Charts for the Week
Soft Landing | Have we arrived?
November 18, 2024
The incoming economic data continues to be generally good, and last week the Chair of the Federal Reserve indicated that policymakers are not in a rush to cut rates further. If the Fed has successfully brought inflation to heel without a recession, then it may be closer to being done lowering short-term rates than investors suspected just a few weeks ago, and long-term rates may have further to rise.
In the mid-90s, when the Fed last engineered a soft landing, it only reduced its target overnight interest rate by 0.75 percentage points as the economy and markets remained strong. Thus far this time, the Fed has once again eased by 0.75 percentage points, but policymakers are inclined to go further even though the economy seems to be growing steadily, inflation remains above their target, and asset valuations are at historical extremes.
Before fully declaring success, policymakers likely want to see the labor market stop losing altitude with each passing month. No matter what the labor market does, sticky inflation could get in the way of significantly more monetary easing. Although, the powers-that-be have gotten good at explaining away recent inflation as a never-ending series of one-off events that can be disregarded.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
New Old Regime | Same enduring challenges
November 11, 2024
Last week was a good one for the stock market. The election was clearly decided before the next business day even began eliminating concerns of a contentious, prolonged battle, and the Fed continued to ease monetary policy by lowering its target overnight interest rate another quarter percentage point. The reduction in uncertainty, the potential for more corporate-friendly government policies, and looser monetary policy boosted the broad market indexes to new all-time highs.
The market reaction to the election was not uniformly positive. International stock markets were subdued as clouds formed over the future of global trade, and long-term interest rates initially spiked higher on concerns about what the new administrations’ policies might mean for the federal debt and inflation. Inflation expectations have been creeping back up even as the Fed has essentially declared victory. Investors have at least begun to hedge how far and fast they think the Fed will cut rates which is a combination of greater confidence in the economy and fears about inflation.
As for the US stock market, the pre-election exuberance was already a tall order to meet before last week’s melt-up. The new administration faces enduring challenges for which there are no easy solutions. When that reality hits home, investors will likely have to recalibrate their expectations. Until then, irrational exuberance can continue to unduly escalate asset values (to borrow Alan Greenspan’s turn of phrase).
Source: YCharts, https://fred.stlouisfed.org/ , www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html, AOWM Calculations
Election Year | Uncertainty that markets love?
November 4, 2024
In theory, uncertainty should increase risk premiums and serve as a headwind to asset price appreciation. However, leading into a highly uncertain election, the stock market has soared. Through October 29, the S&P 500 had returned nearly 44% over the past year which is in the top 2% of annual returns since 1950. Even after cooling slightly in recent days, the market is still having its best year leading into a presidential election in modern history.
While the strength of the rally is surprising, most election years have not been bad for the market. Indeed, valuations have risen over the year preceding a presidential election far more often than not. They have certainly done that again this go-around with the valuation of the S&P 500 stretching to historical extremes.
The strength of the stock market does not tell us much about who will win the election, but whoever does win will inherit market expectations that will be challenging to meet.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
The Fed | Getting ready to pull the other lever?
October 28, 2024
Since the Fed’s rate cut of 50 basis points last month, the case for swiftly easing monetary policy has faded pushing up long-term rates and quickly steepening the yield curve. While the market is still priced for further rate cuts in the coming months, lowering the Fed’s target overnight interest rate is not the only lever policymakers have to pull. In the age of supersized central bank balance sheets, when to cease shrinking the Fed’s holdings of US Treasury debt and mortgage securities is another key policy decision.
The Fed slowed its Quantitative Tightening earlier this year but has continued to reduce its balance sheet even as it has shifted to lowering interest rates. Reverse Repurchase Agreements (Reverse Repos) have been the primary liability on the Fed’s balance sheet that has declined over the past year in step with the decline in the Fed’s assets. After peaking at $2.4 trillion, the Fed’s reverse repos are now down to $258 billion – the lowest level since May 2021.
In a reverse repo, money market funds and other market participants loan money to the Fed using the Fed’s Treasury holdings as collateral. As a result, the decline in the Fed’s reverse repos is driven by market participants moving their money into more traditional US government debt (which the Fed is no longer buying as much of as it shrinks its balance sheet), so there is little potential for market or economic disruption. However, as reverse repos dwindle, further reductions in the Fed’s balance sheet are likely to start reducing bank reserves which has a greater risk of upsetting the delicately stacked apple cart.
