Don't Fight The FED!

Don't Fight The FED!

April 03, 2024

“People often say there’s lots of uncertainty, but when was there ever certainty in the markets, the economy, or the future? I’m just trying to understand the present. The future is unknowable; the economy is highly complicated. So you try to understand what’s going on right now.”

Bill Miller, 1950 – present; investor, fund manager, and philanthropist



It’s no secret that sports betting has become a fixture in American life over the last half decade, and March Madness, the annual National Collegiate Athletic Association (NCAA) college basketball tournament, is the biggest event of the year for sports betting. Every March, over 100 million people across 180 countries tune in to watch the month-long spectacle that is filled with drama, upsets and buzzer-beaters. Estimates indicate that bettors will wager more than $2.72 billion on this year’s national tournaments using legalized sportsbooks, according to the American Gaming Association (AGA). That’s about twice as much as the amount of bets that were legally wagered on this year’s Super Bowl.

From humble beginnings, the ‘Big Dance’ grew from just an 8-team basketball tournament in 1939 to the modern 68-team* ‘madness’ we’ve come to love (*eight of those teams compete in the ‘First Four’ games that take place before the first round of the tournament). Better yet, this single-elimination sporting event never fails to produce a couple of nameless teams that overcome seemingly unsurmountable odds and end up making a run through higher-seeded opponents. Unheralded teams that advance in the NCAA tournament are affectionately dubbed ‘Cinderella stories’. They are one of the reasons bettors love March Madness – it is estimated that one in four Americans fills out a bracket to predict who will win it all.

However, the odds of filling out a perfect bracket, which means predicting the winner of all 63 games, are astronomically high. According to the NCAA, the chances of a perfect March Madness bracket are roughly 1 in 9.2 quintillion (one quintillion is a billion billions)! They estimate that those odds improve with any knowledge of the sport or tournament’s history, but they still remain roughly 1 in 120.2 billion. Not to be the bearer of bad news, but there’s a greater chance of getting struck by lightning twice in your lifetime (1 in 9 million) or hitting two holes-in-one in the same round of golf (67 million to 1, per the PGA). While the odds may seem unbeatable, in 2019, a neuropsychologist from Columbus, Ohio, correctly selected the winner of the initial 49 match-ups and became the first person to carry a perfect bracket past the second round.

The against-all-odds, can-do spirit of the U.S. economy, which despite a turbulent few years marked by high inflation, has proved far more resilient than anyone could have expected. This presents market participants their own version of a Cinderella story: hope that the Federal Reserve might be able to pull off that seemingly impossible feat - the storied economic ‘soft landing’. The term ‘soft landing’ refers to an effort on the part of a central bank – such as the Fed in the U.S. – where it has raised rates just enough that economic growth slows yet remains positive, and inflation continues its descent to the bank’s desired target.

To be sure, landing the economy softly is a tall order and requires both, skillful decisions and a dollop of good luck. Many economists believe that the Fed has managed a soft landing only once in 11 tries over the last 60 years, in 1994-95*, which was a time of rapid globalization that both contained inflation and boosted profit margins (*some give the Fed credit for three ‘softish’ landings - 1966, 1984 and 1995). In all other instances, the central bank either raised interest rates too little and failed to defeat inflation, or went too far and precipitated a recession – known as a ‘hard landing’. In a sample of 140 hiking cycles across the last 70 years of developed market history, a recession has followed a rate-hiking cycle 75% of the time – and this figure increases to 90% for cycles characterized by elevated inflation when hiking started.

Just a year ago, with the Fed in the middle of its most aggressive rate hike cycle in four decades, most investment banks and Wall Street investors were convinced that the domestic economy was headed for a serious downturn in 2023. Today, with businesses and consumers proving their resilience over the past year, the prevailing sentiment on Wall Street is a soft landing scenario that avoids a recession – despite the Fed’s dismal track record. Unfortunately, the ‘hard landing’ versus ‘soft landing’ debate won’t be settled definitively until the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) decides on the official start date of any recession that arrives. That announcement usually comes about a year after the recession has begun - making the proclamation itself utterly useless for investors.

