- The stock market thinks the Fed can pull off a “soft landing”
- Unemployment remains at record low levels, making it hard to kill inflation
- Tech stocks are overvalued thanks to the hype around AI
What happened to the recession we were supposed to have this year? Apparently, the old joke that economists have correctly predicted nine of the last five recessions still resonates. We’ve now had positive U.S. GDP growth for three quarters in a row, and the stock market is acting like the Federal Reserve will be able to orchestrate the fabled “soft landing” – whereby they successfully tame inflation and slow the economy down without causing a recession or some other financial calamity. Being cautious this year has not paid off, since the market has already enjoyed double digit returns, with technology stocks leading the way thanks to the artificial intelligence hype.
The rates market is predicting (with a 90% assigned probability) that the Federal Reserve raises rates by 0.25% one more time in July and then stops. This “one and done” scenario also has the stock market excited, since many market pundits think the next Fed move will be to cut rates in either late 2023 or 2024.
We think the market is overly optimistic. The unemployment rate remains at record lows, which adds to inflation pressures via higher wages. Therefore, there is some risk that the recent good news on lower inflation may not last. If the Fed ends up raising rates more than currently expected, long-term interest rates have some more risk to the upside in the months to come. Additionally, the M2 measure of the money supply has dropped the most since the Great Depression. The U.S. economy is still absorbing the massive money printing during COVID-19, but this is almost over. A decline in M2 could eventually pull the economy into recession, perhaps when nobody expects it.
With that in mind, updates to portfolios in Q3 include:
- Underweight large cap growth, due to limited upside after such a strong first half and high valuations
- Add credit exposure and favor intermediate maturities in fixed income
- Increase cash equivalents
We will continue to carefully monitor market developments and welcome the opportunity to speak with clients in more detail about portfolio strategies.