The 'Five Big Things' are still big

An inside joke at Federated Hermes is that, "whenever Auth heads to the beach, something bad happens to mess up his vacation." I am happy to report I had a delightful holiday, and better still, our thesis is playing out well. So, we are sticking with our call for a broadening out of the market and remaining cautiously overweight stocks as election uncertainty rises.

Here's an update as we see it on the "Five Big Things":

1. The yen carry trade is slowly unwinding. Although the yen and Nikkei rallied briefly following Bank of Japan (BoJ) Governor Ueda's apology for spooking markets, both are in the expected process of grinding back toward the panic levels reached the day of the BoJ’s big rate hike on July 31. The market calmed down after Ueda assured investors that rate hikes would not be as rapid as feared—but still directionally higher. That has bought time for the leveraged players to unwind their positions slowly, as we anticipate they will. At 146 yen/dollar, the yen is now just 1% above its initial panic low, and seemingly headed there and probably on its way towards our 130 forecast. The Nikkei’s bounce has been more substantial, though it is still 8% below pre-crash levels and we think likely to retrace lower. U.S. Growth stocks, another beneficiary of the yen carry trade, have similarly rallied though remain below their highs and are now definitively lagging the broader market. Quarter to date, using the Russell Indices, Growth stocks are now up 1%, compared to Value stocks up 8%, and small caps, 9%. As yen yields rise and U.S. yields decline (see below), we expect continued pressure on dollar yen, and with it a continued gradual unwind of the yen carry trade. Unfavorable to the dollar and to U.S. growth stock indices. 
2. The yield curve continues to un-invert. The un-inversion of the yield curve toward more normal levels continues. At its peak inversion in July of 2023, the gap between the rate offered on the 2- and 10-year Treasury was an alarming 108 basis point. Bears predicted an economic calamity that never came, as tight labor markets, rising stock, increasing real estate values and ongoing government stimulus kept nominal consumer spending strong enough to support what we called a "Rocky Landing" versus a full blown recession. Now, with the labor market finally softening and inflation data (such as August’s 2.6% core PCE indicator) closing in on the Fed's informal 2.5% target, rate cuts loom. While Federal Reserve Chair Powell remained uncommitted to a September rate cut in his address at Jackson Hole, Wyo., his tone and nuance has left the market certain a significant easing cycle will begin at this month's FOMC meeting. This week’s nonfarm payrolls number may tilt the Fed to either 25 or 50 basis points, but at this point, the path ahead looks to have 200 basis points of cuts in sight. As a result, yield curve inversion has dropped 105 basis points to reach 3 basis points. Its likely next stop, within days or at least within weeks, will be “upwardly sloped,” the first normal curve we will have had in a long time. With economic conditions clearly softer and the Fed now about to enter cutting mode, this powerful trend, which favors the broadening-out call, is likely to continue. 
3. The relative earnings growth advantage of large-cap growth stocks continues to shrink. For instance, while Large Value stocks under-grew Large Growth stocks in the first quarter by 27%, following second quarter earnings reports, analysts' forecasts are for that gap to drop to 18% by the fourth quarter, and to achieve only a meagre 4% next year as the economy picks up steam and the yield curve normalizes. For small caps, the gap against large growth next year reverses entirely to a positive gap of 25% in their favor. Similar numbers are projected for the other area we like, emerging markets.
4. The labor market continues to soften. After the post-pandemic period’s historic labor market tightness, employment conditions are heading back towards a more normal balance. Take nonfarm payrolls as an example. On average, over the last three months, employers have added 170,000 jobs, well below the 267,000 average of the first three months and the 251,000 average addition in 2023. Similarly, the number of job openings per unemployed workers, one of the best measures of labor market slack, shows softening. The ratio of openings to unemployed workers peaked at 2.0 in March of 2022 and has since fallen to 1.2, right where it was in January of 2020. Given the softness we are seeing elsewhere, the release of the August jobs report on Friday could surprise negatively, raising prospects for a more aggressive rate-cutting cycle. Rate cuts alone help the broadening-out trade because defensive dividend paying stocks’ fat dividend yields start to look more attractive, and that part of the Value trade has certainly come to life since the Great Rotation started in July. If, in addition, softer labor-market data induces the Fed to respond more aggressively, as we anticipate, the cyclical stocks in the Value trade (financials, energy, materials and industrials) should also start performing better in the months ahead as the economy bottoms out. 
5. The election outcome is reaching peak uncertainty. Since our note in early August, the election outcome has only grown more uncertain, with all seven major swing states seemingly now in play. The upcoming September debate may or may not cause the gap to widen in one direction. Still, with polls opening for mail-in ballots soon, which could throw a wrench in pollsters’ election turnout assumptions, it seems increasingly likely that the winner of the election won’t be known until after election day, perhaps days later. The implications for markets, particularly for the stocks that work within the markets, is higher than usual. Given the tightness of the battle for control of Congress, our guess is that whoever wins the presidency would likely carry the House and Senate with them. Who wins will matter significantly for markets. Should former President Trump prevail, deregulation and lower taxes would favor the broadening-out trade for sure, which is already being helped by the other dynamics noted above and below. Should Vice President Harris win, we may be back to more of the same: slower economic growth, higher taxes and more regulation. All of this favors large-cap growth stocks. As noted in my May piece, From here on in, the election matters, markets will be watching election developments closely in the weeks ahead. If the outcome remains very close and unpredictable, we’d expect more market volatility such as today’s to set in.

Against this backdrop, valuations surprisingly reflect more the experience of the past three years, not the future. For example, growth stocks trade at 27x forward 2025 earnings, while value stocks at only 16x, even while the growth gap between the two is likely to reverse next year due to the “Five Big Things.” While the election uncertainty could cause volatility in the weeks ahead, we expect by year-end that small caps and Value stocks will continue to move “rockily” higher. Although the long sunny days of summer are fading fast, the Five Big Things still look pretty big to us.