Structural Dilemma For Policymakers And Investors
Everything was a winner last week following the soothing message from Powell and the Fed that they ‘got this’. Stocks and bonds were doing very little going into Wednesday’s FOMC policy decision and it wasn’t until Powell started to talk at his 2:30pm press conference that stocks started to really rip. The Dow gained 400 points, the yield on the 2-yr T-bill fell 7 basis points, and gold spiked +1.2% to a new all-time high above $2,200/oz while the DXY dollar index slipped by nearly 0.5%.
On the week, equities were the big winners with the S&P 500 gaining +2.3%, the Dow rising +1.97%, and the Nasdaq Composite ripping +2.86%. Bonds caught a bid as well with yields slipping. Although, treasury yields across the curve are still pushing up against the top of their trading range for 2024. Gold, while moving higher by more than +1% as Powell’s press conference went on, finished the week flat while the dollar ended the week little changed as well.
The breadth of the equity market has broadened out over the past several weeks with the advance-decline line hitting new highs and 8 of 11 S&P 500 sectors either at or above prior record highs. Perhaps surprising to some given the level of attention garnered by the Mag7 and the Tech sector, but Financials, Industrials, and the Energy sectors are all enjoying year-to-date gains of +10%. Another checkmark on the constructive side of the equity breadth ledger is that we now have 180 stocks within the S&P 500 outperforming the index versus 150 last year. Not to mention that investors in the Mag7 have become more discerning between winners and losers as Nvidia (+93% ytd), Meta (+43%) and Amazon (+18%) separate from the pack while Apple (-11%) and Tesla (-31%) fall on tough times.
Back to the Fed as this is where I’m going to spill the bulk of my ink in this week’s missive. Let me first get some near-term housekeeping items out of the way before getting into some meatier long-term structural thoughts. For now, market expectations appear to be correctly repriced for the subtle shift in Fed guidance since the start of the year. Coming into the year markets were pricing in six cuts for 2024 and now are priced for a little less than three cuts. The latest dot plot has a small majority of 10 out of 19 FOMC members calling for three cuts this year whereas 9 expect two or fewer. Furthermore, the swaps market is now pricing in just 71% odds of a rate cut in June and 75% odds of three cuts by the end of the year.
It's the ongoing Fed pause and growing conviction that the next move is a cut that has equity investors excited. And this isn’t out of the ordinary with what history shows. The average gain in the S&P 500 during the traditional pause phase is roughly +10% which pales in comparison to the +17% gain in the S&P 500 since the Fed last hiked in July 2023. Going back to the pre-GFC cycle, Bernanke paused in June 2006 until September 2007 and the S&P 500 rallied more than 19%. So, what we are seeing isn’t out of sync with the typical pause stage of a tightening cycle (although I’ll question the normality of this cycle as you read deeper into this missive), but what history also teaches us is that the economic and equity market problems don’t occur during the pause phase. The problems reveal themselves once the Fed starts to cut rates, and this makes logical sense because the Fed typically cuts when problems arise. Sure, you have the occasional mid-cycle adjustment like we saw in the mid-80’s and mid-90’s, but those have not been the norm.
Rather than compare this interest rate cycle with historical norms, I think it’s more appropriate to contemplate its unique nature. What took most investors (me included) by surprise when reflecting on the Fed’s decision and Powell’s press conference last week was the subtle hints that accepting a higher glide path on the inflation front was acceptable collateral damage for balancing their other objectives – employment and financial stability. Powell wasn’t overly dovish in last week’s press conference, but he most certainly wasn’t hawkish – unwilling to get overly excited about the hotter than expected inflation prints in the first two months of the year while alluding to seasonal distortions and claiming that the path to disinflation was intact.
Ultimately what I think the Fed is doing at this juncture is trying to ‘buy time’ while balancing their Congressional mandates (price stability and full employment) with their third mandate (financial stability). It’s this unwritten mandate that has grown to become more problematic through time as the U.S. economy becomes more financialized and U.S. deficits spiral higher. You don’t hear much about it, but the sclerotic Treasury auctions last October left an imprint on Yellen, Powell, and the brass pulling the strings at the top level of our financial system. Smooth U.S. Treasury functioning sits at the center of this unwritten ‘financial stability’ mandate. As a result, financial market volatility has become a significant variable in the Fed’s decision-making algorithm. When volatility gets too high and threatens the financial stability mandate or increases the risk of a deflationary bust/recession, the Fed reacts with actions or words to dampen volatility back down again. This is what is often referred to as the ‘Fed put’, an option the Fed now has back on the shelf with the fed funds rate back up to 5.25%. The Fed has also shown themselves to go the other way as well when volatility gets too low, complacency runs high, and animal spirits get elevated which heightens the risk of un-anchoring inflation expectations to the upside. The Jackson Hole speech in August 2022 comes to mind.
I thought we were nearing one of these rug pull moments coming into last week where the table was set for Powell to reintroduce some volatility back into markets and humble the rabid animal spirits that have loosened financial conditions to below the levels they were at before the Fed started this rate hiking cycle. Not to mention the threat of a reacceleration in inflation expectations on the back of a broadening wealth effect with the stock market and housing prices setting new all-time highs. Yet Powell and the Fed didn’t push back on any of this which causes me to ponder more seriously the financial stability mandate and the increasing threat of dysfunctional Treasury auctions given the unrelenting rise in U.S. debts and deficits.
