As the midway point of the year approaches, I want to offer our clients an update on our outlook for the markets. I will focus on a few key points that are shaping our current outlook and the firm’s investment strategies.
The Fed: Higher for Longer
We do not expect the Fed to raise rates from here. Current rates remain restrictive and are slowing the economy as needed to bring inflation down to target. It is possible we could see a rate cut before the election, but our base case is that it will occur sometime afterward.
The Fed wants to be able to cut rates at a slow and steady pace rather than be forced to cut dramatically. If the economy slips into recession, the Fed will be forced to cut rates aggressively, and this could disrupt markets. This is not what we expect to happen, but we will be on the lookout for this risk.
We do not expect a recession as a likely outcome of Fed policy. We think the bond market is telling us that recession expectations are balanced. Current yields on corporate and Treasury bonds suggest the fear of inflation heading higher is muted. If we see yields move materially higher from here, then it could be a signal that inflation is picking up and the Fed will need to reverse course. However, a steep decline in rates could signal a recession lies ahead. A stable interest rate environment is what we expect, and this suggests that a recession remains a story for another day.
Much debate has taken place since the Fed began tackling inflation as to whether they could bring about a “soft landing.” A soft landing suggests the economy cools down enough to bring inflation lower while not slowing down so much that it enters a recession.
Importantly, it seems as though the debate on whether the Fed can negotiate a soft landing has shifted to a more binary one that presupposes we are either headed toward a hard landing (recession) or no “landing” at all. We see the data supporting the view that this is what a “soft landing” scenario looks like. Threading an “economic needle” will surely come with data points that support both sides of the debate while never fully becoming either side.
It is worth reminding our readers that since the Great Financial Crisis (“GFC”), the Fed has been battling DEFLATION. Deflation and inflation are two sides of the same coin. However, deflation is more detrimental to the economy than inflation. To be clear, neither is acceptable.
Furthermore, deflation is a risk that the Fed is ill-equipped to fight. Deflation is a force that takes both fiscal and monetary policy to beat. Inflation, on the other hand, is what the Fed can battle on its own with much more efficacy.
The joint response by the Federal Reserve and U.S. Treasury to the COVID-based shutdown of the economy is what was necessary to “whip deflation now.” With deflation slain, the Fed can let inflation run a bit hot just to make sure the deflationary dragon was dead. This is precisely what they have done, knowing all along that controlling the money supply is an effective tool against inflation.
This is why our view is that the Fed will indeed cut interest rates before they raise them. We believe the Fed has confidence that inflation will not reverse course higher. It is for this reason their attention has turned to staying ahead of preventing a recession.
Since we do expect the economy to soften as the Fed grapples with sticky inflation, our strategies are being managed with this in mind. Defensive companies such as utilities, consumer staples, and energy remain attractive to limit the impact of slowing growth.
The AI Story
As investors try to understand exactly what Artificial Intelligence is, companies with an easy-to-see connection to the AI story are rewarded while companies seen as being in competition with the technology are getting penalized.
This scenario played out during the internet boom of the 1990s when “dot com” companies saw their stock prices rally and “brick-and-mortar” companies suffered. While we are far from a “dot com bubble” environment, it will no doubt take years before the true value of AI comes into focus for investors. Until then, it is wise to remain disciplined with regards to valuation and open-minded as it pertains to the use of AI by companies. Above all, it is important to remain patient.
As has happened during previous waves of innovation, the early days are characterized by periods of frenzy and downdrafts as investors sort out the impact of the new technology. However, it is important to note that the antidote to inflation is productivity.
The use of AI, in our view, is the greatest productivity driver since the Internet or even the Industrial Revolution. The Fed understands the anti-inflationary force that AI brings to the economy. It also understands that one of the its anti-inflationary impacts is tied to a wave of job obsoletion.
History offers many examples of this phenomenon. For example, following the invention of the light bulb, the candlestick industry was decimated. Yet, it is hard to argue that society would be better off with candlesticks instead of light bulbs.
The famous dead economist Joseph Schumpeter developed the “Theory of Creative Destruction” to describe this phenomenon. What comes in the wake of such innovations as the automobile, electricity, internet, printing press, etc., is job losses but also an explosion in productivity.
The difference between a period of job loss tied to “creative destruction” versus a period of job loss to economic recession is stark. The former acts as an economic springboard where the latter signals a period of the “economic pie” shrinking. The Internet acted like a springboard despite the jobs it destroyed, while the Great Financial Crisis was a harbinger of economic weakness.
This AI Story has a long way to go. So, as the Chief Investment Officer, I have directed my team to analyze every company, regardless of sector, to determine how they will use AI to enhance profitability and growth.
Opportunities Away from AI
Commercial real estate is beginning to look attractive to us. We told clients during COVID that the need for office space would forever be affected by the change to the corporate work environment. We emphasized that corporate profits would be enhanced by worker productivity and the reduced cost of maintaining office space.
This has played out much as expected. The trade-off to this has been a breathtaking decline in commercial real estate prices. Along with the owners of the office buildings, banks will continue to feel the pain of this decline as their commercial loans under perform.
