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August 2024
Predicted Recession Avoided?
Falling inflation, a cooling labor market and an AI-productivity boost may lead to Fed rate cuts and a soft landing.
Download PDFWhile inflation in the U.S. continues to slowly decelerate toward the Federal Reserve’s target rate of 2%, its sluggish progress (despite a cooling labor market) has delayed interest-rate cuts from the central bank. Heading into the year, markets had predicted the Fed would have already started cutting rates by now, but the fear of reigniting inflation has convinced the Fed from making any changes to the fed funds rate over the first half of 2024.
As anticipated, CPI shelter (which represents about a third of overall CPI) continues to decelerate—albeit remaining relatively high. Given the method the Bureau of Labor Statistics calculates shelter inflation, this official data tends to lag market data by several quarters. This trailing effect is illustrated by the following chart, which compares CPI shelter and Zillow’s rent index.
Cost of Housing Continues to Decline
Price-to-Earnings Ratio Are Still Below the Dotcom Peak
Given that actual market rent prices have already stabilized, we expect inflation as determined by CPI will continue to head toward normalization within the next few quarters. Unless there is some unforeseen catalyst that sparks inflation, the Fed may feel more comfortable to initiate a series of rate cuts starting later this year.
Nevertheless, we recognize that high interest rates have not only slowed the economy, but they have also added pressure to corporate profits. This has been especially challenging for smaller companies that tend to be more leveraged than their larger counterparts. This has compelled us to underweight small-cap stocks and overweight domestic large-cap companies (especially large-cap growth). Although only a handful of companies have benefited from the ongoing AI rally, we do not believe the current market has peaked. For instance, the price-to-earnings ratio of the S&P 500 Index remains well below bubble levels seen during the dotcom boom era of the late ’90s.
With the adaptation of AI, businesses should begin to experience improvements in profitability, which should further alleviate pressures of high valuations. As history shows, advancements in technology can lead to several years of productivity gains. The following chart suggests that we could be in the infant stage of this AI productivity cycle. This has the potential to provide fuel for future economic growth, allowing risk assets to perform well.
Will the AI Revolution Fuel Productivity?
In terms of sectors and style, we continue to favor technology and growth over financials and value. We still believe the environment remains challenging for the banking industry, as many institutions continue to report dismal earnings due to weak loan growth. Despite the wide dispersion between valuations associated with growth and value sectors, we remain cautious about the sector rotation that will eventually occur. Nonetheless, we believe the interest-rate and yield-curve environment will continue to present challenges for some value sectors. Bank profits will unlikely improve until the yield curve starts to steepen, which may take some time before that happens. Additionally, while we expect the long-term bull trend remains intact, the market will likely experience some correction along the way.
Definitions
A bull market is a trend in a financial market characterized by rising prices and investor optimism.
Company leverage, or financial leverage, is a strategy that companies use to increase their assets, cash flows, and returns by using debt to finance their operations. A company’s leverage is the amount of debt it has in its capital structure relative to its industry average.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care.
The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight.
Large-cap stocks refer to a company with a market capitalization value of more than $10 billion. Large-cap growth stocks refer to big U.S. companies projected to grow faster than other large-cap stocks.
Price-to-earnings (P/E) ratio relates a company’s share price to its earnings per share.
The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.
A small-cap is a public company whose total market value, or market capitalization, is about $300 million to $2 billion.
Style refers to the investment approach that a fund manager uses in their investment fund.
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund’s performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.
The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.
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