And just like that, it's time for the September edition of Adding Alpha, the start of my favorite season, pumpkin spice lattes, leaves changing, and of course, college football. But before we get to all that fun, today I wanted to share with you some updated thoughts following Chair Powell's Jackson Hole speech.
For starters, Chair Powell started his speech by saying it would be longer than last year's eight minutes, but the message would be the same.
For investors that remember last year's speech, our collective hearts skipped a beat because back then, Powell referenced pain coming for the economy and labor markets by tightening financial conditions to bring inflation under control.
The S&P 500 fell sharply on the day and interest rates spiked. With the exact opposite reaction the day of this year's speech, market up, interest rates down, it might seem like Jackson Hole was just a nothing burger, but we view it as a something burger in yet another hawkish message the equity market seems to be dismissing.
Equities are still positioned as if the Fed is done raising interest rates and might start cutting rates by Q2 of next year.
The Fed effectively pulled off the impossible after a record setting 11 straight rate hikes and brought inflation under control without driving the economy into recession.
This is the no landing scenario. Meanwhile, bonds are still signaling "Houston, we have a problem." A contraction lies ahead with a sharply inverted yield curve, and the recent bear steepening in very short-term rates.
This is the hard landing scenario. As with many things, we think the truth lies somewhere in the middle, and our PNC economics team still expects a soft landing, mild recession scenario to occur.
We think the equity rally since March takes a breather here, one because the jury is very much still out on whether the Fed will need to further tighten policy from current levels and we still need several more data points for confirmation of inflationary trends, and two, we're entering a seasonally very weak period that can be notoriously choppy for investors.
In late July, AAII investor sentiment had moved to a cycle high bullish level, which tends to be a pretty strong contrarian signal. And since then, technical factors have been rolling over, further confirming of the shift in investor sentiment.
Market breadth never rebounded to the last November peak, longer term measures of breadth never recovered to levels from early February, and performance continues to be driven by a very narrow subset of the largest companies that can benefit in some way from either the slowing economic growth backdrop or from artificial intelligence innovation.
There's just a vast distinction between performance winners and losers in this environment. And a forward P/E of 18.5 times the S&P 500 is still priced for a no landing scenario, rate cuts, and is ignoring the lagged effect of how fast the Fed has raised rates over the past year or so.
In our view, this dynamic leaves us feeling like there's very little margin of safety baked into current valuations and we're struggling to find meaningfully positive catalysts to justify keeping this rally going.
So we remain in this longer for longer Fed dynamic, potentially higher terminal rate than what investors expect and just a longer overall tightening cycle.
The Fed's not out of the driver's seat yet and hasn't signaled the end of its rate hiking cycle, which means monetary policy and financial conditions will continue to remain restrictive into 2024.