The weather is unpredictable, and we should carry an umbrella.
Is it sustainable? That is the question investors ponder on the heels of the strongest nine month start to a year by the S&P 500 since 1997. Investor confidence is high as markets increasingly embrace the “soft-landing” narrative for the economy. To wit, equity risk premiums at twenty-year lows and credit spreads at nineteen-year lows are reflective of markets priced for a continuation of accelerating growth and moderating inflation, the perfect storm for financial assets. The evidence is supportive of this narrative: earnings growth of 11% in the second quarter, a strong September employment report with prior months revised higher, inflation well down from the 9% peak (albeit still stubbornly above the 2% Fed target). Interestingly, against this backdrop of stronger economic data and peak market levels, the Federal Reserve began easing monetary policy in September. This easing coupled with solid earnings growth has propelled markets higher. Importantly, equity performance broadened markedly in the third quarter, from the “AI-centric” theme which drove returns during the first six months of the year.
Back to the initial question: is it sustainable? Can we reasonably expect a continuation of strong returns from equity markets given peak levels of profitability and valuations? Can credit spreads continue to discount minimal risk of defaults? Will the Federal Reserve continue to lower interest rates in line with market expectations if equity and credit market positive assessments of the health of the economy are correct? These are the questions that we wrestle with as we assess both the opportunities and risks present in the current market environment.
While current economic data remains supportive of the soft landing reflected in financial markets, there are patches of potential weakness worthy of consideration. Lead indicators of employment, including job openings, have weakened while housing activity is falling sharply. Consumer spending, which represents roughly two thirds of the economy, is increasingly dependent on employment and wage growth to fuel future growth. To cite our research partners at BCA, there are three sources of consumer spending growth: past earnings (or savings), current earnings (or wages) and future earnings (or debt). For the US consumer, excess savings appear to have been exhausted while credit card debt and delinquencies are elevated. Candidly, the economy has remained more resilient than anticipated supporting stronger earnings. Strong fiscal support and less sensitivity to interest rates have played meaningful roles in this resiliency. The path forward, however, remains less clear, and certainly the election provides room for even greater uncertainty.
In this environment, we continue to position client portfolios to participate in the potential for continued growth while appropriately reflecting risks, seen and unforeseen. Markets are unpredictable, particularly in the face of an election where passions on both sides are high. We will continue to invest with an unwavering long-term mindset, emphasizing quality, while maintaining liquidity and dry powder to take advantage of volatility. Carrying an umbrella right now seems prudent.
We appreciate the confidence that you have placed in our firm. We look forward to discussing your specific portfolio allocations and positioning.
