“We don’t think we’re behind. We think this is timely. But I think you can take this as a sign of our commitment not to get behind.”
Fed Chair Jerome Powell, 1953 – present; after analysts expressed surprise at the magnitude of the rate cut
THE FED JUST CUT INTEREST RATES. NOW WHAT?
Based on true events that led up to the global financial crisis of 2008, ‘The Big Short’ is an Oscar-winning film adaptation of author Michael Lewis’ best-selling book of the same name. The movie features an all-star cast (Christian Bale, Steve Carell and Ryan Gosling) and a host of celebrity cameos to illustrate, in refreshing clarity and humor, some hard to explain and very interesting dynamics in the lead-up to the housing crisis and the eventual bursting of the bubble that led to the worst financial crisis since the Great Depression of the 1930s. Much more than mere entertainment, the movie unravels some of the mystery behind why so many homeowners, investors, business owners and employees took such a big hit when the subprime debacle crashed the economy in 2008.
The film tells the story of a handful of contrarian investors who discovered early on that Mortgage-Backed Securities (MBSs) had AAA ratings (considered one of the safest investments), even though those financial instruments were quite vulnerable. [Contrarian investing is a type of investment strategy where investors go against current market trends]. By conducting extensive research, they discovered that a majority of the mortgages that were packaged into those MBSs were subprime, i.e. borrowers with poor credit and/or low income. Anticipating that the housing market decline in 2007 would cause a collapse in bonds derived from subprime mortgages, they began shorting those products and eventually made a fortune on their trades. [Investors short a security - a stock or a bond - when they think the price of that product will go down in the future].
If you have seen ‘The Big Short’ - you should! - you know that the movie opens with an epigraph attributed to Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” That pithy thought is alluding to the tendency to believe that something is fact when it’s actually just opinion, and that acting on the basis of that belief can lead to disastrous consequences. No doubt, Adam McKay, the film’s director, was making a statement about the massive financial risks hiding in plain sight in the mid-2000s while investors, focused on a growing economy with rising stock prices and real estate values, remained oblivious to the imminent dangers.
This phenomenon is known as confirmation bias, one of several behavioral biases that affects most of us. It is the tendency to seek information that confirms our existing opinions and ignores facts or data that refutes these beliefs. Studies have shown that if you own a security - say Apple (AAPL) - you are more likely to seek out articles confirming why you should continue to hold it than those challenging your beliefs. This can create overconfidence - an illusion of infallibility - with an expectation that nothing can go wrong.
For instance, in September of 1958, when the economy was experiencing a recession while Wall Street, not a bit disturbed by bad corporate news, kept climbing and caused the dividend yield on stocks to fall below the interest rate offered by 10-year Treasury bonds. At that time, if you were an intelligent and prudent investment manager with a strong understanding of investment history, one of the things you knew for sure was that the dividend yield on stocks should exceed the interest rate on a bond - it was accepted wisdom for a couple hundred years! You might have believed that it was a temporary aberration, fueled by speculation. With the benefit of hindsight, we know that things did not turn out the way they were supposed to. From that turning point on, bond rates continued to exceed dividend yields for the next 60 years (see chart above).
A more recent example of this can be found when at the end of last year, bond markets were wagering that the Federal Open Market Committee (FOMC) would deliver six or seven rapid interest rates cuts over the course of 2024, against three in the Fed’s ‘dot plot’ of interest rate expectations. That drove a dramatic rally in bond prices and caused market pricing to deviate far from fundamentals. But what bond markets ‘knew for sure’ turned out to not be so. In the first two months of 2024, the narrative shifted as the market digested higher-than-expected inflation data alongside ongoing economic strength, pouring cold water on those rate cut expectations. That shift precipitated a large sell-off in bonds, showing that the late-2023 narrative for rate cuts was not realistic.
It is therefore essential to identify the dangers of unrealistic investment expectations before markets force a reassessment, especially when it comes to extrapolating past performance into the future. At a minimum, realistic, forward-looking investment expectations should be based on fundamentals, current valuations, and the spectrum of relevant risks. Within our broad outlook for the economy and markets we have identified three potential sources of stress that could leave markets primed for turmoil: the U.S. election (which we addressed extensively in our last newsletter), the economy’s ability to pull off a so-called soft landing, and how Fed rate cuts could affect asset returns.
The Fed’s aggressive rate-hiking campaign, which started in early 2022 and thrust interest rates up to a 23-year high in a bid to combat the highest inflation in decades, appears to have finally come to an end. After holding the line on rates at a 5.25% to 5.50% range since July 2023, policymakers ushered in a new phase in their campaign to softly land the U.S. economy by lowering the federal funds rate by a supersized half percentage point to 4.75%-5.00% at the conclusion of their September policy meeting and left the door open to additional large cuts. Updated FOMC projections imply that the Fed is going to switch to a more gradual pace in future meetings, including cutting by 25 basis points (0.25%) in the final two meetings of 2024.
