Following October's cooling CPI print, expectations have grown that the Fed may pause interest rates. State Street Chief Investment Strategist Mike Arone agrees the Fed is likely done tightening even though the full effects of past rate hikes are yet to be felt by consumers.
Arone notes the data shows inflation and the economy bending towards the Fed, believing officials will likely "talk tough" a bit longer. This backdrop appears supportive for stocks, though bond market volatility continues driving equities.
Arone says so far, small caps and value names have yet to lead the rally as typically expected. However, he believes "broader participation beyond the Magnificent Seven" is essential for sustainability when the Fed finishes the tightening cycle. He highlights attractive sectors like energy, technology, communication services, and industrials.
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Video Transcript
- Wall Street thinks the fed is done raising rates, especially after that latest CPI report showed inflation is cooling. But some central bank officials, they don't want to put the cart ahead of the horse just yet. Cleveland Fed President Loretta Mester telling CNBC, they need to see more evidence. Inflation is moving toward 2%
For more on this, we turn to Michael Arone, chief investment strategist, US SPDR business at State Street Global Advisors. Michael, thank you for joining us. And I want to get right to that point. You know, Michael, a lot of investors clearly thinking they saw those cooler-than-expected inflation reports. And they determined, OK, the fed's done. The rate hiking campaign is over. What do you think?
MICHAEL ARONE: I think the rate hiking campaign is over. I think the fed with inflation-- all items CPI at 3.2%. It's not 2%. They're going to have to continue to talk tough on inflation to keep their inflation credibility going.
But at the end of the day, you look at numbers this week like the National Association of Homebuilders, industrial production, retail sales, inflation. It's clear that the economy and inflation are coming the fed's way. And we haven't even really felt the brunt of all the rate hikes yet. So I think the fed's done. They're just going to have to talk tough for a while.
- Hey, Mike. It's Julie here. It's great to see you. So does this mean up, up, and away for stocks from now till the end of the year?
MICHAEL ARONE: I think it's a nice setup for stocks here, Julie. And the thing that's really fascinating for me is that interest rate volatility has dominated. And what's interesting is that it's dominated the dispersion in stock market returns. So not to be a goofy wonk here, but basically, bond market changes have dominated stock market kind of volatility to a level that we've rarely seen in the last 70 years.
So here's the thing Julie, is that historically, when you see something like this, I think investors get a little wigged out to use a technical term about volatility. They get concerned. But historically, it's been a bullish sign for stocks. And on average, over the next 12 months, they're up 16%. And to tie it in with your previous segment, usually, value and small cap are the ones who lead the way.
Why this is an important is because in order for this rally to continue, we're going to need greater participation beyond just the Magnificent Seven. And I think we're going to get it as interest rate volatility cools as the fed ends its tightening cycle.
- So, Michael, if you're right and the market's going to move higher here into 2024, what sectors do you want to be in, Michael? What look attractive to you?
MICHAEL ARONE: So we have a bit of a mix here of both growth and cyclical. So we continue to like energy as supplies remain constrained, as kind of we make this transition from fossil fuels to something different. Admittedly, it's a multi-decade transition. But the stocks are pretty cheap. They're returning capital to shareholders. They've had good capital discipline.
And our view is that that's likely to continue to be a tailwind for the energy sector. We also mix that in a little bit with technology, communication services. Certainly, not cheap from a valuation standpoint, but growth prospects look pretty attractive there. And kind of mixing in with industrials where profit margins are expanding. And we like those four sectors.
And as you can see, what's absent? What's absent is defensive sectors. So we think even though the economy may slow, we still think that a short and shallow recession has already been kind of priced in, thought of, anticipated. So we expect that those parts of the sectors will do pretty well.
- This is so interesting, Michael, because, you know, we're coming off of-- you know, we're always fixated on the latest thing, right? But I've got retail conference calls on the brain because we've had so many of them report over the past couple of days. And a lot of them are talking about a stressed consumer. Even the ones that are doing OK are talking about that stressed consumer.
So it's interesting to me that you're talking about this sort of dichotomy between the economic backdrop and how these stocks might still do OK, not retailers necessarily, but writ large.
MICHAEL ARONE: Right. I think it's interesting. So, Julie, I mean, just think of 2022. The economy expanded. Earnings grew. We had the best labor market we've seen since the late 1960s. And what happened in markets? We had the first dual bear market in stocks and bonds in a singular year and one of the worst years for 60/40 portfolio in history. This year, we had an earnings recession. We've had of-- you know, kind of, some challenges in terms of geopolitical risk. And yet, markets have largely shrugged it off.
So I think from my perspective, it looks like earnings have probably bottomed. I don't think they'll be as good as analysts are anticipating. But they'll be good enough. And I do think that the interest rate volatility, once again, interesting is that it is dominating stock market performance.
And historically, that's been a bullish setup because what happens is you won't stay volatile for long. And I think that ultimately, as the fed concludes its tightening cycle, you'll see this interest rate volatility dampen. Rates are likely to fall. And I think that'll be bullish for stocks next year.
- Michael Arone, great to see you. Thanks for being here today.