Back in the late 1970’s and early 1980’s, men’s professional tennis was dominated by the rivalry between Bjorn Borg and John McEnroe. The two met 14 times over a 3-year period (split 7-7) and were contrasted not only in their styles of play – Borg was a baseliner, who relied on powerful and nearly flawless groundstrokes, while McEnroe was a serve-and-volleyer, who relied on charging the net whenever he could – but also in their demeanors – Borg was stoic, referred to as “ice-Borg” (we like to think that the Borg in Star Trek were modeled after Bjorn, but we refuse to Google this as we prefer to believe it to be true as opposed to allowing the Internet to debunk it for us), while McEnroe was, well, McEnroe. The rivalry abruptly ended in 1981 when Borg, then only 26, retired from professional tennis after losing to McEnroe for the third straight time (in the finals of the U.S. Open).

We will use the Borg v. McEnroe as a segue in two ways. One – because it allows us to pontificate on one of the great investing analogies that we have come across in our years of “doing this” and two – because the back and forth of the rivalry is a good analogy for our current economic state.

A Tennis/Investing Analogy

There is a school of thought to tennis that if an elite player faces off against a non-elite player, the elite player will virtually always win. However, if a non-elite, but still very good player faces off against a good, but lesser player, there is a formula for success as it relates to the lesser player. In the elite player vs. non-elite player match up, the winners (shots that the opposing player has no chance to return) that the elite player can hit will simply overwhelm the lesser player. However, when a match involves two less-than-elite players, it is not the winners that necessarily decide the match, but rather the unforced errors.

It is here where the lesser player can overcome his/her skill disadvantage. The downfall of most less-than-elite players is not a lack of winners, but rather a plethora of unforced errors. Thus, the strategy for these players should be not to try to hit winners, but rather to focus on simply returning the ball and waiting for your opponent to make the error. Inevitably, the less-than-elite player (but still better than his/her opponent) will try to “force the issue” with an attempted winner and more often than not, this will lead to an errant shot, allowing the lesser player to prevail.

Segueing to investing – this style of – don’t try to hit winners, but simply get the ball back – has lots of merit. We often get distracted by the “new-fangled toy” – cannabis stocks, crypto, toys.com – when the better strategy is to focus on getting the ball back – owning good businesses. This lacks the excitement that an electrifying winner can provide (did you see that shot?!), but it also likely means that you will win the match in the end.

Our Current Economic State

Borg v. McEnroe also serves as a good analogy for the current state of the economy. On the one side, we have some positive signs that point to a likely “soft landing” in the economy. However, that volley is inevitably returned with a shot that indicates we are not out of the woods quite yet. Let’s start with a chart and then comment:

Here, we are looking at the Consumer Price Index (gold line) v. Core PCE (blue line). Core PCE is Personal Consumption Expenditures less food and energy. We bring it up because it is the preferred inflation metric of the Federal Reserve, as the Fed believes it best captures inflation that the Fed can control through monetary policy. As you can see, while CPI has tumbled over the past year, Core PCE has only gradually come down. So, on the one hand, the worst of inflation is certainly behind us, and we are on the path to where we need to be, but on the other, the journey to get there is still going to take some time. Okay, let’s try another:

Here, we are looking at the year-over-year percentage change in payrolls v. the percent change in the average number of hours all workers have been logging in a given week. As you can see, payroll growth has slowed, but it is still quite high, especially given all the interest rate hikes that were designed in part to relieve some of the stresses in a tight job market. But the return of service is that the average work week has remained in negative growth territory. Ultimately, it’s the combination of job creation and hours worked that matters and while overall total hours worked is still growing, it has slowed to ~1%, which would be indicative of an economy that is somewhere between a soft and hard landing. Let’s do one more then “finish the match”:

This chart probably exemplifies best the tennis match that is currently underway. On the one hand, the Fed has sent a variety of hard groundstrokes at inflation and the economy through 500+ basis points of rate hikes. But the Federal Government keeps returning these shots with significant fiscal stimulus (in this case, courtesy of the Inflation Reduction Act, which is not in any way reducing inflation). Fed spending has no doubt helped to keep the economy afloat in the face of all these rate hikes, but it has also probably increased the risks that the economy will fall harder. The Fed for its part, is likely to keep firing groundstrokes either through more rate hikes (less likely) or a reluctance to reduce rates (very likely), which would otherwise not be the case were fiscal policy better aligned with monetary policy.

Game/Set/Match

Pulling together the above, we live in a period of conflicting signals. Many components of inflation have moved in the right direction, but the Fed’s preferred measure has moved much more gradually. Job growth has remained robust, but if we dig a bit deeper and add hours worked, the picture is less rosy. Similarly, while the Federal Reserve has taken unprecedented steps to cool inflation and slow the economy, the Federal Government has added unprecedented stimulus to the economy, which has offset much of the Fed’s heavy lifting. From our lens, the risks remain modest to high as we head into the back half of the year. Markets – especially U.S. tech – are reflecting a soft landing and a quick recovery in the economy. While we give some credence to this view, we do not yet think it is the base case and as such we maintain a somewhat cautious stance.