One-and-a-half out of three ain't bad

I’m probably dating myself, but I’m still a fan of the recently deceased “Meatloaf” rock singer and of his hit single, “Two Out of Three Ain’t Bad.” Maybe it’s my naturally optimistic personality, but I do think in this business, when you get 2/3rds of a loaf, you should actually be ecstatic. “Ain’t bad,” in my book, is more like 1½ out of 3. So, China’s surprise monetary policy bazooka last night, following the Fed's unexpected 50 basis-point cut last week, is positive news for the “rotation trade” (into value/cyclical/emerging markets) we’ve been talking about, and positioned for, since early July. Call it 1½ out of 3, or a half a loaf.

This said, we still have the third big uncertainty to deal with—the U.S. election—and it looks like this one will be with us until election day at least, and probably beyond. And, until China’s fiscal authorities get into the game (which they haven’t so far), its central bank’s policy actions are more likely to fuel its stock market than its economy. So, we are maintaining our cautiously optimistic view on stocks with our 3% overweight to equities, while still reserving some cash on the sidelines for potential further volatility around the election results in the weeks ahead.

Let’s review all three policy areas impacting markets and likely to continue to do so into year-end.

1. The Fed tries to get ahead of the curve. Regular readers of this space know that, while we felt strongly the Fed needed to embark last week on a more aggressive rate-cutting path, we also believed it wouldn’t do so. So, last week’s aggressive action was welcome news, particularly for the rotation trade we’ve been positioned for in our balanced portfolios.

Until last week, the Fed has persistently demonstrated a backward bias toward its rate-setting policy—most clearly demonstrated in its too-long-delayed first hike in early 2022 in the face of structural inflation forces it underestimated. This delay led to an unsettling policy lurch in the opposite direction of ease, with four 75 basis-point hikes in a row at successive meetings in 2022, along with two 25 and four 50 basis-point hikes. Markets crashed, led by long-duration growth stocks, whose valuations are heavily dependent on the yield on the 10-year government bond. And the economy entered a nearly two-year-long rolling recession we called at the time a “Rocky Landing.”

This experience left us concerned this Fed lacked the creativity to set policy based not just on where the economy has been, but also on where the “internals” suggest it may be heading. On the latter front, we and others have noted that the employment markets, so tight in 2021 and 2022, have eased considerably. JOLTS data suggests jobs-on-offer are way down, and the 80 basis-point increase in the unemployment rate off its cycle lows suggests an economic slowdown.

Other economic “internals,” especially in the manufacturing, auto and housing sectors, and retailers servicing lower-end consumers have similarly softened considerably. Tuesday’s manufacturing and consumer confidence indicators suggest the slowdown in the economy we and others been concerned about is quite real. With core inflation readings approaching 2.5%, the Fed's 5.5% upper bound on fed funds is nearly a full 300 basis points above inflation, making life very difficult for smaller companies and lower-end consumers who depend heavily on short-term financing. So, last week’s action, cutting rates by 50 basis points even while inflation is not yet technically at the official 2% target and the economy as a whole is not yet in a recession, was a pleasant surprise. It suggests the Fed sees what we see, and that it needs to begin cutting aggressively to prevent the rocky landing from extending into a full-blown recession. Now that it has figured this out, should the economy continue to slow as we expect, more cuts are sure to follow. The market sees an additional 75 basis points of cuts by year-end, and another 125 in 2025. We see at least this many ahead. All of this is good news for companies in the value and small-cap indices who, unlike the big cash-rich tech companies in the growth indices, finance themselves primarily using short-term interest rates. But investment flows into this side of the market will depend on continued aggressive Fed policy action, along with signs suggesting the current economic softness is stabilizing at pre-recession levels.

