As we assess the current economic landscape, we still believe the most likely path forward is a "muddle through" scenario, which means slow growth along with persistent inflation. However, this scenario may gradually shift to a more favourable one, especially for stocks that thrive in economic cycles. This improvement could stem from the market pricing in potential increases in government spending and changes in regulatory policies, likely under a second term for Biden or a return to a Trump administration. In short these types of stocks may have two ways to win and only a severe recession would change that. 

Our near-term caution stems from recent economic data indicating a softening U.S. economy.  Consumer sentiment has weakened, housing starts and durable goods orders are flat to down, and manufacturing output has stagnated. Although the latest inflation print suggests some easing of price pressures, we expect inflation to remain stubbornly above the Federal Reserve's targets. This leaves the economy in a precarious position, vulnerable to either a growth scare or an inflation shock. On the other hand, these dynamics have helped ease long-term yields and pushed markets higher. We suspect that, in addition to the discounting effect of lower rates, the market is sniffing out the desire for the current US administration to stimulate, given any excuse and even for the Fed to start thinking about one or two 2024 rate cuts.   

In this environment, we have positioned our portfolios defensively, underweight expensive areas of the U.S. market such as technology and overweight more reasonably valued international and emerging market equities. Our valuation work suggests these areas offer reasonable growth prospects and much more attractive valuations, higher free cash flow and less balance sheet risk. We believe this positioning offers resilience in the face of macro uncertainty.

As we look further out, however, we see the potential for a shift in market leadership favouring more cyclical areas of the market. Regardless of the outcome of the 2024 presidential election, we expect the next administration to prioritise fiscal stimulus measures to boost growth. Both parties appear committed to increased spending on infrastructure and a protectionist approach to addressing the "green transition." While their approaches to regulation may differ, with Republicans likely to pursue a more business-friendly agenda, both sides are likely to tolerate higher inflation and interest rates in the near-term.

This mix of loose fiscal policy and tighter monetary policy is likely to benefit cyclical stocks most leveraged to economic growth. We are already positioning for this rotation by focusing our portfolios on select mid-cap and emerging market opportunities. As the market begins to discount the prospects for a political transition, we expect to tilt further in this direction, adding exposure to U.S. small caps, commodities and value-oriented sectors such as financials, industrials and materials. Even more encouragingly there are signs of life in both the beleaguered Chinese stock market and ‘backwater’ European stocks in the current reporting season giving credence to the notion that these areas of the world have quietly lived through their own recession already. 

Importantly, we see the upcoming environment—with likely continued volatility and decreasing correlations between individual stocks—as potentially fertile ground for careful security selection, creating the fabled 'stock-picker’s market.' By focusing on companies that have competitive advantages, pricing power, and strong balance sheets, we aim to construct portfolios that are resilient across a wide range of economic scenarios.

With that in mind we will be spending more time than usual picking over the current reporting season to see if any of this stands up to scrutiny and whether some of these ‘green shoots’ stand a chance of growing into something bigger and more durable.

‍