Investors Are Betting On A Dream Soft Landing

Investors Are Betting On A Dream Soft Landing
Stéphane Renevier, CFA

about 1 year ago4 mins

  • The S&P 500 rose 5.4% in November, following an 8% gain in October. In a year of record inflation and Fed hikes, the S&P is down a mere 14%.

  • There are reasons to be cheerful: the Fed can finally slow the pace of its hikes, inflation has likely peaked, and the economy is slowing very gradually. That’s led investors to bet on a “soft-landing” scenario of slower inflation and moderate economic growth.

  • But the downside risks are still high: the aggressive rate hikes we’ve seen so far haven’t yet fully impacted the broader economy and the Fed might not change direction for some time, meaning there could be more economic pain ahead.

The S&P 500 rose 5.4% in November, following an 8% gain in October. In a year of record inflation and Fed hikes, the S&P is down a mere 14%.

There are reasons to be cheerful: the Fed can finally slow the pace of its hikes, inflation has likely peaked, and the economy is slowing very gradually. That’s led investors to bet on a “soft-landing” scenario of slower inflation and moderate economic growth.

But the downside risks are still high: the aggressive rate hikes we’ve seen so far haven’t yet fully impacted the broader economy and the Fed might not change direction for some time, meaning there could be more economic pain ahead.

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The S&P 500 rallied 3% Wednesday, ending November up 5%. That followed another 8% gain in October. And it means the S&P is now down only 14% year-to-date. In a year when inflation broke 40-year highs and the Federal Reserve (the Fed) hiked interest rates more aggressively than ever to try to tame it, that’s pretty remarkable. But, it may suggest a bit of over-optimism…

Why are stocks rallying?

Actually, it’s not just stocks that have been rallying, but also bonds and gold. In fact, long-term US Treasury bonds (orange line) and gold (purple) did even better than stocks in November.

Gold and long-term Treasury bonds did even better than stocks in November. Source: Koyfin.
Gold and long-term Treasury bonds did even better than stocks in November. Source: Koyfin.

To me, this shows the rally is less about stocks per se, and more about the improving outlook for liquidity conditions – i.e. how much capital is available in the economy, and how easy it is to get it. As we explained here, rising interest rates sharply reduce the availability of capital and shrink the demand for almost all asset classes. That’s why both stocks and bonds had a tough time this year.

With the Fed now getting closer to what it sees as the peak for interest rates, and economic data so far showing only a gradual slowdown, investors are becoming increasingly confident about the prospects for a soft-landing scenario – where the Fed slows the economy just enough to combat inflation, but not enough to push the whole thing into a deep recession. If it can manage that, liquidity conditions should start to improve, and assets that were hard-beaten by aggressive rate hikes – like stocks and bonds – should recover.

And there are fresh cues that support this view – with US inflation finally showing signs of cooling, the demand for workers easing in October, and Fed chairman Jerome Powell himself signaling the Fed is likely to announce a milder rate hike this month. He even said there’s “a path to a softish landing”. When you add to that the possibility of China relaxing its zero-Covid policy (which would help both growth and inflation) and some technical factors (like buying from investors who are forced to close their short positions as markets rally, and low market liquidity exacerbating the price moves), you can understand why stocks – and other assets – have been on such a tear.

Time to go all-in on stocks then?

You have to be careful here. Investors are betting on a soft landing, but that doesn’t mean that the economy will achieve a soft landing. As we explained here, there are long and complex lags between interest rate hikes and their impact on the economy, meaning there’s a fairly high chance the economy hasn’t yet felt the full impact of those aggressive hikes. There’s a reason why soft-landing scenarios have so rarely happened in the past: the lead-lag effects and convoluted interactions between Fed policy and the economy make it extremely tricky for things to slow “just enough, but not too much”. Aggressive rate hikes do tend to eventually tame inflation, but they more often than not push the economy into a recession in the process, even if it doesn’t happen all at once. That would be positive for Treasury bonds, but negative for stocks, as it would likely negatively impact companies’ earnings.

So while the outlook for stocks has marginally improved lately, and might justify higher prices, I’d caution you about becoming overly optimistic at these levels. The Fed will only truly pivot when inflation is without a doubt on its way back toward its 2% target range. We’re a long way from that, and it’ll likely require more economic pain to get there. And when that pain sets in – when the economic slowdown is unquestionably in motion – then you can expect both investor sentiment and fundamentals to deteriorate, and pretty rapidly. The odds look a bit better now for stocks, but if you ask me, it’s still not the time to go all-in.

So what should you do with your portfolio?

You can hold some stocks, sure, but you might not want to go the whole nine yards. Try to maintain a balanced exposure across different sectors (not just tech), styles (not just speculative growth stocks), and geographies (not just US stocks). Value and quality stocks appear particularly attractive at this stage of the game.

You might also want to hold some US Treasury bonds and some gold in case the economy does falter more than investors currently expect. In fact, an “all-weather” portfolio like this one or even a simpler (yet more imperfect) 60/40 portfolio could arguably be better than investing 100% in stocks, in terms of their risks and potential returns. And, as I’ve been repeating all year, hold some cash for when real opportunities arise. Because there’s a fair chance they will.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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