- S&P 500, Nasdaq, and Dow fell in August amid recession fears and market pullbacks.
- Key concerns include Federal Reserve rates, US-China consumer spending, AI trade, and geopolitics.
- Joe Quinlan says recession fears are overblown and shares two good trades.
The second half of 2024 has thrown some curveballs. August rang in a pullback as the S&P 500 fell by 3.27%, the tech-heavy Nasdaq by 4.7%, and the Dow by 3.7%.
Despite the indexes in the red, Joe Quinlan, head of CIO Market Strategy for Merrill and Bank of America Private Bank, says what scares him the most is recessionary fears creating a self-fulfilling prophecy as investors scare themselves out of the market and into spending halts.
Six key concerns are tugging at investors' minds right now, but each is unwarranted, according to Quinlan, who broke them down and shared his thoughts.
The first concern is that the market is afraid the Federal Reserve is behind the curve on cutting interest rates after keeping them too high for too long. However, fears that this could lead to a recession are overblown. The economy is slowing, but it's not stalling, and the central bank is on track to cut two or three times this year, he noted.
"The employment market is so important because employment equals income, income equals consumption, and consumption is around 70% of US GDP," Quinlan said.
But he noted that even as July's unemployment rate ticked up to 4.3%, it's still historically low and pretty strong relative to other countries.
The second concern is that US and Chinese consumers are retrenching. While spending is slowing, what's really happening is that the consumer is normalizing. However, the squeeze of inflation is being felt, especially for lower-income households, he added. The impact will be felt in certain sectors more than others.
More tightness could come from the Chinese consumer. China has been trying to reopen for the last 18 months, and it's not happening, he said. Plus, the Chinese property and equities markets are underwater, which has created a negative wealth effect. There's also a high unemployment rate among college graduates and a lack of jobs, he added.
"You could see some weakness in consumer staples, particularly consumer discretionary," Quinlan said. "You've seen the airlines add a lot of capacity, but the flyers aren't there. You see hotels having to maybe start discounting. You need to watch where the capacity or supply has been added, but the demand is not there, then you start discounting, which means lower profit margins going into Q3 and Q4. So that's kind of what we're watching out for."
The third concern is the unwinding of the artificial intelligence trade, mainly the Magnificent Seven. Here, Quinlan noted that the pullback was to be expected and healthy as the sector got frothy.
This earnings season was rich in guidance and uncovered key trends for Big Tech. One of these was the overarching theme of continuing to spend billions of dollars on AI infrastructure. The potential rate of return on all that capex has impatient investors questioning their bets. They want sooner returns, but the AI trade will take years, not quarters, he said.
The fourth concern is the recent unwinding of the yen carry trade. Japan's low interest rates made its currency a cheap option to borrow and fund other trades in the US and worldwide.
But those arbitraging the yen found themselves getting squeezed as the Japanese central bank raised rates. The unwinding process saw parts of the market, specifically tech, sell off as investors rushed to repay the loans. While no one knows where the bottom is, Quinlan believes the worst is over.
The fifth concern is uncertainty surrounding the US election. At the beginning of the race, it seemed likely that Donald Trump would win.
Polling predicted that the former president had a good lead, particularly in swing states. But that's off the table now, and we're right back to a tight race, Quinlan said. Increased uncertainty also means increased volatility. So there's $6 trillion sitting in money market funds that is being held hostage to politics, he added.
"I speak with clients every day. They're happy getting 5% out of the money market bonds until they see some clarity, more certainty in and around the election," Quinlan said. "They expect more volatility, particularly post-Labor Day, because it's going to get tight; it's going to get pretty interesting. Policies are going to be dissected."
Quinlan emphasized that any significant stock market dips below 5% are buys.. He doesn't advise trying to time the market by selling with profit-taking intentions. One punishing day could be followed shortly after by some nice upside, he noted.
The final concern is rising geopolitical tensions in the Middle East. For Quinlan, this has translated into a strategy of being long the leaders of US defense, aerospace, and cybersecurity.
The escalating conflict between Israel and Iran ups the ante of a greater regional conflict that makes investors nervous, and defense is a key winner of that, he said.
If investors want to skip the volatility that accompanies an uncertain economic environment, then one of the best places to park money is still in bonds with durations between two and 10 years, he said.
"We've had these episodes of market volatility in the past, and the only path was in and out of equities," Quinlan said. "Well, now you get 4% even on a two-year yield; that's a good place to put some money to work as you're waiting out this volatility. Remember, as interest rates come down, you lock in two-, five-, or 10-year yields. You're not locking in anything by owning cash. Those money market funds are going to come down as the interest rates come down."
He also likes small-cap companies across the board. Even though the Russell 2000's rally in mid-July didn't last, he believes the sector will have its day. Smaller companies are more credit-sensitive. If you combine dropping rates with a soft landing, this sector of the stock market is well positioned for upside, he said.
"We're still believers in that small-cap trade. So don't give up on that if you don't have exposure, add to it," Quinlan said.