Market Memo: An opportunity, not an omen

03-02-2018

All bull markets have cleansing periods, and that’s what this looks like now—a healthy retest of early February’s correction, clearing the decks for the next move higher. If this current sell-off extends much deeper, we likely will add further to our equity overweight in our PRISM® stock-bond model, having already bumped it up to 70% of maximum early last month.

There’s just too much to like to get skittish now. For one, we were encouraged by this week’s low 1.5% increase in core PCE, which we see as the ultimate gauge of the Fed’s response function, and by the moderation in bond yields that ensued. The steel and aluminum tariff dust-up is a distraction, in our view—a pullback that smacks of anxious longs looking for any excuse to sell.

Federated’s macro team stands committed to our 3,100 year-end S&P 500 target, which would represent an attractive 15% upside off current stock levels. The drivers for this view are as much in place now as they were at the start of the year: strong economic and earnings growth through 2019, aided by the near-term boost to demand via the household tax cuts and wage gains from the corporate tax cuts and the long-term payoff from tax reforms that should fuel a lot more investment precisely at a time the economy could use it. This, we believe, will pull long-dormant productivity out of its funk, allowing the economy and profits to continue to expand even as wages rise healthily.

Wages can, by the way, rise without taking inflation with them. We got a taste of such this week when personal incomes and wages rose while core PCE did not. The reason is structural deflationary forces--technology substitution and disruption, global competition and demographics, among them—remain intact, a deterrent whenever companies start to raise prices. The bond market gets this, which is why despite all the hoopla over new Fed Chair Jerome Powell’s frankly rather benign testimony, yields pulled in. To be sure, we expect the inflation rate, the federal funds target rate and the 10-year Treasury yield to be higher at the end of the year than they are now. But it should be a grind, not a sprint. Stocks can handle this gradualism given the underlying driver is strong economic and earnings growth.

In a similar vein, we expect equity valuations to expand, not contract, over the next 12 months as the drag of a modestly rising 10-year yield is overwhelmed by growing confidence that a deep recession—and a 40% decline in equities that could come with it—is unlikely anytime soon. So once we get through this unpleasantness, which we believe will be fairly soon, look for something close to a Goldilocks scenario for stocks to settle in, pushing forward P/Es toward 20. Relatively high, true, though all previous secular bull markets saw S&P valuations continue to rise into the high 20s before they ended. We are nowhere near that. So stay the course and, if you feel you must do something, add on dips.