Rocky landings easier to handle from a neutral corner Rocky landings easier to handle from a neutral corner\images\insights\article\airplane-landing-small.jpg August 1 2022 June 28 2022

Rocky landings easier to handle from a neutral corner

Selling equities into rally as outlook for 'Rocky Landing' grows more likely.

Published June 28 2022

With equities up almost 7% off their recent lows, and growth stocks up nearly 10%, Federated Hermes’ macro team again took more money out of growth stocks and added to cash. This is the fourth such sell in the last nine months, leaving our moderate PRISM® allocation model a mere 1% above neutral in stocks, underweight bonds and significantly overweight in cash. Within equities, we are heavily tilted toward value names and especially large-cap defensive dividend payers, and significantly underweight growth stocks. 

Though some will note that this is our most conservative stance toward stocks since we entered the 2008-09 bear market, we are not projecting a bear of that magnitude at present. Absent further major policy errors on the part of Congress or the Fed, which in our view are less likely now, our concern is that the opportunity within stocks over the next 18 months appears limited to a broad trading range, somewhere between 3,400 and 4,000 on the S&P 500. With the markets having rallied to near the top of that range, we believe it is prudent to further clip our positions.

A “Rocky Landing” has begun

When I first introduced this term a few weeks ago on national television, the producer immediately printed a banner during the continuing discussion that read “Auth calls for recession.” To be clear, what we believe we’ve now entered is a period of subpar, +/- 2% real growth that will likely see a few real GDP prints below 0% over the next 18 months. While this is not good for stocks, it is not what some people imagine a recession to be.  A “Rocky Landing” is not, for instance, a rerun of the 2008-09 financial crisis that led to the Great Recession we all remember so well. It is rather likely to be both less severe and less prolonged. The reason our outlook is “Rocky” but not “Hard/Crash” has to do with something investment people call “reflexivity.”

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2008-09 marked by “negative reflexivity”

One of the really dangerous aspects of the 2008-09 economy and market was the negative feedback loop, or “negative reflexivity,” from one to the other. Specifically, with real estate markets oversupplied by excessive spec building and unsupportable financing schemes such as “Liar Loans” and “CLO tranches” that repackaged them, once that residential real estate market starting to come undone, spec projects underwritten without end buyers were forced to slash prices to bail out the builders. That pushed real estate prices down, but as they fell, the big banking institutions holding pools of now delinquent mortgage debt were forced by accounting rules to write down the assets on their balance sheets. This pushed their share prices down, forcing further credit restrictions, thus further tightening the noose on borrowers. That led to more defaults, more write-downs and more stock market drops. On and on, you get the picture. Negative reflexivity.

2022’s list of problems has several self-correcting solutions, or “positive reflexivity”

The present market environment, in our view, while not positive at the moment, at least has some self-correcting brakes that make it likely to be entering a protracted period of range trading. For instance, as prices of goods and services remain elevated, demand is beginning to adjust, with consumers reallocating budgets toward things they need, not things they want. Companies stuck with too much inventory of goods or services are beginning to adjust, and price cuts or promotions on some consumer products should not be far away. A similar story is playing out with a number of former “stay at home” darlings such as video game services, personal computers and the chips that drive them, etc. While these adjustments won’t be terrific for economic growth near term, they will help to eat into the inflation pressures that are driving the Fed. Likewise, the market correction itself may already be having a positive feedback loop toward inflation, as higher-end consumers adjust their demand for goods and services downward to reflect their lowered wealth. And all of this downward inflation pressure, which we expect to play out starting in Q3, is likely in turn to cause the Fed to begin to ease up on its hawkish stance, which has kept so much pressure on stocks. Positive reflexivity.

Upside and downside forces limit trading range

The problem for markets, though, is that near-term upside is probably limited by similar feedback loops to the downside. On one hand, all the uncertain adjustments being made in the marketplace for goods and services are likely to impact corporate earnings, which grow far more smoothly in steadier, trending environments. So, this is a pressure to the downside. And if markets get too ahead of themselves and begin to price in Fed cuts, the subsequent rally in stocks likely would refuel the animal spirits behind the upward inflation pressures we’ve been experiencing, putting the Fed back in play and capping upward advances. 

So, stocks in our view are now bound between two broad ranges. To the upside, markets are likely to be limited by the threat of more than the already anticipated 3-3.5% worth of hikes that we’ve already collectively gotten to, along with rocky landing earnings numbers and projections that will begin in Q2 and probably worsen in Q3. To the downside, beyond another 10% or so, inflation likely would improve substantially amid rising layoffs, supplemented by a Fed that starts easing back on the rate-hiking throttle. And although corporate earnings eventually would come down, growth off a firmer base with the Fed and inflation sidelined would be easier for investors to imagine and be reflected, we think, in expanding valuation multiples.

We’ve lowered our S&P targets for this year and next

Officially, we’ve cut our year-end S&P target for this year to 3,900 and to 4,000 for next year, and we’ve raised our assessment that a low in the 3,400 to 3,500 range is likely as the markets react to possibly worse-than-expected near-term news on earnings, inflation and the Fed. Like everyone else, our crystal ball is more cloudy than usual, and we acknowledge the still possible though less likely scenario that the very flexible American economy adjusts quickly to the new world we are in and that earnings somehow power through in the months ahead. For now, though, we are continuing to advise caution. Rocky landings are easier to handle from a neutral corner.

Tags Equity . Markets/Economy . Active Management .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Growth stocks are typically more volatile than value stocks.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

PRISM: Effective Asset Allocation® is a registered trademark of FII Holdings, Inc., a subsidiary of Federated Hermes, Inc.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

There are no guarantees that dividend-paying stocks will continue to pay dividends.

Value stocks may lag growth stocks in performance, particularly in late stages of a market advance.

Federated Global Investment Management Corp.