However, we are seeing signs that the market for commercial real estate is clearing. As prices come down, the cost of borrowing also declines. This can lead to opportunities for those with a vision and the funds to put at risk.
The difference between the decline in commercial real estate following COVID and the decline in single-family homes following the Great Financial Crisis is significant. Following the GFC, individuals cut their spending, suffered personal bankruptcies, and experienced a surging unemployment rate.Today we are in the late stages of a commercial real estate crash and the jobless rate remains low, individual consumers are little affected, and banks are better capitalized to handle such a crisis.
During the dawn of the Internet Age, investment opportunities developed away from the epicenter of the “dotcom” industries. Chip companies benefited from the need for processing speed, server and switch manufacturers benefited from a need for connectivity, PC makers benefited from consumers adopting the internet, retailers benefited from direct selling to consumers, etc., etc.
The secondary beneficiaries during periods of hyper-growth are the so-called “pick and shovel” companies. This description came from the 1849 gold rush that saw very few people get rich from gold but many, like Levi Strauss, made a fortune selling their wares to the gold miners. Following the bust of the Internet Bubble, most of the dot-com companies perished but others, like Amazon, Intel, Google, etc., continue to flourish.
At the dawn of the Age of Artificial Intelligence, we see similar investment opportunities. We see the Real Estate Investment Trust (“REIT”) sector benefiting from the build out of data centers that house AI servers. The Utility sector will benefit from the need for these data centers for electricity to run the servers. The Consumer Cyclical sector will benefit from the use of AI to manage inventory and determine consumer trends. The Health Care sector will benefit from the use of AI to manage health care costs. The Financial sector will benefit from the use of AI to underwrite insurance risk, deliver banking services, and reduce brick and mortar costs.
The Age of AI and Employment
The proliferation of AI is reshaping the employment landscape with implications for both blue-collar and white-collar workers. While AI-driven productivity gains may lead to job obsolescence in certain sectors, opportunities for skilled trades and technical expertise are likely to increase. However, white-collar service industries may face pressure from AI’s automation of menial tasks traditionally performed by junior associates.
This could mean college-aged adults face lower levels of debt as traditional four-year degrees are shunned in favor of trade school diplomas and on-the-job training. This too would enhance productivity numbers and narrow the wage gap that currently exists.
Political Drama
While there are some unprecedented, if not scary, circumstances surrounding the former President’s trial, markets will continue to take it all in stride. This is because the Market has had plenty of time to digest the trial and its possible implications. This is also true when it comes to the election itself. After all, it has been down to two candidates for some time now.
While some political experts would have you believe that the guilty verdict will influence a large cohort of voters to abandon Trump, we think differently. Our view is that voters had made up their minds about whether the verdict would influence their vote before the decision was turned over to the jury. So, we do not expect the trial to dramatically impact the election… despite that it was unprecedented.
We understand the outcome of the election will affect our clients personally. Some will like the outcome, while some will not. Our job is NOT to share our own opinion about the candidates. Rather, it is to navigate the market regardless of who wins in November.
Currently, we see 100 percent of the electorate as pensive. Half of it fears a Trump victory and the other half fears a Biden victory. Of course, the numbers are not exactly 50/50, but the point is that 100 percent of the electorate fears the outcome but for different reasons. Once the election is over we expect a relief rally to follow, regardless of the outcome.
This forms our view that equity markets could see a rally after the election. Markets can handle good news or bad news in stride. However, question marks lead to the greatest level of volatility. Removing the question mark surrounding who our next president will be could lift stocks into the end of the year.
Outlook for the Bull Market
Readers of our commentary over the years are familiar with my view that bull markets and bear markets alternate between seventeen-year phases. The current bull phase began in 2016 and could continue through 2032.
Below is a chart to illustrate the relationship between bull and bear phases. The chart depicts the Dow Jones from 1885 through what we believe to be its level at the end of the current bull phase. It is important to remember that past performance does not predict future results. However, we manage our client accounts with the expectation that markets will remain in a bull phase for another eight years, give or take.
During bear phases, it is important for investors to sell into upward thrusts in stock prices to avoid the potential of a devastating downdraft. During bull phases, it is important for investors to remain patient during selloffs in stocks to participate in the next leg higher.
We believe the end of the current bull phase will be tied to a confluence of forces. These forces include:
- A wall of corporate debt that will mature around 2032.
- The youngest of the Baby Boom generation will stop contributing to Social Security and start receiving it. This could lead to higher taxes to keep Social Security payments coming.
- We expect the final stages of the bull phase to be characterized by investor complacency like we witnessed ahead of the burst of the “dot-com bubble” in the late nineties.
Our view is that equity investors will have more opportunities than hurdles over the next few years. We believe bond investors will see historically average yields and moderate volatility.
In closing, I want to reiterate our commitment to serving your financial needs and providing guidance amidst market uncertainties. Should you have any questions or concerns, please do not hesitate to reach out to us.
Thank you for your continued trust and partnership.
Sincerely,
Kessler Investment Group, LLC
All information in this presentation is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. All economic performance data is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. Certain statements contained within are forward looking statements including, but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Please consult your adviser for further information.
Opinions shared in this presentation are not intended to provide specific advice and should not be construed as recommendations for any individual. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk.