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Weekly Wisdom – September 28, 2022

By Hightower Great Lakes on September 28, 2022

If We Believe What the Fed is Saying…

The Fed has continued to emphasize the need for “compelling evidence” that inflation is coming down before they consider pausing rate hikes or pivoting their policy stance.

Based on the latest dot plots, they’ve also indicated a fed funds target rate that could remain in the range of 4% through 2024 – a range which is broadly considered restrictive territory for economic growth and much higher than a longer run target closer to 2.5%.

Chair Powell said that today’s target fed funds rate of 3.0-3.25% just begins to enter restrictive territory.

Of course, we take these projections with a dash of salt, since so much can happen over the course of the next two-plus years. Global recession fears are growing, and that is evident across sentiment, market and economic trends.

Chart 1: Depleted Sentiment Reflected in Stock Market Sell-Off1

Further, historical seasonality trends indicate that markets tend to sell-off into the midterms. This year’s midterm elections have significant macro implications.

Implications stem from not only potential fiscal policy, but also from the heightened geopolitical risk environment and deglobalization themes that appear largely bipartisan in their support. Again, pricing higher risk into longer term valuations.

This all contributes to what could be a new era of normal, requiring us to pull back our historical reference-point beyond the growth rally that drove the better part of the past decade.

While sentiment is low and equities have already discounted significant risk, this extended overhang of higher rates, higher risk and higher cost may present a lower P/E environment for a while longer.

The Strong Correlation Between Interest Rates and Stock Valuations

In Berkshire Hathaway’s 2021 annual letter to shareholders, Warren Buffet wrote that, “long-term interest rates that are low push the prices of all productive investments upward, whether these are stocks, apartments, farms, oil wells, whatever.

Other factors influence valuations as well, but interest rates will always be important.”

Higher interest rates generally result in low stock valuations, and low interest rates generally result in high stock valuations. The pace of change is important as well.

Chart 2: Rates and Stock Market Valuations, Consider Pace of Rate Movement2

Chart 3: Higher Household Net Worth Correlated with Treasury Rates

Long term investors tend to view these environments as buying opportunities – investing in more cyclical stocks that might benefit from a market rebound and economic recovery.

The strong labor market and healthy U.S. consumer are underlying positives for the economy, though these dynamics tend to continue pushing elevated inflation and give the Fed greater conviction in their tightening policy.

The Fed is trying to slow demand and wants to see a change in the “unstable” U.S. labor market.

So, while the selloff creates a buying opportunity, there remains a significant overhang from the Fed’s policy impact on things like GDP, currency and liquidity risk, and corporate profits.

If the Fed follows through with what they’re telling us, economic growth will more likely continue to be slow and restricted for the next extended period, and outperformance may continue to derive from value opportunities and dividend income.

In addition to the monetary policy contributing toward growth and recession risk, there is also heightened geopolitical risk and U.S. fiscal policy uncertainty.

All this said, the SPX is already down 23% ytd and the Nasdaq is down 31% – and as a discounted mechanism, a lot of this news is in the market. One thing is for certain, volatility will continue to persist.

Potential Fiscal Policy Implications from the Midterms

Unlike normal times, this year’s midterm elections have significant macro implications.

The impact from higher rates is $2.4 trillion in deficit for the Congressional Budget Office’s (CBO) 2022-2031 budget projection – far greater than the impact of any single bill.

Further, evidence indicates that tax revenues are near peak. In a slowing economy, lower corporate profits and household income will reduce the government’s tax revenues and further stress the widening deficit.

There remains elevated inflation and slower economic growth, so fiscal policy needs to consider the macro implications in this unstable period.

Higher taxes can always pay for spending, but Americans and corporations are already pinched by the restrictive monetary policy and high inflation. Some increased spending could also fuel inflation.

If Democrats maintain majority in the House and Senate, it’s expected they’ll push forward fiscal spending and find ways to pay for it (e.g., corporate taxes, income tax, dividend tax).

If Republicans take control and it becomes a divided government, there is expected to be gridlock, and progress will be limited to bipartisan issues.

These bipartisan matters include deglobalization and anti-China policy. We recently saw the passing of the bipartisan CHIPS Act and Infrastructure Law.

Similar bills could follow, supporting industries like health care and defense. Heightened volatility and sell-off is also expected heading into and throughout the midterms.

There is uncertainty around the elections, plus an element of volatility from “voter fraud” challenges, run-offs, and anything else unexpected that may happen in the modern-day election climate.

Finding Market Inefficiencies

Active management seeks to generate outperformance by finding inefficient pricing in markets – investing in a better selection than what’s offered by the whole index.

A market is a collection of buyers and sellers, the price is what someone’s willing to pay. We aggregate what is known and believed to be known (consensus) and determine where those projections might be wrong and what’s being mispriced as a result.

We consider both macro drivers and company fundamentals when making decisions as long-term investors.

Now is a good time to find best-in-class companies with strong market shares and balance sheets. Now, more than ever, free cash flow is incredibly important. 

Click here to read last week’s Weekly Wisdom (9/23).

SOURCES

1 Source: FactSet (chart)

2 Source: Bloomberg (chart)

Disclosures

Investment Solutions is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors.

All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Investment Solutions and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Investment Solutions and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.

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Hightower Great Lakes is registered with HighTower Advisors, LLC, an SEC registered investment adviser and/or Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through HighTower Advisors, LLC. Securities are offered through HighTower Securities, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors.

All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Hightower Great Lakes, HighTower Advisors, LLC nor any of its affiliates make any representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Hightower Great Lakes and HighTower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice. This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of HighTower Advisors, LLC, or any of its affiliates.

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