harris wins, her promise of tax hikes could cause more economic weakness. Polls suggest the election should be tight, which should mean both the economy and markets will have to grapple with considerable policy uncertainty in the near term. Regardless of who triumphs, the U.S. economy faces a significant post-election fiscal cliff.
As we enter the fourth quarter, we remain cautious on equities at current levels. Valuations are rich, with a lot of the soft-landing narrative already priced in, investor positioning is stretched, and unfriendly autumn seasonality, combined with U.S. election concerns, may create near-term downside pressures on markets.
Given these near-term hurdles, we believe patience is the best approach for investors at this time. With the Fed put back in place, buying on pullbacks in risk assets could be attractive.
The good news is that the always critical U.S. economy does not appear to have any dangerous excesses that could lead to a deep or prolonged recession. On the contrary: solid household balance sheets, significant wealth effects and structurally tight labour markets could limit any real economic downturn to something shallow and quick to recover from.
However, we believe any acceleration in global growth and increasing wealth effects will end up pulling forward the timeline in which structural inflationary forces in housing and commodities begin to reappear, bringing the party to an abrupt end.
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1Source:Bloomberg, U.S. Retail Sales Post Surprise Gain, Helped by Online Stores, Sept 17, 2024.
2Source: BNN Bloomberg, Fed’s Neel Kashkari Expects Two Quarter-Point Cuts Before Year’s End, Sept 23, 2024.
