10 reasons the market's glass could be half full, not half empty
As ‘Rocky Landing’ enters final phases, equity market remains upwardly biased.
As we enter 2023’s back half, views on the outlook from here remain quite mixed. Some are calling for a major pullback, still anticipating the recession that, so far, never came. A select few bulls are off to the races, declaring the beginning of a new bull market built around the wonders of AI. And most of the rest are stuck somewhere in between, wondering if the worst is possibly behind us or, alternatively, ahead of us.
Bears, for sure, have a long list of reasons to see the glass as half empty. Short-term interest rates remain lodged above 5% and the Fed has been clear it has no plans to cut them anytime soon. If anything, policymakers have warned more hikes could be coming. Inflation, though off its highs, remains well above the central bank’s 2% target, and unemployment remains way too low, in their view. Y/y earnings are down and, many feel, could go lower still. The office market is under a ton of pressure, and that could lead to problems in the CRE space, all important to the banking system. And if and when that pressure comes, the recession everyone has been waiting for could truly be upon us.
Despite these well-founded worries, count us among the cautious bulls. As half empty as the market’s glass clearly is, by definition it also is half full. For sure, rocky landings are hard to navigate and as they progress can alternatively appear to be hard, soft or somewhere in between. But with time now clearly on the side of the bulls (this bear market at 18-months-old almost certainly will be over soon, one way or the other), at Federated Hermes we are focusing our attention on what could go right from here, rather than what could go wrong. This list is at least as long as the bears’ issues, but for brevity I’ve whittled it down to 10 possible market positives:
- The job market appears to be softening, and next week’s numbers could underscore this point. A key reason the economy has powered on has been the strength in jobs. Given the massive shortage of labor as we exited the Covid lockdowns, this has been a key force both in keeping inflation stubbornly high and the consumer stubbornly resilient. (There goes that half empty, half full thing again!) Claims, which had been running below 200,000 late last year and earlier this year, have of late been drifting higher toward 265,000. At the same time, average hourly earnings have been coming in from their highs near 6% to 4.3% at the last print. Given ongoing weakness in the manufacturing, real estate and banking sectors, our guess is next week’s all-important nonfarm payrolls number comes in light versus consensus, which at 198,000 already would represent the weakest jobs print since 2020. If so, markets would probably roar at such a visible sign the Fed’s longstanding inflation fight might finally be having an impact.
- Inflation numbers are heading lower. Having soared on a toxic combination of supply & demand imbalances throughout the economy in the post-Covid reopening and a flood of fiscal and monetary stimulus in 2020 and 2021, inflation numbers already are off their peaks and, we think, heading lower still in the weeks ahead. Indeed, this Friday’s nominal PCE deflator is projected to be up 0.1% m/m, which annualizes to just 1.2%! The core number is anticipated at 0.3% m/m, which annualizes to 3.6%. This latter number is still above the official 2% goal, but might be pretty close to a comfortable near-term range for the Fed. And our guess is that if anything, given the dramatic declines we’ve seen in energy prices, shipping rates, food prices and, yes, wages, Friday’s number could surprise on the downside. More fodder for the bulls.
- Mumblings about Mondays. As the economy begins to settle back to normal, we’ve been impressed with the number of times we’ve read or spoken with corporate managers about the virtues of in-office Monday work. We get it that many companies have probably shifted permanently to a three day in-office workweek, but our guess is incrementally, the trend from here will be toward more in-office days, not less. Productivity, culture building, team spirit and even cramped home office conditions, along with a power shift back to employers as the labor market softens, all seem likely to us to shift the calculus on office-home balance. Even a modest shift could have significant ramifications for the gloomy consensus on central city office demand. And that in turn could make the assumed debacle ahead in CRE less worse than forecast.
- Vornado’s 1 Penn investment. We might not be the only ones beginning to think like this. I was impressed for sure by this week’s announcement by Vornado, one of the biggest and smartest real estate companies in the world, that it was investing $1 billion in an office project next to New York’s major commuter hub, Penn Station. This will only make sense if New York’s suburban commuters come back to the city. We’ll see; $1 billion is certainly a statement. If correct, another bullish signal.
- The IPO market comes creeping out of its cave. For nearly 18 months, the IPO market has experienced one of its worst bear markets in memory. Indeed, the U.S. IPO market, where the world’s newest and most dynamic companies come for growth capital, has been virtually closed since late 2021. Now, suddenly, life. Two weeks ago, four deals. This week, eight more. None of them mega deals, yet. Nevertheless, the willingness of companies to come to the market, and the alacrity with which the deals, generally, have been received, suggests to us that something fundamentally has changed. If so, that would be bullish.
- Russia-Ukraine could be entering its final stages. Admittedly, the aborted coup in Russia could portend both good and bad next outcomes. On the bad side, perhaps Russia is on the brink of civil war, with its nuclear arsenal up for grabs. On the good side, it could be a sign the country, even the military complex, is ready to figure out a way to exit Ukraine and end the war. We’ll see. The rocky landing here probably has a few more boulders on the runway, but our guess is that we’ve now reached the beginning of the end of the conflict in Ukraine. Then, the rebuilding begins. (Think “Marshall Plan Plus.”) That would be a big boost to global growth.
- Earnings may have bottomed. Although our official 2023 forecast remains a below-consensus $200, our work at the stock level has us wondering whether our number is too low. We’ve already raised it once, a few weeks ago, and are likely to do so again. We’ve noticed not only are the companies we meet with generally reporting at least stable conditions, but also that sell-side estimates for 2023 bottomed as the Q1 earnings season progressed, and even ticked slightly higher. Importantly, with bank earnings to date not as poor as anticipated, consumer-facing businesses doing OK and AI reinvigorating tech earnings, 2024 earnings seem likely to be significantly higher than 2023. For those not watching the calendar, 2024 is now just six months away.
- Broad market valuations remain cheap. Bears will cite the P/E on the market index as a sign of excess exuberance, and for sure, the cap-weighted S&P 500, trading at 20x this year’s earnings despite a 3.7% yield on the 10-year Treasury, appears rich. This said, the equal-weighted S&P is trading much cheaper, at 16.5x, and, given the narrowness of this year’s tech-driven rally, most stocks are trading outright cheaply, sporting low double-digit P/Es and solid dividend yields. If the market outlook continues its shift toward a less pessimistic economic outcome, many of these stocks have at least 10% to 20% near-term upside, in our view.
- Whatever your near-term outlook, the longer-term outlook appears bullish. We’ve just come through an 18-month period of stagnant economic growth, high inflation, rising Fed interest rates and squeezed earnings. Surely the path ahead looks better on all fronts, and $300 in earnings on the S&P by 2026 within reach, along with a return of interest rates to a more normal level, call it 2.5%. This combination of better earnings and a lower discount rate is likely, in our view, to drive the market, finally, toward new all-time highs, probably above 5,500. That’s 25% above present levels.
- Time is now squarely on the side of the bulls. We’ve written about this before, but maybe the bears should consider that while the market’s returns glass is half empty, the bear market’s hour glass is now more than half empty. And with every day that goes by from here, the better days of 2024 and beyond get closer and closer.
So, at Federated Hermes, while we remain respectful as always of the bearish case, we are holding to our overweight exposure to stocks and in fact added to them earlier this month. Expect us to do so again in the weeks ahead. We see the market’s glass as at least half full, and likely to get more full as we maneuver through the final stages of the rocky landing. Not perfect, but nothing in the market ever is. Half full is a lot better than out of gas.