Enter the 'R' words

The "Great Rotation" we have been positioned for since early July continues apace. Quarter-to-date, all the areas of the market we are overweight in our balanced PRISM^® model-money markets, value, small caps and emerging markets-are outperforming large-cap growth stocks, where we are underweighted. (Some more than others, for sure, but all working.) The five key fundamental forces driving the nearly 4-year bull market in large-cap growth stocks are largely reversing, as we've outlined in our two memos on "The Five Big Things." Navigating this shifting ground beneath them has investors understandably nervous, particularly as two 'R' words are increasingly now in play: Recession and Rotation.

We remain optimistic that the latest slowdown we are experiencing will not lead to a systemic meltdown of the economy, and therefore that the rotation to value and small-cap stocks will continue. Still, the odds of a Federal Reserve policy mistake are clearly rising, and the still-unknown election outcome will clearly matter. Hence our recommended higher-than-normal cash balances at present, our overweight in defensive dividend/value stocks (half of our value-stock overweight is allocated there) and our more cautious overall equity overweight (3% in our balanced model compared to 5% earlier in the year).

Let's break down some of these key points:

1. The underlying forces driving the bull market in growth stocks have shifted. Nearly all the forces that helped these stocks are now working against them: labor markets/economy are softening, the Fed is cutting rates, the yield curve is de-inverting, yen/carry trade is ending, their relative earnings growth advantage is eroding, and the pro-tech/anti-small-business political regime in Washington may be ending. For more on this, see my two market memos "Five Big Things that have changed and The "Five Big Things" are still big.
2. The Fed is behind the curve but poised to get moving. As in 2022,when it was late to begin the hiking cycle due to their rear-view mirror approach to running policy, the Fed's academics are again late to the cutting cycle. All the jobs-related data of the last three months is telling us what the American consumer, particularly the lower-end consumer, already knows: the economy is softening, particularly the private sector. Meanwhile, inflation readings suggest the Fed has already gotten the economy very close to its informal 2.5% target. With short rates a full 250 basis points or more above the core inflation rate, the resulting high real-interest rate is hurting the asset-intensive "older economy" companies, along with the economy's many small businesses that produce the bulk of GDP. Our overweights in these areas are dependent on the Fed waking up in time and beginning an aggressive cutting cycle, which we believe should take rates down by at least 200 basis points over the next 18 months. Similar to 2021, when we were screaming that the Fed was too late in the hiking cycle, we now find ourselves flummoxed that they are too late in the cutting cycle. They need to cut by 50 basis points next week, but probably won't. If they don't, the next six weeks of data will likely push them to do so in November, and, for sure, we are now entering a prolonged cutting cycle. While this is bullish for cyclicals and value stocks, in the near term, markets may continue to fret that the Fed is behind the curve.
3. The banking system is sound. While the economy is clearly softening and may even enter a technical recession, the good news is the banks are over-capitalized and over-reserved. After all, most Wall Street economists, along with some high-profile bank CEOs, have been predicting a recession for the last two years, so the banks reserved against one. We count this is as a big positive, as it limits the potential downside that a temporary pullback in the economy can cause. Given their underperformance since 2020, we see value not only in defensive dividend names, such as utilities and pharma stocks, but also in select elements of their more cyclical cousins such as banks, consumer discretionary and industrials.
4. The election really matters. Even as investors grapple with the state of the economy and the shifting fundamentals of the growth stock bull market, election uncertainty is rising. The two candidates could not be further apart in terms of policy outcomes. A Harris presidency, like Biden's, should be good for large-cap tech growth stocks. Her emphasis on continued rising regulatory overload, along with higher taxes for small businesses/individuals and corporations, would probably hurt the rotation we are calling for. Ironically, Harris' likely continuation of the open border policy, whatever its social and/or political merits, will continue to pressure the low-end consumers who compete in the jobs market with the immigrants flooding our system. Trump's economic policies would beckon the opposite and would be a supportive tailwind to the Great Rotation trade we've been calling for. We think Trump is likely to win but advise caution going into the election; it's really too close to call. Perhaps this week's debate will bring some clarity to the outcome, but our guess is the debate will be much closer to a "draw" than the earlier debate in June, which knocked Biden out of the race. This uncertainty could cause more volatility in the weeks ahead.

As we add these up, our view is that a recession-if we get one-will most likely be a soft patch with a small 'r.' If so, the rotation we've been enjoying within the market will likely continue. It even may be elevated to a big 'R' if Trump wins another term in office. In the meantime, we are maintaining our cautious equity overweight stance and holding to our remaining overweights in both ends of the value trade (defensive dividend payors, along with cheaper, cyclical value names), small caps and emerging markets. There will be a time to get more aggressive, and probably soon. We just need to know which 'r' becomes an "R."