Far from stumbling, the U.S. economy delivered 2.5% real GDP growth for all of 2023, up from 1.9% in 2022, and expanded at a robust 3.4% annual pace from October through December. A strong pace of consumer spending helped drive the expansion, as did rampant government spending. Growth has now topped 2% for six straight quarters as the world’s largest economy continues to surprise to the upside. Moreover, the expansion is expected to continue this year, albeit at a slightly slower pace.

At the Fed’s March 2024 meeting, Chairman Powell highlighted that despite high interest rates, economic growth has remained relatively strong and inflation has materially declined over the past year. Consequently, the FOMC (the Fed’s chief body for monetary policy) sharply accelerated their projections for GDP growth this year to a 2.1% annualized rate, a sizeable jump from their 1.4% forecast in December. The unemployment rate forecast moved slightly lower from the previous estimate to 4%, not far from the most recent reading of 3.9%, while projections for core inflation as measured by personal consumption expenditures (PCE) rose to 2.6%, up 0.2 percentage points, but slightly below the most recent level of 2.8%.

As a result of those bumped-up estimates for economic growth and inflation this year, policymakers left their benchmark short-term rate at a 23-year high of 5.25% to 5.5% for a fifth straight meeting and maintained their projection of three rate cuts of a quarter point each in 2024. Their economic outlook pegs the median fed funds rate at 4.6% at year-end, which was generally in line with their previous projections and reassured investors that rate cuts remained on the Fed’s agenda. What’s less clear is the timing of those rate cuts. Recent economic data reinforces the case for caution as underlying inflation rebounded in the first two months of the year, with core PCE averaging about a 4% annualized rate. This uptick could signal that inflation may return to the Fed’s 2% target more slowly than forecasters anticipated just a few months ago as the so-called ‘last mile’ of the inflation fight will be harder and take longer – especially among categories that are ‘sticky’. Nonetheless, most economists expect the Fed’s first rate cut to occur in June, which would begin to reverse the 11 hikes it implemented beginning two years ago.

The Fed’s counterparts at the European Central Bank and the Bank of England similarly signaled lower rates ahead, while the Swiss National Bank made a surprise cut in mid-March. Major Latin American central banks, led by Brazil and Mexico, are already well along in their rate cuts, easing their restrictive policies with inflation well below its peak. Meanwhile, the Bank of Japan ended negative interest rates after eight years and unwound most of its unorthodox monetary easing policies, saying the move was justified by steadily rising wages and prices in Japan.

Headline inflation, as measured by the Consumer Price Index (CPI) peaked at 9.1% in June 2022 and has since dropped significantly to 3.2% in February this year. The most recent release of the Fed’s preferred inflation measure, the core PCE, rose 2.8% year-over-year in February. So despite progress since early 2022, current inflation is still well above the Fed’s 2% target, putting a spotlight on whether price growth will cool enough this spring to justify an interest rate cut. Incoming data will be critical to confirming whether the last few months were simply one-offs or a concerning trend that could prompt the central bank to delay cutting interest rates.

Yet, even if inflation keeps trending down, the central bank’s messaging could get complicated as the chances grow that those rate cuts end up juicing the economy in the run-up to Election Day – just as Republicans and Democrats fight to leverage the economy in their appeals to voters who tend to rank economic issues at or near the top of their most important election-year issues. While it isn’t unusual for the Fed to change interest rates in election years (see chart above), the impact of such cuts on the economy could boost stocks and consumer spending, while helping shape attitudes about stubbornly high inflation and mounting housing costs that have been a drag on the current administration’s reelection efforts. Fed officials insist politics won’t influence their decisions, but there might be little Powell can do to convince the most committed partisans that the Fed isn’t motivated by politics.