2. China’s monetary policy makers finally act forcefully. For the last 18 months, emerging markets and global investors have been waiting anxiously for China’s policymakers to light a match and stimulate their massive economy, which has shifted into deflationary mode. Its slowdown has hurt its domestic sector, for sure, but also the European export sector that depends heavily on China trade. And as China increasingly cuts prices on its exports to backstop its economic growth, that is negatively impacting economies all around the world. Yet, despite the increasingly high levels of domestic pain, its policymakers have only dribbled out small stimulus measures that simply weren’t big enough to move their economic needle.

This all may have just changed, with the series of actions the People’s Bank of China (PBoC) just announced, designed to bolster the country’s ailing property sector and boost its stock market. The actions include lowering the reverse repurchase rate from 1.7% to 1.5%. It coupled that by lowering its reverse requirement ratio by 50 basis points, said to add 1 trillion yuan of liquidity into the banking sector. The minimum down-payment ratio was cut from 25% to 15% for those buying second homes. And the bank will now cover 100% of loans that local governments use to purchase unsold homes with cheap funding, up from 60%.

Notably absent however, was any coordinated fiscal measures to boost moribund domestic demand; so while the monetary actions may help stocks, it’s not clear the country’s economic trajectory will change much. Still, with expectations very low, markets on their back and growth stocks in China among the cheapest stocks in the world, the latest PBoC actions cannot be ignored. They may be the spark of confidence needed to ignite, finally, a self-reinforcing upward spiral in confidence, economic activity, market updrafts and improved confidence. We’ll see. As a minimum, the PBoC has now joined the Fed in boosting global liquidity, generally a positive for the cyclical trade.

3. The U.S. election looms. The third big uncertainty for investors is the election and, in particular, its impact on the rotation trade. As we’ve noted, a Trump victory would be positive for small caps and value stocks, given the likelihood he would scale back the regulatory regime that adds disproportionately to smaller companies’ costs, and that he likely will extend the tax cuts that have been so helpful to companies in the value and small-caps sectors. Should Vice President Harris prevail, the likely regulatory status quo and higher tax regime would favor the mega-cap growth stocks that have dominated markets over the last three years.

Unfortunately, we don’t see this uncertainty resolving itself until the election, and probably for a period of thereafter. Since President Biden exited the race, the polls have tightened to a dead heat and everything will now depend on relative turnout for both sides, as well as the mail-in vote. Indeed, it now seems likely that the election will be too close to call on election night as counts and recounts occur, and mail-in votes are tabulated. Given the changes in 2020 to the long-standing election process, if the outcome is very close, we can probably expect public protests and unrest from whichever side loses. None of this uncertainty will be good for markets, though eventually, it too will pass.

Which brings us to earnings. One last bit of uncertainty for the market to absorb is earnings season, now almost upon us. Our rotation call has been dependent partly on our expectation the earnings-growth gap between large-cap growth stocks and everything else is likely to decline considerably in third and fourth quarter earnings reports. In the first and second quarters, the so-called Magnificent Seven posted year-over-year earnings growth rates that beat the rest of the S&P 500 by 52% and 27%, respectively. That gap is projected to narrow to 17% in the third and only 7% in the fourth quarter. If we are right, that will add additional fuel to the fires already set by the Fed and China. Coming into the reporting season, we’d note that earnings forecasts for the full market, along with the small-cap sector we like, have come off more than usual. Over the last two months, third quarter earnings estimates have fallen by 2.5%, with the declines driven by downgrades in cyclical sectors. While this might be considered a negative, it ironically often proves to be a positive, as the earnings bar is now lowered and maybe easier to beat. More to come on this in the weeks ahead.

When you add it all up, the unexpected, though overdue, actions by the Fed last week and the PBoC this week are positive for the rotation trade, and as such, very welcome. Still, we advise cautious optimism ahead. Earnings season could be rocky, the Fed is still behind the curve and the second largest economy in the world is still not out of the woods by any means. Finally, the all-important U.S. election is unlikely to be called for weeks. We’re staying modestly overweight stocks, as “One-and-a-half Out of Three Ain’t Bad.” If we get more than that, get ready—the markets could blow past our 6,000 2025 S&P forecast in the weeks ahead.