Federated Hermes Premier Municipal Income Fund : Summer's almost over

When I got back to the office this week after last week's holiday, one of the admins noticed my suit and tie. "Steve, oh no! Are we back to suits? Don't take summer away already!" Well, I hate to be a grinch, but summer's almost over, and the fall is coming. My guess is that will be less good news for stocks. Let's review what's been driving the summer rally, and how those positive forces might be turning in the coming weeks.

Technical analysts might be chasing their tails

One almost universal feature of this summer's rally in stocks has been that many technical analysts, some early, some late-have turned from bearish to bullish based entirely on price action. This contrasts significantly with many fundamental analysts, such as Federated Hermes, who entered the summer cautious and have grown more cautious still as the summer's rally continued. Unlike some of my fundamental peers, I do find a good deal of value in the technical folks; they as much as anything else are trying to read psychological patterns of behavior, which often repeat or at least rhyme over previous cycles. However, the one time when technical analysis can sometimes struggle to read markets is when volumes are lower, and lower levels of "real investors" are active. At such times, price action can temporarily blow through key signaling levels, giving the technical analyst false reads. We won't know until it's too late, but my guess is that may be happening this summer. Volumes for sure have been soft, as they often are in the "dog days of August." So, while I don't want to disrespect price action, which after all is the collective judgment of all market participants to the data in hand, I am concerned that this time around, it may prove less predictive than usual. Particularly if the fundamental drivers-inflation, the economy, earnings and valuations-don't support the technicals.

Inflation may be peaking but unlikely to collapse to Fed's 2% target anytime soon

Beyond the technicals, another key market narrative popular right now is that "inflation has peaked, and after September's hike, the Fed will soon pivot to cutting rates. This will achieve a 'soft landing' and stock valuations, based on assumed lower long-term rates, can rise." Frankly, while I am normally an optimist, I just can't see core inflation dropping to the Fed's target anytime soon. Yes, commodity prices may be peaking, even reversing, as global demand softens and supplies start to come onstream. But the big drivers of core inflation, housing rents and wages, are both in strong uptrends driven by still historic levels of undersupply relative to demand. For example, on the labor front, historically 2% core inflation has been consistent with an average labor supply/demand dynamic of 5 available workers for every job on offer. At the moment, we are about as radically inverse of this relationship as we've ever been: today we have only 1 worker available for every SIX jobs on offer. Hmm. And on the housing side, shortages of housing stock, particularly in the big cities, are driving double-digit rent increases around the country that seem unlikely to abate soon. Net, net, while core inflation might well fall off in the next several months from its current 5.9% level toward our forecasted 4-5% level as commodity prices ease, we don't think you can trendline this to 2% anytime soon.

And the Fed playbook this time around is the '70s, not the '30s

Over the 2008 to 2013 period, readers will recall that one call we got consistently more right than wrong was the Fed's next move. The reason for this is we felt quite certain that, given his career focus on the 1930s' Fed and the mistake it made of being too tight, too long, and of reversing its move to an easier policy too early, Chairman Ben Bernanke wouldn't make the same policy error. Within this historic framework, it seemed probable to us that the Fed would do whatever it took to support the economy and markets, for a prolonged period, as it recovered from the 2008 debt crisis. This time around, however, we think the Fed's framework has shifted from not repeating the Fed's 1930s' mistake to not repeating its 1970s' missteps. In that stagflationary era, the Fed famously declared victory far too early, when inflation dropped from11.7% in February 1975 to 5.9% in November 1977, only to see it reaccelerate again toward even higher double-digits in the early 1980s. When this happened, it took even more drastic policy tightening, and two difficult recessions, to finally bring inflation under control. Today's Fed is very aware of this error, and several speakers have alluded to it. We believe that not repeating the 1970s is the Fed's primary playbook today. And if so, the market's assumption of a quick pivot toward rate cuts in late 2023 is most certainly premature. Rather, our expectation is the Fed will continue to hike until its target fed funds rate rises above the core inflation rate, which we think will still be north of 4% this time next year. And if so, the summer rally built on the idea of looser Fed policy on the near horizon is also premature.

Meanwhile, the consumer's "3X Summer Vacation" is coming to an end

Another worry on our minds is that as much as we all talk about "revenge vacations," it is simply difficult for any of us to imagine exactly how distorted the consumption/retail/economic numbers coming through in this first full summer holiday season in three years might actually be. Quite likely, the "revenge vacation" spend this summer might be even more than the simple arithmetic sum of three holidays rolled into one, as math is often thrown out the window when people are let out of their apartments after three years of seclusion. My guess is that spending patterns this summer that led investors to believe that the economy is holding up fine is probably premature. As consumers return home from their summer holidays (which by the way most certainly cost a lot more than they budgeted for) and visit the supermarket or their local gas station, a slowdown, even reversal, of the "3X" summer of spending could well be upon us. News flash: that won't be good for any of the macro numbers that fuel markets.

And earnings guidance could be the next to follow suit

Another key driver of the summer rally has been corporate earnings, which while slowing, have continued to beat expectations, on average. And more importantly, forward tone and guidance, broadly, was not negative. In the end of the day, earnings are what really matter, and broadly, they are holding up. Frankly, we expect them to continue to do so, at least at a nominal level, and even in our own more cautious view on stocks, we have 500 earnings only declining modestly, perhaps 5% to 10% from present high levels. Our concern has been less that we will see a dramatic decline in earnings, but rather that a dramatic improvement is equally improbable, particularly within the context of the economic "rocky landing" we envision through next year. And while we do think that eventually the companies comprising the will produce as much as $300 in nominal earnings, our guess is that we will not get there till 2025 or beyond.

The big issue we think remains valuations

The summer's 15% stock market rally has been based almost entirely on valuations rising from 16x forward earnings in June to 18.5x last week. This revaluation higher, in turn, has relied on the view that a Fed pivot back towards lower rates was nigh. Our primary concern for markets now is that with a Fed pivot towards ease unlikely anytime soon, valuations will once again swoon, particularly among longer-duration growth stocks that have benefited the most from the summer's revaluation higher. At Federated Hermes, we continue to expect the markets to settle out longer-term toward a 15 to 16 multiple on forward earnings, more in line with historic periods of inflation running in the 3-3.5% range that we expect.

Cutting exposure to stocks within our balanced models further

Readers of this space know that Federated Hermes macro team has been cutting exposure to growth equities for most of the last 12 months, largely at levels on the 500 of 4,100 or higher. While we do anticipate that the market can gradually rise to 5,000 over the next three to five years (on nominal earnings of $300 and a of 16.6x), the path for getting there is replete with risks, particularly from present levels. Should the market swoon this fall toward our low-end target of 3,400, we would feel much more positively inclined towards stocks. As we've pointed out before, positively reflexive forces, including rising unemployment, lower macro demand, lower inflation, Fed easing and low-equity valuations, would all converge at those levels to help stocks put in a firm bottom. But for now, we continue to think defense works better than offense; the move our committee undertook today, cutting growth stock exposure another 1% and adding an additional 1% to cash while remaining dramatically overweight defensive value stocks, underscores this point.

Time to start pulling your cold weather gear out of the closets; summer is almost over.