With inflation seemingly on a downward path – although a bumpy one - and policymakers increasingly confident the U.S. economy could achieve a soft landing this year, the Fed is now shifting its focus to the risk of overtightening. That said, the inflation genie isn’t back in the bottle yet and, in Powell’s words, “(they) still have ways to go.” Many tail risks remain, not least the possibility of tight labor conditions keeping wage inflation high, housing supply constraints sustaining excessive shelter costs, and energy markets staying too elevated to ease price pressures, as the central bank will not tolerate a reacceleration in prices.

Some reliable indicators also suggest the threat of a recession remains elevated:

  • The inverted yield curve - when the yield of the 2-year Treasury notes (currently 4.6%) exceeds the yield of the 10-year Treasury bonds (currently 4.24%) - has anticipated eight out of eight recessions since the 1960s and has yet to send a false signal.
  • The Leading Economic Index(LEI) provides an early indication of significant turning points in the business cycle and where the economy is heading in the near-term. While the latest LEI inched up in February, marking the first monthly increase in two years, it continues to signal headwinds to economic growth going forward.
  • In theory, Gross Domestic Product (GDP) and Gross Domestic Income (GDI) are supposed to be equal. However, these growth measures diverged significantly over the last 15 months, with GDP growth eclipsing GDI by 2.8%. GDI has historically been better at anticipating cyclical changes, signaling several past recessions (including 2008) before GDP did. We can therefore not rule out the chance that the U.S. economy has less momentum than it seems.

Meanwhile, several other trusted indicators do not suggest that such a downturn is likely. The CBOE Volatility Index, better known as the VIX, which projects the probable range of movement in the U.S. equity markets in the immediate future and typically rises above 30 during recession, currently sits at an ultralow 13.01. Similarly, the Sahm rule, devised by former Fed economist Claudia Sahm, which holds that the economy is contracting when the three-month moving average of the unemployment rate rises 0.5% or more relative to the low point during the previous twelve months, is far from indicating a recession.

The strong positive performance of risk assets this year also suggests that the market seems to be shrugging off recession concerns. A renewed wave of AI enthusiasm and reassurance by the central bank that it will embark on a protracted series of rate cuts this year have sent stocks on a seemingly relentless record-setting run and added trillions of dollars to shareholders’ wealth. With markets increasingly pricing-in rate cuts this year, market valuations are reflecting a ‘Goldilocks’ economic scenario of slowing inflation and resilient growth, supported by easier monetary policy.

With markets remaining heavily focused on the Fed’s next decision about interest rates, one question is top of mind for investors: how will the equity markets react to the first interest rate cut? If history is a guide, above-average stock returns could follow. According to Investor’s Business Daily (IBD;, over the past 11 cycles dating back to 1982, the S&P 500 and Nasdaq have averaged nearly 10% returns over the six months following the initial rate cut (see chart above). Notably, prior to 2000, stocks reacted positively to Fed easing, but that pattern changed after the turn of the century. The central bank was unable to prevent steep market drops resulting from the dot-com bust in 2000-01, the global financial crisis of 2007-09, and at the onset of the Covid crisis of 2020. Bulls should hope last century’s pattern is the precedent for Fed easing.

Besides, while interest rate trends can have a bearing on the stock market, performance is also closely tied to the strength of the U.S. economy and corporate earnings, with the outlook for both brightening considerably in the past several months. Earnings expectations often help drive the direction of the broader stock market. After declining in 2023’s first two quarters, corporate earnings, measuring the profitability of publicly traded companies, showed improvement in the third and fourth quarter, with encouraging signs for ongoing earnings growth this year. Earnings of S&P 500 companies are projected to grow 10.9% this year, according to FactSet. That’s up from low single-digit increases last year, a leap that can partly be traced to faster growth in productivity, or output per worker.

Ironically, the sustained rally in asset prices – and the sense of affluence it induces across Wall Street and Main Street – has in some ways undermined the Fed’s efforts to slow growth and tame inflation. Since the November FOMC meeting, when future rate cuts started to be discussed, the U.S. stock market has gained $10.9 trillion in value, while the bond market has grown $2.6 trillion, adding fresh fuel to the consumption and investment cycle and working against the central bank’s efforts. At the end of 2023, investors expected seven quarter-point cuts over the course of this year. With the economy still healthy and two months of stronger than expected inflation data, those overly optimistic expectations have been reduced to just three cuts, or 75 basis points. A strong economy and a record setting stock market sound like a good thing, but not if they undermine the consensus call for multiple Fed rate cuts that the market has already priced in.

