'Don't play Hearts with someone who doesn't know the rules'
Still cautiously favoring equities as unpredictable Putin plays under his own rules.
One of the many hard-earned lessons during my 40 years in this business is “Don’t play Hearts with someone who doesn’t know the rules.” Without delving into the intricacies of the card game or the entertaining specifics of how I learned this particular lesson many years ago over a losing hand, let me get quickly to the point. When someone is at the table who is playing the game by an entirely different, and unpredictable, set of rules, it’s prudent to pull in your horns and play more conservatively than usual. And within our adjusted framework for markets that supplemented the four cornerstones of economy, earnings, Fed and valuations with a new—and critical—fifth variable, the war in Ukraine, that has meant a more sober view of the wider-than-normal range of outcomes facing investors in coming months.
Specifically, with Russia’s President Putin playing by an entirely different and unpredictable set of rules, we see at least two almost equally probable, but very divergent, potential outcomes ahead. With this lower confidence in our base-case scenario for higher markets by year-end, the Federated Hermes PRISM® committee last week decided to further scale back our equity overweight in our moderate growth stock-bond portfolio model, selling into market strength. This was our third trim of the model’s equity overweight since last September, bringing it to 30% of the maximum overweight—our most conservative, though still modestly bullish, positioning since 2020. So, we’re still leaning into stocks over bonds, though less so than usual and heavily tilted toward more defensive, “value” stocks. And we also are holding more than our usual allocation to cash.
Let me update where we think the framework elements are as we close out the first quarter and enter spring:
Ukraine war outcome moves to 50-50, a bit more positive than where we were
Since we added this building block to our market framework three weeks ago, the war’s course has increasingly tilted in favor of a Ukrainian victory, at least in regards to the ground war. As Russian casualties mount (some 40,000 killed or wounded by some estimates), it has become increasingly clear odds of a Russian takeover of its neighbor by conventional military means is unlikely. However, getting back to that Hearts lesson, this doesn’t necessarily mean the base case is now a quick ending, which generally would be more bullish for the economic and market outlook. Increasingly isolated and backed into a corner, Putin seems to be resorting to simply bombing Ukraine’s heavily populated cities off the map. Is this a feint to draw out the Ukrainians to surrendering the east to save the rest, or the beginning of a more prolonged fight with the Ukrainians fighting hand to hand from within the rubble? We don’t know. But we’ve raised the probability of a quick, negotiated outcome to 50%, leaving the prolonged war outcome at similarly 50%.
As we explained in our last memo, the difference in market impact of these two scenarios is subtle but not insignificant. If the war ends soon, our guess is that while Russian commodities will remain off limits in the eyes of Western governments, Ukrainian commodities at least will come back onto the global markets and the potential for a further recession-inducing oil shock might be alleviated. In this case, we’d have oil stabilizing for next few years in the $120 range, enough to take some steam out of the global economy but not enough to kill it. However, if the war runs on through the summer, our guess is oil is likely to grind higher still, making it difficult for Europe at least to avoid a recession.
Fed tilts more hawkish, moving our economic outlook to soft landing, also a bit more positive
Since our last piece, actions and noise out of the Federal Reserve have shifted to a more hawkish tone, with the market now anticipating a series of 25 basis-point hikes, with a few 50s thrown in for speed, toward an eventual terminal feds funds rate in the 2.25-2.50% range. We, with others, cheered this hawkish shift by the Fed. Given how on fire nearly every segment of the economy is and given the still yawning gap between supply and demand for labor, commodities and finished goods, Fed attempts to gradually slow the post-Covid recovery with gradual but persistent rate increases raise the odds it won’t have to crash the economy later.
We also think that the rise we’ve seen in food and energy prices, at least to date, will help the Fed achieve a soft landing rather than lead to so-called “demand destruction.” Demand destruction happens when there is a sudden crisis, such as a banking panic or a stock or real estate market meltdown. At the moment, this hasn’t happened, nor do we see one as likely. So, with jobs still plentiful and many more on offer than we have labor to fill them, our guess is consumers will only gradually adjust downward their spending, not suddenly crash it. Call it “demand softening,” not demand destruction. That’s market positive.
And by the way, we are not of the view that the now nearly flat 2-year/10-year Treasury yield curve is in any way predictive of a looming recession. Though in some cases sharply inverted yield curves have presaged recessions in the U.S., we think it’s more important to look at each curve in the context of where the economy and rates are at that instance, than to believe the yield curve is somehow a market Ouija board that forecasts the future. For us, what we see in the sharp narrowing between 2-year and 10-year yields to around 2.5% each (with both perhaps reaching 3.0% eventually) is a market view that over the long haul, the Fed is going to raise the fed funds rates to that level, that inflation is going to come down from 7-8% now to 2.5-3.0% as well, and that the Fed can get there through a soft landing. A steep negative slope, of course, would be a different matter, but that is not on offer at the moment. We’ll keep a close eye on this but for now, we see today’s yield curve as more predictive of our base case soft-landing scenario than anything else.
Earnings outlook declining modestly
We will be entering earnings season next week, and with it, we expect the market’s focus to shift again to stock-by-stock distillation of where earnings are coming in. Generally, Federated Hermes’ analysts remain fairly sanguine on the coming quarter, across most sectors. Indeed, from what we can tell, most of the S&P 500 companies are doing a reasonably good job of managing their costs and prices to offset the negative impact of rising labor and commodity prices. This said, our attention is largely going to be on margin guidance going forward, and our fears are that, with the Ukraine war and related pressures apparently not ending anytime soon, margin guidance is likely to be guarded. In advance of this, our macro team has already cut our base-case S&P earnings forecasts for this year and next, from $230 and $260, respectively, to $220 and $250. This is not market positive, though we do think the correction we’ve already been through has at least partly discounted this news.
Valuation outlook under pressure, though the worst may be behind us
The good news for the market is, with the Fed’s hawkish shift, investors can feel more confident that between Fed hikes immediately ahead and the demand-suppressing impact of higher inflation, prospects have brightened for the 10-year Treasury yield stabilizing around 2.5-3.0%. If this is the case, the relentless pressure on market valuations from rising rates may be stabilizing, too. We think the fair valuation on the market, broadly, should rates and inflation settle around 3% is a forward P/E somewhere between 18x and 19x. That would mean the market, now trading at 18.1x our 2023 estimate, is currently close to fairly valued.
Conclusion: Modest equity overweight warranted
With the market in our base case about fairly valued, positioning balanced portfolios with a modest equity overweight makes sense for now. The range of outcomes ahead still leans bullish, but with a card player at the table playing by his own rules, some nasty potential negative outcomes can’t be easily dismissed. Better to play more conservatively until the rules—and the cards—become clearer.