Print
One of my core beliefs as a portfolio manager is that we get paid to worry so investors don’t have to. Several weeks ago, Brad wrote about what was worrying investors and whether those issues were worth worrying about. He also acknowledged that there are some real concerns out there as well. I want to build on that idea and provide insight into how portfolio managers think about risks when everything seems to be going exactly as investors had hoped and, except for some short pullbacks measured in hours or days, markets continue to move higher.
We remain constructive on the outlook for the equity markets as the economy continues to show signs of strength and Fed Chairman Powell reiterated the expectation for three rate cuts this year after the Fed’s March meeting. But part of our job is to think about other potential outcomes, so that is what portfolio managers do on a daily and weekly basis. We try to figure out what concerns could come to fruition, what that could mean for portfolios, and what opportunities might present themselves because of future volatility.
Is Sticky Inflation a Temporary or Ongoing Problem?
One topic that has been at the forefront of investors’ minds for a couple of years is inflation and the Fed. For months during 2022, high inflation readings weighed on markets. Now, consensus has shifted to the belief that inflation is headed to the Fed’s 2 percent target. But headline inflation reports have been sticky lately, and progress toward that 2 percent goal has stalled. While this might ultimately be temporary, the unfortunate closure of the Port of Baltimore could affect supply chains in the short term before adjustments for the flow of goods are made, and oil prices have risen to levels not seen since last fall. Gas prices at the pump have also begun creeping higher as we enter peak driving season. This all calls into question when the Fed will begin lowering interest rates, and by how much, over the rest of the year.
Further, just when everyone seemed to have arrived at the same point—that the Fed would begin to lower rates in June and do so three times before year-end—other views have started to emerge. Just last week, Minneapolis Fed Bank President Neel Kashkari said the current momentum in the economy could lead to the Fed reducing rates fewer than three times or perhaps not needing to cut rates at all this year. In the short term, markets continue to take their cues from interest rates. Given that, how these factors play out over the summer bears watching.
Where Is All the Earnings Growth?
Another issue we spend time assessing is S&P 500 earnings growth. My colleague Rob Swanke did a nice job in his recent blog post discussing earnings for the upcoming quarter. From a portfolio construction perspective, the breadth of earnings growth going forward will drive the appropriate allocation. Large-cap growth companies such as Amazon, Nvidia, Meta, and Microsoft have led the market for some time now. This has occurred in large part because these companies have the best fundamental stories and future outlooks. This combination has led to strong earnings growth for this part of the market, attracted investors’ attention, and driven valuations higher.
The rest of the market has some of the more attractive valuation levels. But their fundamentals haven’t been as strong, and earnings growth has been muted. If we can see earnings growth accelerate across more companies and sectors, we should see breadth across the market improve. This should bode well for diversified portfolios.
Will the Geopolitical Landscape Continue to Percolate?
History would say it is the “unknown unknowns” that ultimately cause a recession and a market pullback. While it is hard to anticipate these unknowns before they happen, geopolitical risks are always a potential catalyst. Here, there are certainly some known areas, including the prolonged Russia/Ukraine war or the Israel/Hamas war that has now been going on for more than six months. What ultimately happens in these two regions, whether that’s a resolution or further escalation, could affect the current consensus view of U.S. investors.
Two other areas to monitor are U.S. and China relations as well as the escalation in the Gulf. There have been some recent signs of improvement in communications between China and the U.S., with the recent call between President Biden and President Xi, as well as a visit by Secretary Yellen to China. But tensions remain. Trade issues and export controls are the biggest economic concerns between the two countries and could potentially affect global growth.
At the same time, news from the Middle East continues to suggest heightened tensions that could affect both the global oil markets and shipping channels. Rhetoric over the weekend suggests that Iran might be drawn into the conflict currently going on in that part of the region. Iranian spillover would certainly have an impact across the globe, particularly on important trade routes like the Strait of Hormuz.
Volatility Creates Opportunity
The truth of the matter is that there are always things for portfolio managers to worry about. While it is important to be cognizant of the issues that could cause market volatility, it is equally important to remember that, if that volatility occurs, it will create opportunities to deploy capital to add value to portfolios. So, stay invested. Stay balanced and diversified to navigate the uncertainty. And keep your eyes open for potential opportunities as they present themselves.
