As we move into the summer doldrums and people turn their attention to vacations, time spent by the water, and the sound of children running around outside, we wanted to give a few quick thoughts on some of the topics that have captured US investors’ attention over recent months. From inflation to recession, and banks to debt ceilings, we hope to provide some clarity on where we may be going from here and what it means for investors.
Inflation in the US remains a polarizing topic. On one hand, inflation has fallen well off of its peak and continues to slowly grind lower. On the other hand, we remain two-and-a-half times in excess of the Fed’s target inflation rate and a number of underlying metrics remain incredibly stubborn. Consider that while headline inflation has fallen from just over 8% in March of 2022 to 4.9% in April of 2023, the Fed’s preferred inflation metric – Personal Consumption Expenditures excluding food and energy – has fallen from 5.4% to only 4.6% at last reading.
These dynamics complicate the decision regarding monetary policy, which itself presents several questions for investors. Right now, it appears that the market doesn’t seem nearly as concerned about inflation as the Fed or the consumer may be.
On the economy
The US economy is potentially the principle point of debate at this moment for many investors. Afterall, earnings are predicted upon the economy to a large extent, and a weaker economy tends to mean lower earnings.
Today, some people will point to the resiliency of economic growth, in particular, the King Consumer. Others would point to the continuing deterioration in the manufacturing sector and cracks that are starting to show under the surface in consumption. In reality, both of these things are true. We see this cycle playing out slowly, as more traditional economic cycles do. The Fed hikes rates, financial conditions tighten, activity slows, eventually labor markets crack, this further weighs on consumption, and the cycle feeds on itself until the Fed ultimately relents and the economic cycle resets.
On the banking sector
Stresses in the banking sector have moved on and off the front page since early March of this year. While we have seen regulators move swiftly to ringfence issues and provide a liquidity backstop to banks, we don’t believe that the stresses have reached their end. The conditions that are driving deposit flight from banks remain in place and we continue to see deposits leave the banking system, albeit at a slowing pace. While lower bond yields provide a cushion to balance sheets, we remain very cautious on banks given both our view on the stresses in the system and our place in the economic cycle.
On the debt ceiling
Conversations surrounding the debt ceiling deserve a bit more nuance than they tend to get. One point we should highlight is that we see almost no circumstance under which the US would default on its debt obligations. The full faith and credit of the country is enshrined into the constitution as part of the 14th amendment, and revenues generated by the government more than adequately cover interest payments on US debt securities. As such, we view a true default as being essentially out of the question, though this does not mean that we couldn’t see a situation where the US Treasury was forced to prioritize debt-related payments over other expenses such as entitlements or government salaries.
With that said, we anticipate that the fight surrounding the debt ceiling will continue to be noisy and will likely come down to the last minute. As we saw in 2011, this can have serious implications for financial markets and we anticipate that volatility may be pick up as we move closer to the so-called “X-date”, or the date on which we will breach the debt ceiling. In the end, a negotiated settlement is the likely outcome in which we see the debt limit temporarily raised in return for the promise to cut spending some time in the future.
Bringing it all together
To put things simply, we continue to view risks to financial markets as being elevated. This is particularly true in equity markets, where we do not believe current multiples and earnings estimates capture the reality of the economic situation facing the market.
In the type of environment, we continue to favor defensive positioning in client portfolios. We prefer companies that are able to generate strong cash flows through the economic cycle and have strong competitive positions in their respective industries. While we have started to find some opportunities in more traditionally early-cycle industries, we believe that conditions remain such that it is important to be patient and wait for a better opportunity to increase our exposure to more pro-cyclical parts of the market.
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This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product.