Investors need to recognize that we have entered into an era of fiscal dominance that coincides with dysfunctional Congressional leadership that can’t raise taxes or lower spending in an effort to regain confidence in U.S. fiscal responsibility. As a result, the Fed is being drawn into the swamp, knowing that they have become a significant player in expanding or reducing the deficit level depending on what direction they move interest rates. Not raising interest rates, lowering interest rates, and/or keeping asset prices higher (increases tax receipts) all work towards assisting with slowing deficit growth. This applies to central banks all around the globe. Consider the following chart from BofA where global government debt is above $80 trillion and is up $20 trillion since Covid and more than $50 trillion since the GFC. Think about that – global debt north of $80 trillion with more than $50 trillion of that coming in the last fifteen years with interest rates higher today than they have been at any point in the last fifteen years.
As for the U.S., gross Treasury issuance is set to take out the all-time highs reached during Covid – a period where the U.S. was handing out money to virtually anybody with a pulse. No wonder scarce assets are ripping to the upside. Equities, gold, bitcoin, and real estate are all examples of scarce assets relative to U.S. Treasury’s. Think about it this way. U.S. deficits are rising between 6-8% per year which means the Treasury must issue that much more in Treasury bonds each and every year. Compare this to gold where the annual stock of gold increases by less than 2% per year. Or equities where the number of publicly traded companies have almost halved in the last two decades. Or bitcoin which I’m far from an expert on, but I do know (as of now) that only 21 million bitcoins will ever be mined. Scarce assets are doing what one would expect while the world’s reserve currency is being diluted by 6-8% per annum.
I have no interest in going down the rabbit hole of the U.S. losing its world reserve currency status at this moment. Yes, it’s a fascinating and worthwhile conversation, but doing so here and now would dilute the point I’m trying to make and turn this missive into a chapter book rather than 10–15-minute read. However, I think the following long-term charts posted by Brent Johson on X plotting the 5, 10, 20, and 30 year performance of the DXY (white), S&P 500 (blue), Dow (red), Russell 2000 (pink) and Nasdaq (yellow) paint a fascinating perspective for why investors should favor real assets relative to cash over time.
Past 5-year’s
Past 10-year’s
Past 20-year’s
Past 30-years
Bottomline, the willingness of the Fed to cut in this environment (inflation above target, labor market at full employment, and economic growth strong) raises the question of whether the Fed is signaling it is willing to accept above-target inflation outcomes. Investors are not waiting around to find out. Instead, they are taking action with a forward-looking mindset until proven otherwise. Which means you buy/own real assets – equities, commodities, precious metals, and real estate relative to bonds and cash. The former should handsomely outperform the latter over time until/unless the Fed changes course about how much forward inflation they are going to allow. I think central banks around the world and the Fed in particular are aware and rightfully sensitive to the level of outstanding debt around the world, and the increased stress higher interest rates has on the debt carrying capacity of the financial system. Do I wish it was different? Without question, and likely so do you. But it is what it is, so adapt accordingly, and if/when this changes then change with it.
It’s important to understand that such a portfolio composition carries with it increased volatility and risk. Keep that in mind, this isn’t a raging endorsement to go out and pile on risk because 10 and 20 years out your portfolio balance will be higher (though it should be), but a combination of short-term Treasuries/high quality debt instruments combined with equities, real estate and commodities should be favored relative to long-duration nominal sovereign debt.
It's also worth noting that with sentiment at excessively bullish levels and valuations stretched, today is not the optimal time to ramp up risk exposure. Likewise, picking your spots to purge your portfolio of long-duration debt is a prudent exercise. Bonds and interest rates have already recalibrated for a total of three cuts this year (from six at the start of the year), so a fair amount of repricing has already occurred. It’s the risk further down the road of inflation staying elevated, spiraling deficits, and gradual currency debasement that really undermines my confidence in holding long-duration debt. I suspect that if we were to have a recession these instruments would work well for the moment, but it’s hard for me to get a recession outcome with government spending growing at 6-8% per year.
One last point I want to make, none of this is an endorsement to abandon prudence and discipline in your investment decision making. Anyone can take risk in capital markets, managing risk is a whole different ballgame. The structural dynamics of passive investing and runaway deficits have altered principles that we believed to be pillars of investment management and strategy over the past century. I’m not saying they are no longer applicable, but it would be disingenuous to not recognize things have changed. Keep your expectations in check, you can get away with fundamentally unsound investments when everything is going well. It’s when times get tough that we learn who has been doing the homework.
It’s never been easier predicting the past and as smooth as the ride has been over the past five months where the S&P 500 has roared by more than 30% - it was never obvious that we’d be where we are at this moment. Keep in mind, this cautionary tone is coming from a humble analyst that has been constructive on risk assets since yields peaked, the Fed pivoted, and the Treasury issuance mix changed last fall. While I continue to remain constructive, I find myself focusing more on looking for cracks in the “everything is awesome” narrative because the air gets thinner as price outpaces fundamentals.
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