Opportunities In A ‘Good’ Rate Cutting Cycle
Last week’s Fed decision to cut 50 basis points rather than 25 to kick off an interest rate-cutting cycle was music to the ears of equity markets, with most of the major averages rallying more than +1% on the week (the Nasdaq led the charge at a little over +2%). The jumbo cut from the Fed catapulted the S&P 500 through 5,700 and the Dow past 42,000 – new record highs for each. The S&P 500 has registered 39 record closes this year and is approaching a +20% year-to-date gain. If you were aware of nothing other than the scoreboard, you could easily conclude that this thing we call ‘investing’ is a piece of cake. But the science (not the art) part of market analysis reveals that this 20% YTD gain from the S&P 500 is triple the pace of earnings as speculative fervor, structural passive flow dynamics, price momentum, and career risk have become forces as dominate as fundamentals in driving market prices (in either direction). I find it interesting and welcome that the broad equity market is performing as well as it is, with Nvidia’s stock faltering -2.6% last week and undercutting its 50-day moving average in the process.
Chairman Powell did his best to make it clear at last week’s press conference that this 50bps cut should be treated as a non-event or a mere “insurance policy” aimed at achieving a soft landing for the economy. He also did the standard economist double talk; on the one hand, the economy is in “solid” shape, and on the other hand, he referenced the weakness coming through in the Fed’s Beige Book, which revealed that over half the country is either stagnating or contracting. In the end, time will be the ultimate arbitrator on the future path of policy moves, and future economic data unfolds. Powell stressed that downside labor market risks now trump upside inflation risks. We’re all awaiting additional data to determine whether the rapid decline in hiring rates will presage a layoff cycle. He pointed out that the evolution of the data and the economy, not the dot plots, will guide policy. And he repeated over and over the Fed’s “greater confidence” that inflation is returning sustainably to the 2% target. Our analysis continues to show an economy that is decelerating but still much too strong to get too worked up about a recession.
Fed Governor Chris Waller (widely view as one of the most influential voices within the FOMC) put an exclamation point on the shifting view within the Fed on the balance of risk between employment and inflation:
“I just think that inflation is on a lower path than we were potentially expecting. I think inflation is on the right path, as long as we don’t let it get too low.”
It was not all that surprising to see the bond market trade off following the 50 basis point cut given how much interest rates have declined leading up to the decision. The yield on the 10-year T-note is roughly +10 basis points higher than before the cut was announced. Gold welcomed the decision and continued to push higher as it has done much of the year with the yellow metal pushing north of $2,600/oz and up +27% year-to-date.
However, humor me as I introduce a couple of points of sobriety into this ‘everything go up party’:
Both the credit and equity markets are pricing in another 200 basis points of cuts and 18% S&P 500 earnings growth between now and the end of 2025. That’s a high bar for an S&P 500 already trading at a P/E north of 21x on forward estimates (historical average is around 16x). In all fairness, putting a ceiling on what valuation level the S&P 500 can trade up to has been a foolish exercise and bereft of disappointment over the past decade. Nevertheless, investors need to be aware that most asset prices are priced for an environment in some state of ‘nirvana.’ As long as it persists, all should be fine, but be mindful of your risk management strategies when/if it changes.
Last week, we observed pockets of reality setting for several well-run, globally operated companies. FedEx missed on earnings and guided its full-year revenue lower (the stock plunged 15%). Lennar (one of the largest U.S. homebuilders) disappointed on margins due to stepping up its discounting program, and Darden highlighted slowing foot traffic, especially in its fine dining segment.
How the economy performs over the next several quarters will determine the fate of equity prices. We’ve all seen some version of the same chart; if the Fed cuts and the economy doesn’t slip into a recession then stocks are up double digits over the ensuing 12 months. If the Fed cuts and the economy slips into a recession, then stocks are down and, in some cases, down big depending on the depth of the contraction in growth. Right now, the stock market is leaning heavily into this time being the former, and I agree with such an outlook. Still, I don’t think it's an acceptable excuse for analysts not to be highly diligent in checking their blind spots.
For example, last week, we received the August state-level jobs data, which showed that the employment level in 32 states (up from 28 the prior month) is now below the cycle peak. Also, the unemployment rate is up at least 0.5% from the cycle low in 39 states (up from 31 in July). The Sahm Rule has been triggered in 11 states (up from 9 in July). Bottomline, none of this is overly dire, but it does confirm that ongoing deterioration is occurring in the labor market. These trends need to slow and or reverse before they deteriorate much more – which is what the Fed is attempting to achieve with its actions.
Let’s not forget that the BLS revisions through March showed an economy that added 818,000 fewer jobs than originally thought – meaning instead of 2.9 million jobs being created in the twelve months ending March 2024, employers added about 2.1 million. In the interest of piling on let me add one more labor market data point, private-sector job growth gains have slowed to just +96k/month over the past three months, a meaningful slide from +155k at the end of 2023.
All right, Corey, so what are you looking at? What are you thinking about? For me, the labor market remains key, and if this current deceleration in economic activity turns out to be just a ‘growth scare’ and we get a ‘soft landing,’ then job growth should continue to clip along at around +125k jobs per month (+/- 50k). In such a case, I think the most mispriced assets are commodities and resources, which, as of a couple of weeks ago, were priced 70% (my estimate) of the way toward a recession. These assets, along with energy, should bounce back in a confirmed ‘soft landing’ scenario and also provide optionality for portfolios as a hedge against a reacceleration in inflation in 2025. Additionally, I think international equities look compelling given the current setup: 1.) U.S. dollar not a big threat for a significant rally, U.S. interest rates trending lower over time, Fed cut cycling just getting started, all of which provides cover for other central banks to lower rates. Not to mention emerging market valuations are much cheaper on a P/E basis: EEM @ 11x, ACWI @ 17x, and SPY @ 21x (see chart below from BofAML). The last potential kicker is that commodities and international equities (via global growth) benefit from a thaw in geopolitical tensions.
Speaking of energy and resources, the Nuclear Renaissance got another notable confirmation last week with Constellation Energy's announcement that it is going to restart Three Mile Island while inking a contract with Microsoft to send 100% of the power output from the restarted plant to fuel the buildout of its AI data center portfolio.
Anyone doubting the energy demand necessary to fulfill the A.I. future should dig in and peel back the onion a bit, but in the meantime, start with the chart below.
The last thing I’ll hit on is a Goldman Sachs report I reviewed, which called out mid-cap stocks as the best-performing market cap segment when the Fed cuts rates. Going back to 1984, the S&P 400 has outperformed the S&P 500 by +3 percentage points and the Russell 2000 by +8 percentage points in the year after a cutting cycle commences. Mid-caps enjoy more stable and profitable business models than small-caps and offer a better growth/valuation mix than large-cap names, creating a sweet spot in the current macro environment. For comparison purposes, the S&P 500 and the S&P 400 are forecasted to grow earnings by +11% annually over the next three years. However, the S&P 500 trades at a forward P/E of 21x compared to 16x for the mid-cap index. This is something to think about while considering how and where to deploy your U.S. equity exposure.
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