Tactical allocation takeaways
- Will future profit growth support equity valuations? Inflation, tariffs, employment, interest rates, war, tax cuts, regulation/deregulation, technology developments, debt, and deficits… There are many factors to consider in today’s markets, but in the end, it boils down to that one question for equity investors. Valuations may give many investors pause at these levels, but momentum is quite strong.
- Constructive on the economy, skeptical on equity valuations. We don’t see a recession on the horizon given the current level of economic activity and fiscal support globally. Our main concern in the near term is whether valuations can be sustained. Importantly, there is a wide chasm between valuations of U.S. large cap stocks versus all the rest (e.g., small caps, non-U.S., emerging markets), most of which remain fairly valued.
- Inflation risk. There doesn’t seem to be an end to government deficit spending on the horizon; we expect inflation may persist at levels above those desired by the Fed. As a result, investors may feel the squeeze between low or even negative real returns in fixed income and the alternative of investing in highly priced equities, where further upside potential may be difficult to imagine.
The Macro Picture
There is no shortage of topics to consider in evaluating the current macroeconomic environment. We noted many of them in the first bullet point above in our Key Takeaways. Any one of those topics can quickly lead one down a rabbit hole of potential outcomes. But let’s take a cue from Curly, the cowboy played by Jack Palance in the classic movie City Slickers. When Mitch, played by Billy Crystal, asks Curly, “What’s the secret of life?” Curly points a finger and says, “One thing. All the rest doesn’t matter.” In today’s macroeconomic climate, that “one thing” is whether future profit growth will sustain equity valuations. Focus on this, and the rest is just noise.
United States. The U.S. administration is priming the economic pump, aiming to outgrow our national debt. Pressuring trading partners for more concessions and allies to pay more for defense, extending tax cuts for individuals and corporations, and reducing regulations sit at the forefront of that effort. Cuts in funding for universities, foreign aid and scientific research, and for various social programs and incentives previously in place to support clean energy, are also key tactics.
There are many drivers of future economic growth, including the technology races in artificial intelligence, cybersecurity, blockchain, and quantum computing. The risks of falling behind in those categories is too great and will likely drive ongoing competition to spend more, at least by the U.S. and China, if not others as well. These areas of investment ultimately will affect all sectors of the global economy, leading to greater productivity and presumably greater profitability (at least among those that can successfully deploy those technologies).
Europe and Asia. Europe is in an interesting situation currently. Inflation is largely in check and interest rates have been lowered to around 2%, a level that should be supportive of borrowing. The bloc is collectively increasing its investment in defense, is likely to find ways of becoming more energy independent. There is also a need for more home construction to satisfy demand that has ballooned from Airbnb and the like as well as ex-pats looking to enjoy the European lifestyle. A revitalized growth opportunity exists for a progressive-thinking European Union.
The Chinese equity markets seem to be caught in the crosshairs of global investors as a place they’d prefer to avoid. It is no surprise, considering the entanglements of China with the likes of Russia and Iran, that this would be the case for Western investors. Keep an eye out, however, for a time when Chinese consumer confidence returns and people are willing to spend more of their income rather than save it.
Not by choice, but the rest of the world will have to deal with the U.S. administration on some level as it relates to tariffs. The result is that global trade is likely to suffer, but one hopes to be a country that suffers less than the rest.
Fixed Income. Investment grade fixed income appears to be priced for a scenario that anticipates a Federal Reserve that will eventually lower interest rates down to the 2.5-3.0% range. Not only is the path longer than initially anticipated, but there also remains a decent risk that inflation could stay stickier and perhaps growth more robust via the combination of more fiscal stimulus and ongoing tariff impacts. In our thinking, current yields are likely to be a pretty good indicator of what returns will look like for the year ahead. On the high yield front, we are mindful that spreads are relatively tight, indicating investors’ comfort with the underlying risks. The compensation is below normal and therefore there is a risk should we see any negative turn in the economy.
This is a summary of our full Tactical Allocation Viewpoints report, which includes detail on Pathstone’s current recommended allocations by asset class and sub-class.
