Broadly, the market has made limited progress since our decision in early July to cut back equity exposures to a more “cautiously bullish” position from the “aggressively bullish” stance we held in the first half. Indeed, since that move on July 8, the S&P 500 is up just barely 3%, following its double-digit run higher in the first half. Beneath the surface, the areas we like in the broader market—small caps, value stocks, and emerging markets—have advanced more: 8%, 9% and 6%, respectively. Still, with the extra cash we raised in July still sitting in money markets, and our long-term outlook still positive, we continue to look for a re-entry point to get more aggressive again.
To begin more definitively its next advance, we think the market has to resolve five big uncertainties, and these are the areas we are monitoring closely:
1. The third quarter earnings season
As we enter the third quarter earnings season, analysts have lowered their expectations, with overall downgrades running at about 3.5%. This is a bit higher than the historical norm, but not dramatically so. Energy stocks have been a key culprit, though the downgrades there seem more to do with the decline in oil prices in the third quarter that now have corrected back up. Large-cap pharma has also been hit, though these stocks tend to trade on forward pipeline developments than current earnings, anyway. And financials have seen downgrades due to the lagged effects of the US Federal Reserve’s (Fed’s) September rate cut, which hurts net interest margins temporarily then helps them later. Bottom line, most of the action this earnings season will hang on what companies say about the forward outlook.
For the banks, starting Friday, we will be focusing on the net interest margin guidance as the rate-cutting cycle gets underway, as well as any indications of deterioration in their credit books. Our expectations are positive on both fronts. For big tech, we will be looking for evidence that the “AI revolution” is making anyone, other than Nvidia, any money so far. Here, our expectations are more cautious. Elsewhere, we’ll be watching the industrials for evidence that the longstanding weak manufacturing PMIs are having any impact on profits, which so far they haven’t. And overall, we’ll be looking to see if the improved earnings growth outside of tech that we’ve been expecting to begin to show signs of life in the third quarter actually happens.
We’re optimistic. Net-net, we see the upcoming earnings season as market supportive, though not uniformly so.
2. Whither the inflation rate?
With last week’s jobs numbers supporting the view that the economy remains resilient, markets are now more focused than ever on the inflation numbers. Progress toward the Fed’s 2% inflation target would auger well for the path of rate cuts ahead. Consensus calls for the core CPI number this week to drop to 0.2% month-over-month, which annualises to 2.4%. If this turns out to be true, that would be market positive, given that the Fed’s current fed funds upper target sits at 5.0%, a full 260 basis points above that level. We’re less certain. As suggested by the recent dockworkers settlement, lagged wage increases are still coming through. If the CPI print is above expectations, markets are probably in for another bout of volatility. Our own view is that inflation this cycle is likely to settle in around the 2.5% level, but that it might take longer than the market expects for us to get there. We’ll see.
3. The Fed’s rate-cutting path
Expectations, including our own, about the Fed’s rate-cutting path have changed substantially with the strong jobs numbers last week. It now seems likely that the Fed will be cutting with less urgency, unless the labour market shows more signs of cracking. This probably means the next few meetings will see 25 basis point cuts, not 50’s. Still, the endpoint for the Fed is likely substantially lower on the short end of the curve, something like 3.0%.
We think this path is the most bullish one for markets, particularly for the cyclical/value stocks that would benefit from a still buoyant economy even while the Fed is cutting and the yield curve is steepening. The next big data point on the Fed will come at their November 7 meeting; if the cut is 25 basis points, as expected, and if the interim employment market reports remain positive, that would be market bullish.
4. China’s stimulus program
As I noted in my recent piece One and a half out of three ain’t bad, the good news out of China is that its central bank has unleashed a monetary bazooka to revive its moribund economy. We and everyone else are still waiting for the other shoe to drop, i.e., substantial fiscal stimulus. Here, we were all disappointed by this week’s underwhelming fiscal package announcement, by some estimates only 10% of the amount of stimulus markets were hoping for. This lack of fiscal follow-through is temporarily negative for our cyclical/value/emerging markets call, though we continue to think that a larger fiscal package out of China is a matter of when, not if. And in the meantime, the monetary stimulus is feeding financial markets. We’ll see.
5. The outcome of the US election
Given the divergent policy outcomes likely from a Harris versus a Trump victory, the US election matters heavily for investors, especially for sector weightings as different sectors would be likely “winners” under the two possible regimes. So a new, broad market advance seems unlikely until the election outcome is clearer. This could take several days beyond the likely close election night outcome, as mail-in and early ballot votes are tabulated. And beyond the now customary issues around polling accuracy, we have the further complication of the two big hurricanes, particularly Hurricane Helene, which so badly affected the western portions of North Carolina where Trump’s vote shares tend to be highest. A Harris upset here could be an election night surprise that markets are not expecting.
On the other hand, Trump’s results have historically outdistanced what the pollsters pick up, and if that pattern holds, he’d have a path to an electoral college victory without North Carolina by taking Pennsylvania and one other swing state currently not in his column, such as Nevada or Michigan. Again, we likely won’t know until sometime after November 5. As we’ve stated previously, a Trump win (lower taxes, less regulation, steeper yield curve) would likely favour older economy, “value” and small cap stocks, while a Harris win (higher taxes, more regulation, flatter yield curve), the growth trade. So this election matters.
Bull markets are known for climbing walls of worry, so in some ways, the present batch of uncertainties is not unusual. However, with the market already less than 5% away from our 2025 6,000 target on the S&P, we think investors can afford to be measured here. Our caution is underscored by the reality that the uncertainties cited above will impact not just the market level, but within the market, the relative winners and losers. So for now, we’re sticking with our modest overall equity overweight and our tilt towards value, small caps, and emerging markets. Next up: bank earnings.
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