Early last August, with the S&P 500 index in the midst of an alluring +19% rally off its then Jun’22 low, uncertainty over Strategas’ generally bearish outlook for the market and the economy had become a consistent feature of our daily morning research meetings.  Ultimately, the framework on which we had relied – and continue to rely – to gauge the durability of any signs of nascent economic reacceleration and the concomitant market advance carried the day: 1) had inflation, and the volatility of inflation expectations, been arrested back to a level acceptable to both the investors and policymakers; 2) had valuations reset to levels historically commensurate – or in the ballpark – with both the higher prevailing level of interest rates and intense pressure on margins; and, 3) had organic drivers of growth emerged durable enough (time) and capable of generating the required returns (breadth) to call capital from both corporate operators and investors? Last August the list largely went O-fer.  What proved to be a powerful counter-trend rally broke down a few weeks later and the S&P 500 corrected back to the increasingly lauded Oct’22 low. With the S&P 500 now solidly +20% above the October mark, intellectual honesty (and most of the sales team) begs us to revisit our framework again…

First, is the framework itself still relevant?  If individual investors are any measure – we think they are – qualitatively, the answer would seem to be yes.  The feedback loop may be self-reinforcing but inflation, valuation, rates, liquidity, and “AI” (the leading organic growth candidate of the moment), regardless of the view expressed, dominate discussion on client calls and in meetings – along with the LIV Tour’s acquisition of, ahem... merger with the PGA and the omnipresent presidential election handicapping. 

Second, in contrast to last summer, notable “progress” has been made on several tenets of our framework.  Is it enough to support a new bull phase or has the equity market momentarily and near-convincingly, decoupled from underlying fundamentals? 

Headline price measures are well below their 2022 peak and investors appear reconciled to a structural, higher lower bound for inflation – i.e., 3.0-3.5% vs. 2%.  But policymakers are unconvinced; some of the stickier core elements of inflation, particularly wages & rents, remain too high for their liking.  The global policy vernacular has retreated from “pivot” to “pause” to “skip.”  Global monetary policy is likely tighter before it's easier.

Source: Strategas Securities, Bloomberg as of 5/31/2023

Valuations are in-line, even slightly higher than levels in evidence last fall; the numerator is higher and aggregate S&P 500 EPS has been flat at ~$220-$225 since 3Q’22.  Consensus estimates show S&P EPS bottoming in 2Q’23 (~$215) before finishing the year roughly flat (~$220). Analysts have looked through 4-5 quarters of negative real revenue growth and margin compression and are estimating earnings to increase +12% Y/Y in CY’24.  An earnings “soft patch” is sufficiently rare.  We see the world differently believing sluggish top-line, a higher cost profile and the lagged-effects of tighter monetary policy will conspire to knock earnings down, in-line with the median -22% median drawdown evidenced in recession-related profit cycles.

Source: Federal Reserve, US Treasury, Bloomberg LLC and Strategas Securities, as of 6/12/2023

One aspect of the bull case that has troubled us was how dependent higher share prices were on easier monetary policy.  Expectations have downshifted from the “pivot,” to – and until recently – the “pause,” and now – as the Fed chair intimated most recently and has already been executed by Canada and Australia – the “skip.”  Taking up the slack – and then some – has been easier fiscal policy, in the form of the Treasury’s drawdown of its General Account (“TGA”) during the debt ceiling showdown.  Risk assets responded favorably to this super dose of Marshallian K, i.e., liquidity growth in excess of nominal GDP.  But can you have it both ways?  The knock-on effects of the impending refill of the TGA when coupled with signs of weakness in the Labor market and softer Capex, doesn’t portend well for the economy or risk assets.

Source: Strategas Securities, Bloomberg as of 5/31/2023

What can we say about AI that it can’t say for itself in 2,500 words at the click of a button?  While the commercial applications and emerging use case are still early days, the vocal championing of, productivity-enhancing investments in and, commercial roll-out of applications for, artificial intelligence (or “AI”) appears to have all the makings of a durable, long-term trend.  Is AI enough to pull this economy out of its malaise?  We are watching closely but remain suspicious as to the power this new pocket has in the near-to-intermediate-term to offset the cost of global economic disequilibrium and the growing list of deterioration we see developing domestically.  The leading indicators of economic activity keep us worried. 

That said – thematically – this AI as an emerging technology and the related capex follow-through likely has legs.  The realities of both managing a business and running money, suggest few will want to be caught absent from seemingly durable new area of investment – ourselves included.  “Artificial Intelligence” has become an important alpha-seeking theme[1] in our Strategas Macro Thematic Opportunities ETF (NYSE:SAMT) alongside the more defensive themes: Cash Flow Aristocrats; De-Globalization; Recession Protection; and, Energy Security. 

Broadly, we remain cautious on the prospects for the economy and the capital markets in the intermediate-term and, as we have written in these pages in the past, “comfortably wrong” on our base case vs. the generally narrow – though expanding – performance profile of the equity markets.  We fully acknowledge the potential power of the incipient AI revolution, though we will tread carefully.  NB