This marks the first reduction in borrowing costs since March 2020 and signals a pivotal shift in monetary policy that reflects the Fed’s confidence that inflation is moving sustainably towards its 2% target while shifting its focus on supporting a slowing labor market, which has shown signs of softening from the tight conditions of the past couple years. In July, the unemployment rate increased to 4.3%, marking its highest level since October 2021, before edging down slightly by a tenth of a percentage point to 4.2% the following month. Yet despite mounting fears over the labor market and its ability to continue powering consumer spending, the story for the U.S. economy as a whole remains positive.
The Fed’s preferred method for measuring inflation, personal consumption expenditures (PCE), continued to show muted growth in August. On an annual basis, the PCE price index increased just 2.2% after rising 2.5% in July. Similarly, core PCE inflation - which excludes volatile food and energy costs - measured 2.7% in August, a tad stronger than the 2.6% growth recorded in July. The core PCE target is now forecast to decline to 2.6% by the end of this year, 2.2% next year and 2% in 2026. The central bank targets a 2% annual rate of inflation as measured by the PCE Price Index. This outlook is an indication of the Fed’s confidence that it has achieved price stability, which is allowing it to shift its focus to maintaining full employment.
Although real gross domestic product (GDP) slowed in the first quarter of this year to 1.4%, resilient consumption and a surge in inventories put it on track for strong growth of 3% in the second quarter. Since then, wide-ranging economic data point to a gradual economic downshift, with consumers and businesses still spending but doing so with more prudence. Overall, forecasters expect real GDP to increase at an annual rate of 2.4% this year before slowing to 1.7% in 2025 as still restrictive monetary policy and elevated costs continue to curb private sector activity.
Will the economy achieve a soft landing?
With neither of the 2024 nor 2025 real GDP growth forecasts showing an outright contraction, does that mean the once unthinkable ‘soft landing’ may now be within reach? While there’s no official definition of a soft landing, it is the equivalent of ‘Goldilocks’ for central bankers: when a central bank is able to bring inflation down and cool a hot economy without triggering a recession – neither too hot (inflationary) nor too cold (in a recession). Historically, soft landings are probably the rarest of economic feats given the number of times that the Fed tried and failed to balance inflation with economic growth. In fact, the Fed has managed to achieve only one soft landing in the past 60 years - in 1994-95 when then-chair Alan Greenspan raised rates seven times, doubling the fed funds rate from 3% to 6% and managed to keep the economy steady, avoiding recession.
However, the economic backdrop back then was entirely different from today. Throughout the rate hike cycle of the 1990s, the unemployment rate consistently drifted lower, indicating a robust and growing economy. In contrast, the current unemployment rate is not moving in the desired direction, which raises questions about the feasibility of a soft landing in today’s economic climate.
Another major difference between Greenspan’s soft landing is that he proactively raised rates since the real federal funds rate (nominal rate minus inflation) was around zero and the FOMC anticipated inflationary pressures. The current rate hiking cycle was very reactionary: in 2021, inflation rose to levels not seen in nearly four decades, yet the Fed waited to adjust policy until March 2022. The slow response subsequently forced them to hike interest rates much faster and in larger increments to chase out-of-control inflation.
Yet after four years of upheaval, the U.S. now seems to have falling inflation, low unemployment, and solid economic growth. This is how an economy is supposed to look like and vastly improves the odds of a soft landing – sustainable, without the excesses that lead to either recession or accelerating inflation! The Fed chief expressed confidence in the U.S. economy’s ability to pull off a soft landing and financial markets are rejoicing at the prospect of such an outcome, with stock prices continuing to challenge market highs. According to the Bank of America Global Fund Manager Survey, expectations of a soft landing rose among investors from 76% in August to 79% in September (see graph above). In addition, over half of them believe there will not be a recession in the US within the next 18 months.
So, is the U.S. economy indeed on track to avoid a recession and pull off the much sought-after soft landing? The odds of an imminent recession are fading fast and policymakers have made substantial progress in taming inflation, making a soft landing increasingly conceivable. Evidence of a deteriorating labor market, decreasing consumer spending, and ‘sticky’ inflation that’s still above target are reminders that a soft landing is not yet assured however. Which scenario is more likely - recession or no recession (soft landing) - remains open for debate. Depending on your view, you can find compelling data to support either scenario. In the interim, we’ll stay on alert for any incoming economic data that show whether the soft landing hopes that have fueled recent gains in equities are justified.
How will rate cuts affect asset returns?
