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LC IDEAs: Views & Insights recently spoke with Sunil Garg, Managing Director, Chief Investment Officer at Lighthouse Canton on his views on equities as market prices in a rate cut from the Federal Reserve in September.
Views on equities with the recent volatility and Fed cuts in sight
In equity markets, the saying "stairs up, elevator down" highlights how markets can rise slowly but fall rapidly. Current market conditions reflect this trend.
Valuations alone don’t drive market movements—earnings and other factors do. Our shift to a more cautious stance is premised on expectations of weaker economic growth as consumption and labor markets soften.
If the biggest driver of high valuations was earnings growth, any softening in demand becomes problematic. This was evident when companies like McDonald's, Airbnb, Disney, and Domino's Pizza recently reported — demand is not as robust as expected, which will likely impact earnings.
So, if high valuations were supported by strong earnings, and those earnings are now under pressure, there’s a question mark over the market’s direction. This leads us to adopt a more cautious view.
Our model has been signaling a softening economy.
The consensus narrative remains one of a “soft landing”, notwithstanding a brief interlude with recessionary thoughts (early August). We find a disconnect between market expectations of a goldilocks economic outcome and an aggressive easing cycle (market pricing in 6 rate cuts over next 12 months).
Also, do note that historically, when the Fed starts cutting rates, markets tend to decline and don't recover until the rate cuts are well underway. Just as rising rates have a lagged impact, so do falling rates. Moreover, central banks cut rates because they see a growth problem.
Despite slowdown signs, equities have traded up post the early august swoon, comforted by better than expected retail sales. We are focused on trends, which suggest a continued slowdown in consumption and in the labor market.
Despite the economic headwinds, both the narrative and price performance are a challenge to our cautious stance on equities. While it’s easy to dismiss price signals as temporary blips, ultimately price trends, a key pillar of our investment framework, need to converge with economic trends.
As part of market signals, we should expect to see growth stocks responding positively to growth delivery and guidance, a feature that has been lacking in the recent reporting season. In fact, the asymmetric response to misses remains of concern.
We are cognizant of anchoring behavior and biases (we are not immune to these). Our approach is to have a view but also identify milestones that indicate when we need to reassess that view. This is similar to the approach we took at the beginning of year (S&P was around 4800) when downside risks were giving rise to cautionary views, and we outlined data points that would lift our anchors, becoming more positive as the year progressed.
Economic indicators have been easing for some time, then why now the volatility?
It's often assumed that higher interest rates reduce spending, but spending and leverage decisions are more closely tied to cash flow confidence. As long as people have a secure job and feel confident about it, they will continue spending even if rates rise. This is particularly true in the U.S., where many have long-term, fixed-rate mortgages unaffected by rising rates. People only cut back on spending when they feel uncertain about their cash flow, and companies do the same, pulling back on investments when they detect weakening demand. This can trigger a cycle of job cuts, reduced consumer spending, and declining corporate sales, leading to a swift and harsh downturn. That's why recessions are typically short and sharp. The key indicator in this process is the jobs market.
About four or five months ago, we argued that jobs, not inflation, will define 2024, and we're starting to see this play out.
The trigger for our view shift has been the anticipated spike in unemployment, which we've long been focused on.
We weren't sure when it would happen, but it was inevitable.
The recent jobs report showed unemployment rising from 4.1% to 4.3%, marking a significant spike. The job market has been gradually weakening, and while unemployment lags, continuing jobless claims have been climbing—indicating people are struggling to find new jobs.
The job openings-to-seekers ratio, once 2:1, is now closer to 1:1, reflecting the tougher job market. As uncertainty grows, fewer people are quitting jobs, with the jobs quit rate falling, signaling further labor market weakening. This could lead to a significant unemployment spike, impacting the market. Both consumer spending and the labor market have been softening, and this trend may worsen.
Views on small caps from here
There was a lot of bullishness around small caps recently, with the belief that the Fed would cut rates and these companies, which were hit hardest by rate increases, would benefit the most from rate cuts. As a result, small caps surged.
However, we see it differently.
In an environment where demand weakness is a factor, these companies could actually be hurt even more. A rate cut might not be enough of a counterbalance. Small caps, by definition, are higher-risk companies, and you typically invest in higher-risk assets when the market is driven by 'animal spirits'—when there's optimism and growth at the beginning of a cycle. You don't invest in them at the end of a cycle when growth is slowing.
There was a utopian argument that the Fed would cut rates in anticipation of a soft landing, and everything would be perfect, like a Goldilocks scenario. But we have two points about this.
- First, if we were truly in a Goldilocks scenario, the Fed wouldn’t need to cut rates dramatically. For the Fed to cut rates continuously, there would need to be a growth problem, given their dual mandate of inflation and jobs. In a Goldilocks situation, you might see a modest 50 to 75 basis point cut, and then they would hold steady. That wouldn’t be enough of a benefit for small caps.
- Second, while the Fed might cut rates, the optimism surrounding this has already driven up small caps. Meanwhile, large caps, particularly high-quality, high-growth technology companies, were down 25-30%. They were expensive, but now they’re a bit less so, and I find more interesting opportunities there.
The key factor is never going to be just interest rates; it’s always about the top line. We recently wrote a report titled 'Price is What You Pay, Value is What You Get,' where we looked at various correlations.
Share prices and valuations showed a limited inverse relationship, but it was statistically insignificant. Sales and earnings, however, had over a 90% correlation. Interest rates are relevant, but nowhere near as significant. The real driver is top-line growth, which drives earnings."
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