Politics is Evolving Faster than the Economy
The economy continues to roll ahead, while investors wait for growth and inflation to moderate further so the Fed can start lowering interest rates. These are reasonable expectations, even as we are all distracted by the rapidly evolving political landscape as we move closer to a Presidential election in just four months. Fears of an impending recession remain misplaced. Instead, the outlook remains quite benign, even if interest rates stay higher for longer.
The bond market repriced dramatically at the beginning of the year, as investors came to realize that neither a recession nor a sharp moderation in inflation was imminent. So, expectations for several rate cuts in 2024 had to be repriced out of the market. Nonetheless, the realization that rates would remain higher for longer did not hurt the stock market, as profits forecasts had to be increased in the absence of a recession. At midyear, the market now expects only one or possibly two quarter-point rate cuts this year, which is vastly more realistic. And earnings growth has supported stock prices, although the gains have been extremely uneven, as AI related companies have surged, while much of the rest of the market has moved only modestly. In a notable way, this is an impressive performance. Many would have argued the stock market would have retrenched in the face of expectations of higher rates for longer. Instead, the headwind of higher rates was offset by the tailwind of higher profits.
We still think economic growth will slow, but there’s an important caveat. We had expected a slower pace of growth at the beginning of 2023, which did not occur. The unemployment rate declined to multidecade lows, so only around 6 million people were unemployed, implying the expansion could not possibly sustain monthly job gains of 200,000 to 250,000 without setting all-time lows for the unemployment rate and setting up unacceptably high wage inflation. In fact, that pressure cooker of strong hiring demand was met by a most unlikely source; illegal immigration across our Southern border brought a few million new job seekers into our market. This enabled firms to continue hiring at a pace well above what was possible just from domestically sourced labor and it relieved the upward pressure on labor costs. Illegal immigration has extended the life of this economic expansion. But growth and inflation may not moderate while immigration bolsters the workforce and fiscal policy remains so expansionary. So, the Fed remains on hold waiting to see how these trends play out.
Now introduce the potential for changes in policy by the Administration as it prepares for the election campaign, even as uncertainty increases with the possibility of a change in government. Suddenly, even the identity of the candidates has become uncertain. Already, some restrictions have been imposed on border crossings, which could curtail the influx of job seekers, but these appear not terribly binding. And the time until the election is short, so major effects on the economy are unlikely to occur quickly. It seems likely that investors will be obsessed by the evolving changes in the political landscape, which is unfolding rapidly.
On the investment front, the trends seem to be unfolding glacially compared to political developments. Hiring seems to be slowing, albeit only slightly. Yet, growth remains above the long-term trend, bolstered by the influx of immigrants. Inflation may be slowing, but also very slowly. So, policy is likely to wait until these trends become more advanced. In this context, we still see many solid investment opportunities in the equity market. The case for the Magnificent Seven varies, since they are hardly similar, except in that they are all expected to grow substantially and are priced accordingly. We own some in portfolio strategies for which they are appropriate, but typically below their market weighting. On the other hand, the unloved S&P 493 offer many outstanding long-term values. On the fixed-income side, we continue to manage our risks by keeping our average duration below our benchmarks, while we seek extra yield through careful security selection. This also enables us to be nimble and take advantage of unusual opportunities when they crop up. Looking ahead, the markets are likely to be less dramatic than the political scene over the coming months, unless political developments spill over into economics.
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