Nothing moves in a straight line

As regular readers of this space know, our focus at Federated Hermes is heavily oriented toward the intermediate- and longer-term horizon, especially one, three—and yes—even five years out. Hence our practice of setting not just year-end price targets on the S&P 500, but as we did in One Big Beautiful World, a two- to three-year target, as well. With so many investors, both retail and even institutional, focused on the short term, we think that gives us an edge. We can spend time focusing on understanding and investing in companies, for which the longer-term outlook is often more clear and even more certain than the stock price volatility engendered by the daily news cycle.

Within this framework, we tend to view near-term volatility as opportunity at best, noise at worst. Unless something happens that fundamentally alters the long-term picture of where the economy and/or a particular company is heading, we have a tendency to move in the opposite direction of the market on a day-to-day basis. In our present circumstance, in which  we are already overweight stocks at 50% of max in our balanced models, our plan is to use short-term volatility—if we’re fortunate enough to get some—to add more. Here are the six most likely sources of volatility ahead and how we are thinking about them.

1. The government shutdown starts to impact the economy. We are now in Day 14 of the government shutdown, with no sign as yet that either side is prepared to compromise. So far, the market has largely ignored this political scuffle, with good reason; all 10 of the past such shutdowns ended with little long-term impact, and in each case the market was higher six months later. This is not a coincidence; it is in no party’s interest to have the government shut down for a prolonged period; sooner or later one side gives. We anticipate that will be the case this time, but there are a few ways the market might start caring about this before a compromise is reached. One could be the lack of data on the economy that the federal government produces, perhaps causing the Federal Reserve to hesitate to act within its current rate cutting cycle (see below), or maybe leaving market participants in doubt about the economy. We think the latter circumstance highly unlikely, however long the shutdown proceeds. Most investors simply no longer depend inherently on government statistics, which are at best trailing indicators and at worst severely flawed ones. Another way the shutdown could start to matter would be if the executive branch is forced to cut back further than it has already on key government services, for example, on the TSA or the FAA that administers critical air travel. President Trump’s tariff revenue is fortunately, for now, giving him the flexibility to avoid this, but should the shutdown continue into the holidays, it’s possible we could see something like this. If so — and if the market were to react negatively — we’d see it as a buying opportunity for sure, as the pain of an air travel shutdown would surely force a political compromise that would reopen the government.
2. The Fed does something unexpected. Another possibility that could cause a pullback would be the Fed shifting course from its rate cutting path, perhaps on the argument that they are in a “data vacuum” that demands caution. We see this probability as quite low in the near term. The labor market, on both the most recent Fed indicators prior to the shutdown, alongside private sector data like the ADP and Indeed, has clearly softened. Even the hawks at the Fed would probably admit privately they’ve been too late in resuming cutting rates, particularly for those areas of the economy that are very rate sensitive and in a virtual recession, such as housing. With expectations at nearly 97% for an October 29 cut, any move back to “pause” mode would be greeted poorly by the market. This is extremely unlikely to happen, but should it, it likely wouldn’t change the path toward a 3.0% fed funds rate, 50 basis points above the likely core inflation rate. We’d be buyers.
3. The Supreme Court rules against the president’s use of tariff authority. We don’t know for sure when the Supreme Court will rule on the pending case, but most likely before year-end. A negative ruling seems extremely unlikely to us, given the Roberts court’s historic efforts to avoid weighing in on matters that touch on the authority of the other two branches of the federal government. Exhibit A might be the legal contortions they went through to avoid overturning Obamacare, as an example. This said, should such a ruling happen, we don’t see it impacting the long-term picture as President Trump has a variety of other authorities that could be employed to continue to pursue his strategy of threatening tariff outcomes to encourage renegotiation of trade arrangements around the world. Again, should a downdraft come here, we’d welcome it.
4. The trade war with China deepens. This risk is probably the most likely of our list, and one that certainly could undo the presumed outcome of the China-US trade negotiations. That result, which we and most of the market expects, seems headed towards some kind of rapprochement, one that keeps the basic framework of global trade in place, except with China now paying an ongoing 20% or so tax for the privilege of accessing the US market. However, this weekend’s back and forth between President Xi and Trump, ahead of their planned late October summit in South Korea, has rattled investors for sure. In particular, Xi’s willingness to play so boldly his one true ace card—China’s control of 90% of the world’s rare earth production—would be a fundamentally bad outcome for the global economy. Given rare earths’ presence throughout the global manufacturing supply chain, up to and including chips and defense equipment, if China pursues this course, and the US retaliates by shutting its economy entirely to China, a global recession would surely ensue. If this outcome happens later this month, look out below. We’d expect more than a routine market correction and would be patient, at best, with our next add. However, given how profoundly negative this outcome would be for both sides, our base case remains it won’t happen. Somehow or other, they will achieve a “deal” that, at a minimum, gives both economies a three to five year runway to de-link. Even this outcome is less than our base case, which is a permanent realignment of the trade relationship that keeps China as an integrated player within the global economy but within a set of rules and tariff arrangements that creates a more level playing field. We’ll see. That summit in Korea is almost upon us.
5. Earnings season takes a wobble. Another possible source of volatility ahead could be earnings season, now upon us. Again, a major wobble here seems unlikely, at least at a market level. The leadup to third-quarter releases has been unusually positive, with analysts raising their numbers throughout the quarter—the first time in six quarters they’ve done so. When sell-side analysts raise numbers, it’s usually because company managements are guiding higher as the quarter proceeds, so missing these higher numbers seems unlikely, to say the least. Our own estimates here at Federated Hermes call for companies on average to again beat estimates, bringing growth for the year ever closer to our estimate of $270 for the full year. And the banks have started things off with a bang, with all of the first batch of numbers released today positive versus consensus. However, given the raised expectations coming into the season, it is possible many companies will fail to beat “whisper” numbers of even bigger-than-expected results. This could cause some modest pullbacks stock by stock, and of the market generally. Again, we’d be buyers of such a pullback.
6. Something happens that bursts the AI bubble. Given how important AI stocks have been to the rally off the April lows, and even how important the AI buildout is to the broader market of companies either helping with that buildout or benefiting from it, any sudden shift of sentiment on whether AI will “work” or not would be treated very poorly by investors, and would likely lead to at least as large a drawdown as point 4 above. Our read on this, taken from our teams’ dozens if not hundreds of company meetings across the economy, is that a sudden shift here is unlikely. Too many really smart people have invested too many hundreds of billions of dollars to be utterly wrong on this call. And in addition, too many companies, across multiple sectors of the economy, are already achieving productivity gains from early AI innovation. So, any news flow here, in our view, would be noise, and if the market reacts, a buying opportunity.

Given the list above, alongside the nearly straight move up from the April lows, a market pullback of some sort seems possible, at least. Afterall, nothing moves in a straight line upward, and the present 33% move off the Liberation Day lows is now among the longest such moves without a 5% correction. Our guess is that any pullback, if we get one, will be short-lived. Too many investors raised cash in the dark days of early April/late March, and are anxious for any and all opportunities to “buy the dip.” The fundamental long term picture, as we’ve noted previously, is pretty “Big” and pretty “Beautiful.” Our updated 2026 and 2027 year-end price targets of 7,800 and 8,600 imply healthy double-digit annual returns. So, if there is a pullback, watch this space. Absent a completely unexpected source of disruption to the long term view, we’ll be buying.