Midnight musings: 3 risks keeping us up at night

Through everything, everywhere, all at once, both the economy and markets have defied the challenges.

We don’t think this represents a disconnect from reality, and we remain constructive on the path ahead. Yet any good investment outlook requires a genuine evaluation of the risks. Today, we share three midnight musings that (occasionally) keep us up at night.

• Will “higher for longer” rates hurt?
• Are valuations too high?
• Does election uncertainty fan the risk flames?

Will “higher for longer” rates hurt?

After noting “lack of further progress” in the inflation cooldown, the Federal Reserve signaled it plans to keep rates higher for longer at its policy meeting last week. The worry that follows: Will cracks in the economy deepen along the way?

So far, credit stress has been mostly contained to the office commercial real estate sector, but persistently high rates could see those pockets of pressure broaden. Smaller banks are more exposed to commercial real estate than larger banks, and unrealized losses on some of those banks’ balance sheets (thrust into the limelight during SVB’s collapse) haven’t gone away. Elsewhere, small and medium-sized businesses tend to be more indebted, with their ability to repay interest obligations now below pre-COVID levels. Those companies also employ about three-quarters of the private sector, and consumer spending is already under a microscope amid low savings rates and rising credit card delinquencies.

And again, this is all while inflation still remains above the Fed’s 2% target, calling forth the dreaded “stagflation” word that plagued the 1970s.

What quells our nerves: One of our favorite quotes of last week came as Chair Powell said, “I was around for stagflation...I don’t see the stag or the -flation.” This means it’s equally important to stay focused on today’s backdrop: Growth is solid, not stagnant, and inflation is sticky, not reaccelerating. To that point, Friday’s jobs report showed heady wage gains are still cooling. Echoing the soft landing and booming economy of the 1990s, the Fed is thus in a holding pattern to make “the last mile” of progress, rather than to fight off new and growing threats. Such likewise prompted Chair Powell to affirm that “it’s unlikely the next policy move is a hike.”

Finally, as much as higher rates and tighter credit conditions are a risk, they can also be an opportunity. Elevated yields mean that investors can opportunistically step out of cash to lock in high rates for longer. Preferred equity and private credit can enhance yield and take advantage of some of the idiosyncrasies of a “higher for longer” environment. And as friction points arise, active stress and distressed managers can nimbly navigate overleveraged pockets of the market.

Are valuations too high?

Alongside high policy rates and bond yields, equity valuations are also high. (Read: Stocks feel expensive.) Despite investors aggressively paring back Fed rate cut bets for this year, from highs of roughly 160 basis points (bps) to around 35 bps today, the S&P 500 has rallied over 20% from its lows last October.

The fear: What if the stock market is in a bubble? Thanks to the meteoric rise of the so-called “Magnificent 7,” and enthusiasm around AI hype still in the process of proving its worth, the S&P 500 is also at its most concentrated in decades. This might feel scarily familiar to the dot-com bubble of the early 2000s.

What quells our nerves: While the rally has been strong, it would be unfair to say it’s just been propped up by exuberant sentiment. Rather, earnings growth has driven 80% of this year’s S&P 500 return. In the ongoing Q1 reporting season, S&P 500 earnings are expected to grow over 4.5% year-over-year (up from just above 3% at the start of last week and flat 2 weeks ago). Of the roughly 80% of companies that have reported, nearly 80% have beat earnings estimates and are doing so at an almost 8% rate—both above their 10-year averages. Finally, mention of AI across an array of sectors only seems to be growing.

That strength is expected to accelerate as we move through the year, and it’s in part thanks to the current backdrop. Moderate inflation enables firms to pass higher costs on to consumers. That fuels sales, and if costs are managed effectively, boosts profits. Looking at history, stocks also tend to do pretty well when the Fed is “on hold,” especially in soft landings: Going back to the ’90s again, stocks continued to rally for years despite the Fed holding policy rates above 5% for a considerable time.

Finally, return dispersion between the best- and worst-performing companies is high. This opens up an opportunity for active managers to hunt for alpha, especially in markets such as U.S. mid-caps, Europe and Japan—the latter two of which are showing a big boom in shareholder friendly practices relative to years past.

Does election uncertainty fan the risk flames?

As we barrel toward a Trump and Biden rematch, a number of our midnight worries come to a nexus. The U.S. debt burden is already high, and neither of the candidates is likely to be fiscally conservative. This probably means more deficits, even higher debt, and at some point, probably higher taxes—something that bond markets will also need to account for. Changes in immigration policy could call into question the labor market rebalancing that’s aided in cooling down wages. Trade-related policy, complicated by ongoing geopolitical flashpoints, is sure to create ripple effects. Regulatory upheaval could create its own new winners and losers.

The information presented is not intended to be making value judgments on the preferred outcome of any government decision or political election.

All market and economic data as of May 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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Index Definition

The S&P 500 is a market-capitalization-weighted stock market index that tracks the stock performance of about 500 of some of the largest U.S. public companies.