We are using the snapback to downgrade equities and raise cash one notch. As we look at a combination of historical, fundamental, and technical analysis, the weight of the evidence suggests being slightly more defensive is warranted.
In late February, we downgraded stocks from attractive to neutral, small caps to less attractive and upgraded cash one notch.
Today, we are using the sharp ~10% rebound from the lows to take an additional step to a slightly more defensive posture.
- We are downgrading equities from neutral to less attractive
- Reducing U.S. large caps from most attractive to attractive
- Downgrading U.S. mid caps from attractive to neutral
- Upgrading cash one notch from neutral to attractive
Economy set to slow in a meaningful way
Whether the U.S. sidesteps a recession remains an open question. Our head of U.S. economics places recession odds at roughly 50%.
More importantly, our work suggests the U.S. economy is set to slow in a meaningful way later this year given the current uncertainty and disruptions caused by the tariffs.
Although the economy may appear stronger in the near term as businesses pull forward inventory to get ahead of tariffs, there is likely to be an air pocket later in the year. Moreover, with businesses adding excess inventory today, there are risks there will not be sufficient demand to absorb this excess supply later. This could lead to discounting of goods and an erosion in corporate profit margins and subsequently to a reduction in labor as companies attempt to reduce expenses to protect the bottom line.
In the face of a slowing economy, the Federal Reserve (Fed) is likely to act less forcefully given lingering concerns around tariffs and the potential impact on inflation. This is occurring at a time when we are likely to see less, not more, fiscal spending.
Although the tariff issues have been delayed, uncertainty reigns. Even if the average tariff rate comes down further to 10% for everyone (including China), that's still 4x what it was previously.
Fundamentals – Markets far from cheap
The S&P 500’s forward price-to-earnings (P/E) is around 19.5x. Notably, the forward P/E remains above the highest level reached in any of the 15 years prior to the pandemic, despite arguably higher-than-average uncertainty.
Importantly, the actual forward P/E is likely even higher given that forward earnings estimates have yet to be cut in the face of a slowing economy and potential profit margin pressure many companies will face given tariffs.
Technicals – Upside capped
Markets became extremely stretched to the downside in early April. However, since the intra-day low of 4835, the S&P 500 has rebounded about 10%. We see a strong band of resistance in the 5500 to 5800 range. This area coincides with the declining 50- and 200-day moving averages as well as an area where buyers who bought prior to the drop may look to sell on a bounce to “break even.”
Thus, the upside based on valuations and technical levels appears capped near term at around 5% from current levels.
Where could we be wrong?
The market became extremely oversold at the recent lows, we had a spike in negative sentiment and the Volatility Index (VIX), and many studies suggest after extreme selling pressure, akin to what we saw at the lows, longer-term returns skew strongly positive.
That said, a key driver of these rebounds was a strong monetary or fiscal response, such as what occurred in both the global financial crisis and COVID that appears to be lacking today. A stronger-than-expected policy response could change our view.
Moreover, there is a possibility that investors look through the short term hit to the economy and earnings. Given the valuation of a company is based on the long-term cash flow outlook, if investors gain confidence that earnings are not impaired, the market could rebound more swiftly than our base case. Moreover, an easing in tariff levels relative to current market expectations could also go a long way in supporting markets.
Bottom line
The weight of the evidence currently suggests a slightly more defensive near-term posture following the recent market snapback.
We will continue to keep an open mind and follow the weight of the evidence.
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