Stocks have slipped in August as investors get anxious following a four-month-long market rally, and a long-time market strategist sees even more pain ahead for equities and the economy.
Brent Schutte, the chief investment officer for Northwestern Mutual’s wealth management arm, isn’t sure this year’s returns have staying power. Much of the S&P 500’s 16% year-to-date gain was driven by a few large tech stocks, he noted — a parallel to the dot-com bubble that should give investors pause.
“This reminds me a lot of 1999 to 2000 where a small group of stocks kept pulling the market higher,” Schutte said in a recent interview with Insider. “And then in the next five, six, seven years, those didn’t do as well. They were fantastic companies, but they’d already discounted all their future prospects, and they were at a high valuation.”
Enthusiasm about artificial intelligence and the productivity gains it can generate for companies has gripped traders in 2023. Several of this year’s top performers are tied to the technology, but even if AI lives up to the hype, some fear those high-fliers will suffer the same fate as internet stocks in the tech bubble of 2000.
AI is far from the only area of the market with overly optimistic sentiment, in Schutte’s view. He also believes positive rhetoric about the US economy has reached a boiling point.
“There’s extreme pessimism at the beginning of the year, even into last year, that has now become more optimism,” Schutte said.
Schutte added: “Just over the last month or so, you’ve had everybody say, ‘The coast is all clear. Inflation has come down, and there was no recession. Therefore there won’t be a recession, and the Fed could be done because CPI has come down.’ That’s where I just think it’s a bit misguided.”
Workers’ raises raise risks for the economy
There’s no bigger mystery in markets than how the economy, specifically the labor market, has held up so well this year. Historically high inflation and restrictive interest rates had strategists all but certain heading into 2023 that an economic downturn was coming.
Instead, investors seemed to get the best of both worlds. Inflation has steadily fallen toward normal levels without economic growth wilting. Meanwhile, the unemployment rate has defied logic by staying near multi-decade lows.
However, Schutte said the US economy’s apparent strength may be somewhat deceptive. Hours worked by employees are sliding ever so slightly, and he said companies may be holding off on layoffs because they’re worried they won’t be able to rehire in a tight labor market.
Unless there’s a sudden influx of workers that drives down wage growth through competition, the investment chief said the economy will steadily lose momentum. The last three recessions besides 2020 were preceded by interest rate hikes in response to a wage-price spiral, he noted.
“I think that there’s a recession on the doorstep at some point,” Schutte said. “If it’s six months from now, nine months from now, I don’t think there’s going to be a ton of people that are going to come back to the labor market.”
Schutte also said: “In the last three or four economic cycles, there hasn’t been a quote-unquote ‘better way’ out of the potential inflationary aspects that come along with wages rising sustainably high.”
Other concerns for the economy that Schutte cited include a dip in activity on the goods side, rising credit card debt rates, and continued declines in liquidity from a shrinking money supply and restrictive financial conditions.
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Despite the recent market pullback, investors don’t seem to be too worried. Volatility, as measured by the CBOE Volatility Index (VIX), has ticked up recently but is still at modest levels. That complacency and confidence is a chief reason for Schutte’s caution.
In May, Schutte said he downgraded stocks from overweight and got bullish on bonds. Though equities still had room to run in hindsight, Schutte isn’t playing Monday-morning quarterback.
“We have humility, and we don’t try to time everything,” Schutte said. “And so we’re kind of taking off some of our equity risks while leaving on those parts of the market that are cheaper and increasing our bond exposure. So it’s kind of a give and take, a little bit on each side.”
Schutte is bullish on three types of investments right now: fixed income, value-oriented companies, and small- and mid-cap stocks.
Bonds are an obvious choice for safe, steady income in a late-cycle environment, Schutte said.
“I just want people to pump the brakes on the equity markets a bit and not pile in as much as they have been recently,” Schutte said.
The investment chief continued: “Whether I think the recession starts tomorrow, whether it starts three or six months from now, we are at least closer to the end of the economic cycle, and that’s where you want to behave just a bit better.”
Schutte likes value and so-called SMID-cap stocks because they trade at a discount to their growth and large-cap peers. And although smaller companies tend to be hurt worse in recessions given their sensitivity to economic swings, the market veteran thinks the group is worth owning because they’ve already priced in pain as their earnings have fallen.
“We’re going to ride through that cycle because I don’t believe that I can time this perfectly,” Schutte said. “And just given the valuation cushion that I have there, even if there is a recession, I still think it’s short and shallow.”