“Happiness in intelligent people is the rarest thing I know.” – Ernest Heminway
Third Quarter Summary
Summer marked a wide variety of returns throughout financial markets.
- Equities rose higher at a much tamer pace than the previous quarter, with considerable rotation among sectors and stocks.
- Bonds sold off sharply as Treasury 10-year yields moved from 4.47% to 5.16%. Most global bond indices were similarly weak.
- Commodities rose with copper and oil spiking. Gold also bounced, following an earlier spring swoon.
The Micro versus the Macro Environment
Ceasefire negotiations between the US and Iran in March disintegrated as major differences remain: The Administration wants to restore access to the Strait of Hormuz, its prewar norm, with free access for all countries. The Iranian Revolutionary Guard Corps (IRGC), which really holds the power in Iran, wants to charge tolls to ships passing through the waterway. Complicating matters further, the conflict has spread to the Arabian peninsula, as Houthi rebels in Yemen continue to disrupt the East-West pipeline and the Saudi economy.
Besides energy prices causing inflation to remain elevated, global government deficits have played a role in increasing bond yields. Most developed countries, including the US, Japan, the UK, France and Italy, have reported worsening fiscal outlooks, with little movement by legislative bodies towards remedying the situation. As a result, new Fed chief Kevin Warsh and voting board members have been forced to raise the short-term Federal Funds rate from 3.75 to 4.00%. More hikes are likely.
The tariff situation has calmed but unfortunately, not gone away. Companies have passed on some of the court-ordered rebates to their customers helping consumer spending. However, margins at many retailers continue to be squeezed by higher costs due to inflation.
Meanwhile, US economic growth is picking up due to AI-related capital spending contributing to pressure bonds. This is really a doubled-edged sword, since S&P earnings growth (excluding investment gains from the largest technology stocks) has increased over 30% in the second quarter and slated for similar levels in the third and fourth quarters. Overall, earnings have proven to be the most important driver of stock returns over time and the major reason why equity returns remain positive despite a falling bond market.
Although earnings growth has been robust, not all stocks are rallying. Narrow market participation has become a concern for many analysts. This phenomenon can last for some time, but at some point, participation must broaden to include more sectors and individual companies. If this doesn’t happen, stocks will be vulnerable to significant correction.
The narrowness of market advance is also due in part to the AI phenomenon, which continues to significantly impact the economy and society. Considerable debate over AI winners and losers has been ongoing, including an emerging doomsday scenario. At this stage, however, it appears to be exaggerated though many agree AI must be monitored carefully.
Additionally, issues such as soaring electricity prices from new data centers being built are factoring into the upcoming mid-term elections. The rate of inflation, especially with respect to gasoline and food prices, may lead to change in party control of the House of Representatives, as well as the US Senate in November.
Fourth Quarter Outlook
- Volatility in the markets will continue with geopolitical events in the Middle East and mid-term election results factoring heavily.
- The AI story will have an ongoing impact on the markets, with trends in capital spending and monetization (actual revenue generation) being closely watched by investors.
- Energy prices will stay elevated, with stopgap measures to lower gasoline and diesel prices helping only at the margin. West Texas Intermediate (WTI) is now seen at $85-100 per barrel, with product prices (gasoline, diesel, jet fuel and heating oil) remaining under pressure due to refining bottlenecks.
- As a result, inflation will remain sticky, although the employment outlook is stable. With that backdrop, we have changed our outlook and now see the Fed raising short-term rates at least once this year, with one to two 25 basis point (0.25%) increases likely by next spring.
- Inflation and fiscal policy concerns in most developed economies should keep the 10-year Treasury yield trading between 5.00-5.35%.
- Real GDP growth has firmed due to capex spending for AI and may trend around 3% for the second half of this year.
- Corporate profits should continue to be strong, with 25-30% growth forecast through the end of the year.
- At The Rice Partnership, our outlook remains constructive on equities, though somewhat tempered due to risks stated above. Diversification is key. Bond yields will be faced with headwinds that are well-known, yet they offer an alternative to stocks for the first time in 25 years. International investments away from the familiar AI trade should also provide a good buffer against future market volatility.