Equity markets rallied strongly to close out the week, with the S&P 500 gaining +4.0%, the Nasdaq ripping +5.94%, and the Russell 2000 rallying +4.36%, while the Dow lagged but gained a respectable +2.60%.  The mood of the market took a decisive turn last Wednesday around 11:00 am when details of a WSJ piece penned by Nick Timiraos "The Fed's Rate-Cut Dilemma: Start Big or Small?" suggesting the Fed is strongly entertaining a 50bps cut at this weeks meeting.  Prior to that news coming out, the S&P 500 was trading down 90 points on the day at just over 5,400, and then it went on to rally 150 points to close out the session at 5,554.  We'll see what the Fed actually does on Wednesday (more on this below), and while the S&P 500 is back near its all-time highs, it really hasn't done much but chop around for the last two months, unable to break to a new all-time high.   

What has been a constructive development since the July 16th high is watching stock market breadth broaden out, with 10 of 11 sectors in the green last week (energy was the only laggard).  However, it remains to be seen if the S&P 500 can move meaningfully higher on improving breadth alone, given that technology makes up more than 30% of the index.  If the dollar were to continue to weaken as the Fed pivots to a more dovish stance relative to other central banks around the world, perhaps foreign markets, for the first time in over a decade, might be poised to outshine U.S. markets for a window in time. 

Sector Weights of Major Indices:

Like equities, Treasuries, which move inversely to interest rates, continued their strong run, with the yield on the 10-year T-Note slipping to 3.65% despite what was hotter than expected inflation data reported last week.  Gold, which has been strong for most of the year (+24% ytd), understands where the puck is going, with the yellow metal breaking out to a new record high above $2,600/oz as it gained nearly +3.5% last week.  Lower interest rates and a falling dollar are music to the ears of the precious metals complex.

Back to the Fed for a moment and the dilemma it has created for itself and markets.  The Fed's most recent dot plot had the central bank easing just 25 basis points by year-end (with three meetings left), whilst the futures market is currently priced for more than 100 basis points of cuts.  The fact that the yield on the 2-year T-note (3.55%) is trading nearly 180 basis points below the Fed Funds rate is the market's way of showing the Fed how much it thinks they are behind the curve.  The following chart from Ed Yardeni plots the Fed Funds rate against the 2-year Treasury yield in which two things stand out: 1.) they track closely over time, and 2.) the 2-year Treasury yield leads the Fed Funds rate in both directions (up and down)

Put me in the Bill Dudley camp (former President of the New York Fed) that 50 basis points should be how the Fed kicks off this cutting cycle. 

THE FED SHOULD GO BIG NOW AND I THINK IT WILL: BILL DUDLEY

"A 50-basis-point cut would also fit well with the Fed officials next set of economic projections, which they will publish this week. Markets are expecting a total reduction of at least 100 basis points by the end of 2024. If the Fed does only 25 now and projects another 50 at its next two meetings this year, it will send a hawkish signal. If it does 25 and projects more than 50, people will wonder why it isn't cutting more immediately. The larger cut thus helps the Fed get out of this predicament."

Well, between Timiraos and Dudley, the probability of a 50bps cut on Wednesday has risen above 60% from sub-30 % at the start of last week.  But here in lies the dilemma for asset prices: stocks are near all-time highs, interest rates across the curve have priced in more than 200 basis points of cuts over the next twelve months, and the U.S. dollar is falling – it's already priced in.  What can Powell and the Fed do or say this week that won't upset the apple cart?  I'm not insinuating that I'm bearish, but rather that I have a hard time imagining what scenario drives much upside to asset prices as they are currently priced.  Some markets are going to be disappointed, and that will cause ripples to other markets in time.  Moreover, investors with an intermediate to longer-term time horizon should not lose sight of why the Fed is cutting: growth is slowing, inflation is falling, and policy is presently restrictive.  Historically, when the Fed has been this far behind the curve in a cutting cycle (2-year T-note yield < 150 basis points below Fed Funds), the outcome for the economy and risk assets hasn't been kind (see chart below – grey bars notate recessions). 

I know this time is different, and in some ways, I agree, and in other ways, I have a hard time being quickly dismissive of what history has shown us.  The S&P 500 trading at a P/E of 21x on forward earnings is fully priced for the Goldilocks outcome.  That doesn't mean the big bad bear will surely come next, but it does require things like growth, earnings, jobs, and inflation to trend in a fundamental direction, confirming current and higher asset price levels.  We already see elements of this cycle's 'pushing on a string' reaction function.  Even before the Fed has executed its first rate cut, mortgage rates have declined more than -1.5% from last October's peak to 6.3%, and yet mortgage applications for new home purchases have barely budged – activity levels are bouncing around three-decade lows.  This causes you to wonder how stimulative rate cuts will be, just as we've been surprised at how well the economy handled the most aggressive rate hiking cycle in four decades.    

One area where lower rates will have a constructive impact will be on Uncle Sam's wallet where we learned last week that the budget deficit is set to threaten the $2 trillion mark as we close in on the end of the 2024 fiscal year.  For the first time in 65 years, U.S. interest expense is greater than defense spending.  The archives of history show that those countries functioning as the world's reserve currency have not retained such privilege when a hegemons debt service persisted above its defense spending.  Will this time be different? Probably, and is as good a reason as any why investors with longer-term time frames should favor real assets (stocks, gold, commodities, and real estate) over financial assets until these trends change (if ever).     

When digging into the federal deficit, two things stood out to me:

1. Income taxes (individual and corporate) now fund less than 50% of government spending.

 2. The deficit isn’t as much a problem of deficient revenues as it is a problem of unchecked spending.  Federal government receipts are at an all-time high and about at their ceiling as a % of GDP, but even then, they have been unable to keep up with spending.

I don't have much analysis or actionable advice to offer regarding the deficit other than to acknowledge that at some point, it will be a problem that markets, and society will have to contend with, but when and at what level is unknowable. So, keep a watchful eye on it, but don't allow it to dominate your investment strategy, as it has proven thus far not to be very actionable. 

As for some final thoughts, as I close up this week's missive.  Starting today through October 9th is the worst seasonal period of the year for the S&P 500 and Russell 2000. Moreover, I think markets across the board are priced for a dovish outcome at this week's Fed meeting.  If anything, I think there is more room for disappointment than a positive surprise, but as long as the S&P 500 can hold in above its rising 200-day moving average (currently around 5,200) through the election then I think we can get a pretty solid push higher to new all-time highs by year-end.  One area that's looking interesting of late is the energy sector and oil companies in particular.  Sentiment and positioning are nearing negative extremes, with the CFTC data reporting the first negative short position among money managers since the data first began being published in 2011.  I'm not in the camp that says oil prices will shoot back above $80/bbl in the near future, but there are several high-quality operators in the space that generate solid cash flow with oil prices hanging around the $70/level.     

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