Key Takeaways

The combination of a resilient economy and steadily cooling inflation has raised hopes that the Fed can manage to achieve a coveted ‘soft landing’ by fully conquering inflation without triggering a recession. Equity markets have embraced the soft landing scenario and seem to expect a powerful rebound in economic growth and corporate profits. Plus, fiscal policy remains stimulative with the federal government projecting a $1.5 trillion deficit in the fiscal year ending on September 30th, which equals about 5% of GDP. Powell has forecast 75 basis-points of rate cuts that could come ‘at some point this year,’ stopping short of saying whether the Fed’s first cut could come at its next meeting in May or in June.

All this has given investors plenty of reasons to continue buying. In a stellar first quarter, the benchmark S&P 500 boasted a 10% gain – that’s about in line with its historical average for a full year! Any weakness in the stock market hasn’t lasted more than a few sessions, with investors buying the dip and sending the index to 22 all-time closing highs. And unlike last year, it wasn’t just a small group of megacap tech stocks participating in the rally as more S&P 500 stocks are outperforming the benchmark so far this year versus last. Risk-taking appears bountiful, with oil prices (WTI) gaining 14%, Bitcoin advancing 61% year-to-date and gold soaring 8.4% in March, its largest one-month gain in four years. Of major markets, only China has been left out of the party as its once roaring industrial growth engine continued to sputter.

The yield on the 10-year U.S. Treasury note, which rises when bond prices fall, climbed from 3.86% since the start of the year to 4.21%, partially on mounting concerns about the issuance of nearly $2 trillion in expected new U.S. government bond issuance this year needed to fund government spending and the growing deficit.

While the odds of an imminent recession are fading, investors now must grapple with a new question: What comes next?

Overall, the prospect of a solid economy and steady rate cuts is unusual and makes for a favorable environment for investors. Still, after the breathtaking advance of the stock market to record highs, it now fetches 21 times expected earnings over the coming year, which is well above the historical 5-year average of 19.1 and the 10-year average of 17.7, according to FactSet. In some respects, investors are already incorporating a lot of good news into stock prices and the market is likely due for a consolidation or decline at some point in the year. Earnings growth will be a key driver in determining if stocks continue to move higher.

With yields across most fixed income sectors at attractive levels rarely seen in the last 20 years, bonds are a compelling long-term investment. Starting yields are near their highest levels in more than a decade, and the Fed is expected to start easing policy later this year, which should provide a boost to fixed income total returns as long as inflation continues on its downward (if occasionally bumpy) path. The expectation of rate cuts later this year means that cash should progressively deliver lower returns, which makes this an opportune time to revisit elevated cash holdings and lock in still attractive yields.

While the soft landing scenario currently dominates the market, we believe it’s essential to scrutinize the data and prepare our portfolios for the possibility that this narrative may not unfold as anticipated. Besides the uncertainty surrounding monetary policy, the most likely sources of uncertainty are political (election year politics, ever worsening federal debt) and intensifying geopolitical risks that could overwhelm the economy and markets. Yet the dominant views about the economic outlook seem to either ignore or underweight these dangers.

While a soft landing scenario is the one policymakers would most like to see, pulling it off will depend on a lot of factors and the consequences of failing could be severe. In such an environment, we maintain our confidence in our diligent and proactive approach to managing our clients’ investments. We remain disciplined and focused on their long-term investment goals by building portfolios with the assumption that turbulence will be the rule, not the exception. The goal should be to walk away from the landing – whatever form it takes – without significant losses or declines in portfolio values. After all, good pilots don’t wait to put together a flight plan until they are in the air – neither do diligent investment advisers! Being well positioned enables anyone to come out ahead, no matter what obstacles the unknown may present.

APRIL 2024