BY: Robert Strauss, CFA®
Senior Portfolio Manager, Argent Trust
The Argent Allocation Strategy Committee recently decided to move to a slightly underweight position for equities in asset allocation targets. The decision considered the attractiveness of other asset classes relative to equities, mixed economic data, restrictive Federal Reserve policy continuing, and a potential rise in the unemployment rate.
Cash and fixed income have become more attractive. Interest rates have increased across all maturities following policy actions by the Federal Reserve. Short-dated maturities have increased more than 400 basis points in that timeframe. Money market instruments now yield over 4.7%, levels not seen in over a decade. Even core fixed-income investments have seen similar yield increases, with some credits and maturities yielding 5% or more.
Conversely, the equity risk premium (ERP) has shrunk in recent months, which is a measure of how much return an equity investor should receive above the risk-free rate. Currently around 1.5%, the ERP is calculated as the difference between the estimated return on stocks and the return on risk-free bonds (currently 4.75%). Recent years have seen the ERP exceed 3.0% or higher. Items contributing to the current lower equity risk premium are higher equity valuations, higher interest rates, and company earnings expected to moderate.
Economic data is mixed in the current environment. Inflation measures have slowly decreased over previous months, but core inflation measures, which exclude food and energy, are still elevated and well above Federal Reserve targets. Manufacturing indexes have moved to contractionary levels. The ISM Manufacturing index at 46.7 has ticked well below 50, the neutral level. A slowing manufacturing environment has led to economic recessions in previous periods. Consumers appear under pressure as delinquencies on credit card payments have increased. Headline retail sales fell -1% in the most recent month, which follows a decrease in the previous month. As consumer spending comprises almost 68% of GDP, it is a crucial factor in economic growth. However, the labor market has remained resilient, with job increases of 200,000+ monthly and the unemployment rate of 3.5% remaining low. Though initial jobless claims have been increasing in recent weeks, the number of people continuing their jobless status has been consistently rising.
Financial markets have already reflected a level of interest rate decreases expected later in 2023, which may not materialize. The yield curve remains inverted, with rates on longer-term maturities at lower levels than short-term maturities, suggesting that market participants believe rates will decrease in the future. If interest rates and inflation levels do not fall as much as some expect in the coming months, it could lead to lower overall margins and earnings and ultimately lower equity valuations.
Federal Reserve policy is now restrictive and likely to be more restrictive than some expect.
As inflation measures remain elevated, the Fed could keep its policy restrictive. Having increased rates by 25 basis points at its most recent meeting, current levels are between 5.00% and 5.25%, which was zero early last year. The Fed has also been reducing its balance sheet, further tightening financial conditions. Each action has reduced liquidity and the money supply, i.e., M2 has fallen by $1 trillion since April 2022. Federal Reserve members continue to state they plan to keep policy tight to ensure inflation measures move lower and closer to their target. When the unemployment rate eventually rises, we believe this will be a key factor as to when the Federal Reserve reverses its stance on tight policy.
The impact of tightening financial conditions should eventually push the unemployment rate higher. When the Federal Reserve tightens financial conditions by raising interest rates and reducing its balance sheet, aggregate demand moves lower, reducing economic activity. Early in this process, inflation moves lower with a limited negative impact on output. However, as the Federal Reserve maintains a restrictive monetary policy for longer, the relationship shifts, with lower inflation having a meaningful negative impact on output and unemployment. Once this occurs, typically in recessions, it is difficult to quickly reverse the rise in unemployment through monetary easing. Financial markets, including equities, typically react negatively to increases in the unemployment rate should that materialize.
Overall, a slight reduction in equities is appropriate given the attractive cash and fixed income yields, mixed economic data, and uncertainty surrounding future monetary policy from the Federal Reserve. Companies will likely continue to see their margins come under pressure and their forward earnings estimates revised downward. The unemployment rate could also rise given tighter financial conditions, adversely affecting financial markets, including equities. As we move through this process, adding back to equities would be warranted, especially for asset classes that do well following an economic slowdown. Going forward, the Asset Allocation Committee will continue to review conditions for this change and adjust allocations as appropriate.
