Quick Thoughts
It’s a holiday-shortened week where attention is better served on family, friends, and loved ones than flipping through a lengthy word salad on markets from this humble analyst. So, I’m going to keep it short and sweet, but I do think last week’s Fed meeting and market pricing in certain areas represent potential trouble and opportunity.
Last week, the Fed cut the Fed funds rate by 25 basis points, and it has now implemented 100 basis points of cuts since September. However, we are living through an unprecedented event in the archives of financial history. Never before has the Fed cut rates -100 basis points in a three-month time span, and the yield on the 10-year T-note responded with a nearly 100 basis point increase. Jim Bianco put together the chart below, plotting the cumulative change in yield on the 10-year T-note in the aftermath of the rate-cutting cycles going back to the mid-80s. Typicall, when the Fed eased the 10-year yield fell, so what we are seeing is, without question, abnormal.
This move in interest rates so far in this rate-cutting cycle is similar to what investors experienced following cutting cycles in the inflationary period of the late-60s through the early-80s:
However, I hear and read many talking heads assert how easy financial conditions are and that the Fed should be more cautious about future policy moves. Powell himself echoed as much at his press conference last week:
“With today's action, we have lowered our policy rate by a full percentage point from its peak and our policy stance is now significantly less restrictive. We can therefore be more cautious as we consider further adjustments to our policy rate.”
Okay, on the surface, that makes sense. Still, outside of a stock market that has ripped higher for much of the year, I’m having difficulty finding the “easy financial conditions” many prognosticators mention. Most borrowers outside of Uncle Sam borrow at rates that are priced off the 10-year T-note, and this yield has surged since the Fed started cutting. Why? For starters, investors are worried about inflationary pressures resurfacing, and another possible explanation is that Fed guidance on future interest policy has become less clear. It’s comments like this from Powell that speak to the confusion:
“We've reduced our policy rate now by a hundred basis points. We're significantly closer to neutral. At 4.3 percent and change we believe policy is still meaningfully restrictive.”
“We’re significantly closer to neutral,” implies policy is neither restrictive nor stimulative, but in the same breath, he says, “policy is still meaningfully restrictive.” Which is it?
Nevertheless, I’m less interested in proffering any analysis of how to interpret Powell’s comments – I make ignorant and inconsistent comments all the time; just ask my wife and kids. What I do think is important to call investors attention to is how much financial conditions have tightened in the past three months. Agency debt yields are up more than +80 basis points, investment grade credit and mortgage rates are up some +60 basis points, high yield rates have added +50 basis points, and auto loans have firmed +2- basis points. Keep in mind that borrowers finance transactions at prevailing interest rates (which are higher), not spreads (which have compressed). In summary, while the Federal Reserve has cut interest rates at the short end of the interest rate curve, yields on pretty much everything else have increased. This has not loosened policy for anyone but Uncle Sam and the banks, who finance some of their borrowings at these lower short-term rates.
So, the Fed’s intent to cut interest rates to make monetary policy less restrictive has resulted in a cut to an interest rate that is meaningless for the economy on its own – the funds rate is only stimulative if it spills over into other borrowing costs that are actually relevant to Main Street – but higher rates in areas that are meaningful for the economy. Not only that but when the Fed cuts, the dollar usually goes down and gives a shot in the arm to the export sector. Not this time – the DXY dollar index has spiked more than +5% these past three months and has now surpassed all previous peaks, except 1985.
This is where the opportunity lies as the market prices in peak hawkishness following this meeting and the repricing in markets that have already taken shape. With the hawkish shift in both sentiment and price, the Fed has bought itself a lot of room to ease policy through both words and actions going forward. The futures market has all but priced out any more easing from the Fed for 2025. Perhaps one cut is now being discounted. This has been a challenge for bonds, but I would argue that at current prices and yields, the bond market represents a favorable risk-reward for investors. High-quality mortgages, investment grade CLOs, and even emerging market government debt offer investors +6% yields with only a modest level of credit and interest rate risk. It’s been several decades since investors have been able to sock capital away in such a conservative fashion while still generating a real yield above +2%.
I know the allure of +20% returns year after year in the stock market is a tough temptation to pull chips away from, but as I’ve pointed out over the last several weeks in this missive – the expected return profile for the broad stock market at current valuations, sentiment levels and investor positioning don’t fundamentally justify double-digit expected returns. Not to mention the higher financing rates coming down the pipe and a U.S. dollar at multi-year highs – both of which represent a headway to 2025 earnings estimates that are very optimistic at +15%.
That’s not to say that equity prices have to follow fundamentals, but as an investor it’s always easier to put capital at risk when the fundamentals setup as a tailwind rather than a headwind. Take this year as a good case and point for prices not lining up with fundamentals. This time last year, the consensus on S&P 500 earnings growth was $243.5 (EPS) or a +10% YoY expectation. Instead, we seem set for something a bit lower than that – more like $242 for EPS or +8.5%. This time last year, the consensus for the S&P 500 price target was 4,900, and we are now close to 6,000. So, if anything, earnings slightly underperformed expectations, and yet the price of the market topped expectations by well over +20%. And now, virtually all the strategists are calling for 6,500 to 7,000 for 2025. So everyone, even the strategists, are momentum chasers today. Other than needing to play catch-up to the speculators, what was the reason for the strategy community to dramatically lift their price targets even as corporate earnings, at the margin, underperformed initial projections? What happened was that the trailing P/E multiple swelled to 27x from 23x. That was the story: radical multiple expansion.
Bottomline, I think certain areas of the credit market offer a great risk/reward at the moment and represent a nice secure place to stash some capital away without giving up much return potential relative to the equity market. Without question, stocks could put up another double-digit year in 2025, but unless earnings move up in lock-step its only going to make already stretched valuations even more stretched. One last thing, watch the U.S. dollar – it’s a risk for all risk assets at these levels and will apply a lot of pressure to emerging markets.
Happy Holidays to all you loyal readers, we appreciate the support, feedback, and the occasional “you’re crazy” comments. We hope 2024 was a great year for you and your families and wish you good luck on the year to come.
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