One of Bay Street’s more respected investment strategists believes it’s a good idea to raise some cash because more pressure is coming for stocks.
But he expects a recession to be avoided.
And says an inverted U.S. Treasury bond yield curve is not as dire as in the past.
This strategist also recommends the sectors to overweight.
Find out more.
by John Aitken, Investment Strategist, TD Securities
Stocks have sold off in 2022 due to the combination of rising bond yields, slowing earnings growth and the fact that many sectors are expensive relative to bonds.
Much of this year’s rise in US 10 year treasury bond yields can be attributed to rising expectations for the degree of Fed tightening that would be required to reduce inflation pressures.
Bond yields and Fed Fund futures jumped on this morning’s release of the stronger than expected May ISM Purchasing Managers Index (PMI) but remain below the highs set in early May.
We continue to expect the year ahead will feature inventory corrections in a growing number of sectors in the US and around the world which will take the US PMI slightly below 50 by early next year and substantially reduce pricing pressure in the goods sector.
We expect a ‘soft landing’ similar to the 1985-86 and 1995-96 experience rather than a ‘hard landing’ recession.
A recession will be avoided partly because the consumer and business sectors will remain flush with cash even after several months of the Fed’s quantitative tightening program and partly because inventory clearance pricing will help lower inflation, capping the degree to which the Fed will have to hike the Fed Funds rate.
Inventory clearance pricing will lead to a further sharp deceleration of goods inflation which will more than offset the rising inflation now seen in the service sector.
Compared to services, goods have half the weight but more than twice the cyclicality.
Walmart, Target, and other retailers have revealed excess inventory levels requiring promotional pricing to clear.
This could translate into a lower-than-expected May core CPI release on June 10th.
This would be a very bullish short term positive for stocks, although 2022 will remain a difficult year for risk assets as economic and earnings growth will continue to slow.
While we expect a recession will be avoided, we believe there will be at least one more recession scare before the markets become comfortable with the very bullish implications of the coming soft landing (bullish because soft landings dampen inflation and cap Fed tightening which in combination extends the cycle).
One scare will surely come when the US yield curve fully inverts in early 2023.
By then the US PMI will have dropped close to or below 50 and the Fed Funds target will have risen above declining 10 year treasury bond yields.
The coming yield curve inversion will be a false signal of impending recession because seven or eight months of QT will still leave the Fed with an enormous balance sheet keeping bond yields lower than they would otherwise be and leaving the economy very flush with cash.
Normally, a full yield curve inversion reflects a tight money environment.
It’s the lack of spendable and loanable funds that causes recessions.
It will take at least three or four years of QT before the yield curve becomes a reliable reflection of tight money and therefore an accurate predictor of recession.
We remain cautious on the outlook for stocks and bonds in 2022.
We did recommend ‘buying the dip’ in early May in a tactical (and early) recommendation.
Stocks have further room to bounce from oversold lows before we recommend taking profits as we get ready for the next correction.
We continue to recommend investors overweight energy, materials and financials while underweighting technology.