Welcome to the on-site version of our Unhedged newsletter. We appreciate all the responses we received yesterday. It’s interesting to note that readers’ views align quite well with the latest meeting minutes from the Federal Reserve. According to Fed staff economists, there is a forecast for a mild recession later this year, but there is also a strong possibility of narrowly avoiding it. This mix of resignation and optimism reflects readers’ sentiments as well.
We asked readers to share their views on the economy one year from today by assigning a probability distribution to different outcomes. Compared to a year ago, readers have become less concerned about a recession, with the chances of one dropping from 60% to 55%. The odds of high inflation have also decreased from 45% to 40%. Readers have also shown less fear of stagflation, reducing the chances of entrenched inflation and a recession in the next 12 months. Overall, readers have a slightly more positive outlook than they did a year ago, which is not surprising given recent easing of inflation and resilient growth.
While Unhedged has been skeptical about a soft landing, recent economic data suggests that the probability is increasing. One theory of a soft landing revolves around the Beveridge curve, which ties the job vacancy rate to unemployment. The pandemic has shifted this curve, with higher vacancy rates even at the same levels of unemployment. Fed governor Christopher Waller suggests that vacancies might fall with only a modest increase in unemployment, which would be unusual based on historical data but could be possible due to the current structural labor shortage in the US.
Investors seem more eager to buy on good economic news, as seen by the positive market reaction to resilient economic data. This suggests a more favorable growth/inflation trade-off than before. For investors looking for a trade opportunity, small-cap stocks may be worth considering. Valuations for the Russell 2000, a small-cap index, are relatively favorable compared to the expensive S&P 500. Additionally, small-cap stocks tend to perform well early in the business cycle. Currently, small-caps are discounted due to recession fears, but if a recession is avoided and the business cycle continues, this discount should disappear.
However, there are risks associated with small-cap stocks. If rates stay higher for longer, it could negatively impact small-caps, especially those with high levels of debt. The composition of the Russell 2000, which includes a significant amount of biotech stocks, also poses a risk. Lastly, small-cap banks may not be a wise investment choice at the moment. These issues can be mitigated by selectively choosing stocks within the small-cap index, such as low-leverage stocks in the industrial sector.
In conclusion, readers’ views and recent economic data point towards a more positive outlook for the economy. While there are still risks and uncertainties, small-cap stocks may present a favorable opportunity for investors.
If you want to delve deeper into the latest market news and financial headlines, don’t forget to check out our FT Unhedged podcast hosted by Ethan Wu and Katie Martin. It’s a 15-minute dive into the world of finance. Also, be sure to sign up for our recommended newsletters, Swamp Notes and The Lex Newsletter, for expert insights on US politics and investment trends. Stay informed and prepared for what’s to come.
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