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Equities notched fresh all-time highs toward the end of the second quarter. However, as investor confidence in a soft landing for the U.S. has strengthened, signs are emerging that the economy is starting to weaken. Unless sticky services inflation begins to roll over, the U.S. Federal Reserve may be hesitant to cut rates. Against a backdrop of pricey valuations and widespread bullish sentiment, we remain cautious about equities at current levels.
Executive Summary
As we enter the third quarter, equities continue to notch record highs. Part of the strength is no doubt attributable to persistent optimism about generative artificial intelligence (“AI”). However, growing belief in a soft U.S. economic landing seems to be the key driver for risk assets. And faith in a “Goldilocks” outcome seems to have strengthened recently: according to Bank of America/Merrill Lynch’s June fund manager survey, 73% of respondents do not expect a recession in the next 12 months—the most in nearly two years, and up from 64% in May 1.
Ironically, as fear of an economic contraction has dissipated, we are seeing signs that the U.S. economy is beginning to falter. While excessive fiscal spending, easing financial conditions, and the emergence of a powerful AI spending cycle have helped contribute to keeping the economy stronger for longer, the lagged impacts of aggressive tightening of monetary policy are starting to take hold. Leading indicators warn of rising risks, and the all-important U.S. labour market is showing signs of cracking.
But the U.S. Federal Reserve (the “Fed”) is now committing to sitting on the sidelines, opting to keep policy rates unchanged for the time being. In their public comments, Fed officials point to the need for even more favourable data points that confirm inflation has been tamed before rate cuts become appropriate. Some, according to the May 22 Federal Open Market Committee minutes, have even raised the possibility of further rate hikes, should inflation re-accelerate. All in all, it’s reasonable to assume the U.S. central bank is wary of underestimating underlying inflationary forces—a mistake it already made when the global economy surged following the pandemic.
In our view, the Fed is faced with a real problem. Even though goods are in outright price deflation, core services inflation is uncomfortably high, and seemingly staying there. Unless this stubbornly high services inflation rolls over, we believe the central bank should be hesitant to cut rates. The longer the Fed doesn’t ease policy, though, the greater the odds that a recession will develop. This is the Fed’s sticky situation: it doesn’t want to abandon the inflation fight too early, but neither does it want to commit a policy mistake by staying too tight for too long. It’s a delicate balance.
We see risks in equity markets and other risky assets, particularly if weakening U.S. economic data cause investors to abandon the soft-landing narrative and start focusing on an impending recession instead. After all, valuations are high, positioning is stretched on the long side, and various signs of late-cycle speculation have returned to the market. Trading of penny stocks, for example, has surged, a classic sign of investor euphoria.
Global liquidity, meanwhile, has not supported the recent run-up in equities, with the Bank of Japan’s balance sheet starting to contract.
The looming U.S. presidential election presents yet another risk. A Trump win will likely raise the spectre of new tariffs aimed at China, which could materially raise U.S. inflation. But if Biden wins, some of his party’s more left-leaning policies may start to imperil U.S. competitiveness. Regardless of who wins, the U.S. economy faces a significant post-election fiscal cliff: tax code changes enacted in 2017 are set to expire in 2025, which could result in tax hikes on the order of approximately USD 3.5 trillion over the next decade 2.
Outside of the U.S., economic problems are mounting. Europe is weak, Canada would be in recession were it not for massive population growth, and China continues to grapple with the fallout from its twin housing and demographic crises. As a result of differences in growth, inflation and monetary policy between the U.S. and the rest of the world, the greenback may strengthen in the second half of 2024. Historically, this has often been a recipe for an economic accident, particularly in emerging markets that have borrowed heavily in U.S. dollars.
Against this backdrop, we remain cautious about equities at current levels, sensing that better entry points are likely to present themselves in the months ahead. A deeper sell-off can’t be ruled out if recessionary forces are felt.
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1Source: BofA Global Research, Global Fund Manager Survey. June 18, 2024.
2Source: TD Cowen, TAXMAN: $3.5T TAX CLIFF ON 1/1/26 FOR INDIVIDUAL RATES, MORTGAGE, ESTATE & SALT, April 30, 2024.