As much as investors would like a playbook for rate cuts, there just isn’t one - every easing cycle is different. Adding to the challenge is that the Fed has embarked on just 10 rate cut cycles since 1974 (excluding the current one), which doesn’t constitute a statistically significant sample size to evaluate. Still, one common perception among investors is that the stock market will perform well once the Fed starts cutting interest rates. History tells us this is not necessarily always the case. Data from Ned Davis Research shows that, since 1974, stocks have been positive about 80% of the time in the 12 months following the first rate cut, with an average return of 15% (see chart below). However, in the event of a recession, returns one year later were positive only 33% of the time, with an average return of negative 8% So, while market performance can vary dramatically in the year after a new easing cycle starts, history does not indicate that the Fed’s accommodative policy will routinely carry the market higher.
Underlying the wildly disparate performance are contrasting market fundamentals and Fed attitudes. The market will react differently if it perceives the central bank as confident and in control - engineering a soft landing for the economy - versus if it thinks the bank is reactionary, slashing rates amid the threat of recession. Thus, when policymakers cut rates preemptively to recalibrate monetary policy - as they are now - rather than to stave off a recession, markets often reacted favorably.
Equities:While the rate cuts could bode well for an economic soft landing, they don’t tell the whole story. The state of the economy is important for investors looking to gauge stock performance, but over the longer term, earnings growth is the primary driver of shareholder returns. According to FactSet, consensus forecasts for the S&P 500 currently call for 10% earnings growth in 2024 and about 15% through the end of 2025 - ambitious targets at almost any point in the cycle.
Whether or not earnings will meet those lofty expectations, we believe that a good measure of optimism is already baked into stocks from both earnings estimates and valuation perspectives. Equity markets have seen a remarkable record-setting run so far in 2024, with the S&P 500 gaining over 20% - its best year-to-date performance at September’s end since 1997. That has left the benchmark index trading at over 21.4 times forward earnings, well above its long-term average of 18.0 times. Although valuations have historically tended to rise after the start of easing (see chart below, courtesy Edward Jones), we believe the upside in stocks will be more modest than during previous easing cycles due to currently elevated valuations relative to history.
Fixed income:It’s not too late to add fixed income exposure to portfolios for diversification benefits as well as return potential. Rates seem to be trending lower, and this trend may be just starting. Investors historically experienced positive performance from most fixed income sectors in the aftermath of the first cut, with corporate bonds, on average, outperforming government bonds. With inflation-adjusted interest rates firmly in positive territory, bonds remain a good choice for both income and diversification portfolios. To effectively capitalize on the changing rate environment, we recommend an active approach to ensure careful interest rate (duration and yield curve) management with bottom-up security selection.
Cash: If there is one thing we can learn from past rate cutting cycles, it is that cash is likely to underperform as yields on shorter-maturity investments will drop rapidly and thus limit the appeal of money market funds. Investors should now take on a little more interest rate risk in the form of short-to-intermediate duration investments to effectively capitalize on the changing rate environment.
Key Takeaways
Having gained greater confidence that inflation is moving sustainably toward 2%, and concluding that the risks to achieving its employment and inflation goals are roughly in balance, the Fed lowered its key interest rate by a hefty half percentage point last month. This was a major headline event, but the move was widely anticipated. While the interest rate cut matters for deposit and savings accounts, asset prices - money markets, equities, bonds - were expecting a big shift in policy and had already adjusted accordingly.
In anticipation of interest rate cuts, bond yields across the board began a steady decline in the middle of May. After peaking at 4.70% early that month, the yield on the benchmark 10-year Treasury note fell more than 100 basis points (1.0%) over the course of five months to land at 3.62% ahead of September’s Fed meeting (yields move in the opposite direction of prices).
Simultaneously, Wall Street traders, betting the Federal Reserve will be able to engineer a soft landing, spurred a rally in riskier corners of the market, with stocks hitting all-time highs as 2024 is shaping up to be a remarkable year for markets. US stocks even survived what’s traditionally their toughest stretch of the year, with investors expecting the rally to keep running in October despite a heated lead-up to what appears to be a contentious presidential election, geopolitical tensions, and concerns of a slowing economy. But the relentless pace of gains has some market watchers worried about soaring valuations. According to FactSet, the S&P 500 trades at over 21.4 times forward earnings, well above its long-term average of 18.0 times. Others contend that U.S. equities are expensive for good reasons: low interest rates, strong earnings growth prospects, and capital-saving technological progress (AI) have caused both profits and valuations to rise.
At Telos, we remain allocated to the equity markets as momentum, relative strength, and the overall trend remain bullishly biased. However, we continue to regularly implement risk management protocols, evaluate opportunities, and closely watch the incoming economic data. In the ever-shifting landscape of financial markets, humility and adaptability are as valuable as any metric, because it’s what you know for sure that just ain’t so!
What we do know, however, is that your Telos wealth adviser is always just a phone call away. This might be an opportune time to check in with us to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your time horizon, risk appetite and long-term financial goals.
OCTOBER 2024