Stopping the reduction in the Fed’s balance sheet could also ease some pressure on long-term interest rates which have thus far counteracted the Fed’s initial move to ease monetary policy. Thus, for many reasons, an announcement that lays out the Fed's plans for winding down its Quantitative Tightening seems likely before the end of the year. If so, the Fed’s balance sheet will once again be left far larger than it was before the crisis that precipitated its massive expansion – a decision that is not without its own perils.
Source: YCharts, https://fred.stlouisfed.org/ , www.fdic.gov/quarterly-banking-profile/fdic-quarterly-banking-profile-archived-issues , AOWM Calculations
Federal Finances | Precariously profligate
October 21, 2024
Last week, the US Treasury reported that the federal government ran a deficit of $1.8 trillion for the 2024 fiscal year that ended in September. As a percentage of the nation’s economic output, the federal deficit remains elevated at approximately 6.5% of GDP despite solid economic growth and low unemployment. High structural deficits driven by the increasing costs of mandatory spending, such as Social Security and Medicare, have been compounded over the past couple of years by the rising net interest expense on the burgeoning federal debt. More than 27% of the federal budget last year was paid for with borrowed money.
Over the past three years, the federal debt held by the public has increased by roughly $2 trillion each year which has pushed the national debt back towards 100% of GDP. Without a change in policy, the federal debt is expected to continue swiftly growing relative to the size of the economy even if economic growth remains strong. Interspersing a mild recession at some point over the next decade would only exacerbate the problem that is hindering the long-run growth potential of the economy and risks engendering higher inflation and/or interest rates. And a deeper economic downturn could find the federal government without the flexibility to respond like it did after the financial crisis in 2008 and the pandemic in 2020 given the current size of the debt.
Despite the clear and present risks posed by the state of federal finances, little care is being paid to the issue (and in many ways the opposite). Even though the net interest expense on the federal debt as a percentage of GDP has rocketed back to where it was in the 80s and 90s when there was significant societal anxiety about the deficit, the issue is absent from the national dialogue today. That is likely to remain the case until either the financial markets focus the minds of Congress, or the electorate no longer views profligate federal finances as a free lunch.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.cbo.gov/data/budget-economic-data#3 , AOWM Calculations
Investor Sentiment | Too hot?
October 14, 2024
CPI inflation came in higher than expected in September, but that did little to alter the narratives driving the stock and fixed income markets. Bond investors still anticipate the Fed will ease monetary policy aggressively over the next year, and stock investors still see nary a cloud in the sky.
Even if the economy has entered a Goldilocks state, the current enthusiasm for equities risks being dangerously hot. The nation’s Financial Accounts indicate households are allocating a record amount of their financial assets to stocks. In addition, the number of investors professing concerns about the market’s prospects has dwindled, and the options markets - which investors increasingly use to lever their bets - remain largely priced for the good times to keep on rolling over the next year. Such lopsided positive sentiment has often been followed by weak returns.
One potential sign that some investors may be starting to grow a little wary of the stock market’s run to ever higher valuations is the uptick in the “fear” index of expected market volatility over the next 30 days even as the S&P 500 has hit several new all-time highs. But that may be driven more by concerns around the upcoming election than actual fears of a market downturn. If the uptrend in the VIX index continues through earnings season and past the election, that will be a more telling warning about the strength of investors’ animal spirits.
Source: YCharts, https://fred.stlouisfed.org/ , www.minneapolisfed.org/banking/current-and-historical-market--based-probabilities , shillerdata.com , www.aaii.com/sentimentsurvey/sent_results , AOWM Calculations
Economic Data | Positively surprising
October 7, 2024
Recent economic data has been surprising on the high side, suggesting the economy is holding up well. That positive data includes the latest jobs report in which the unemployment rate declined for the second month in a row to 4.1% in September and employers added more jobs than expected. With the labor market appearing stronger than feared, long-term interest rates increased last week, and investors pared back expectations for Fed rate cuts.
While it is the market’s nature to react to every bit of news, the jobs report is inherently volatile, especially the payroll data which is subject to significant future revisions. Little in the report clearly changed the picture of a labor market that is oddly stagnate – neither really expanding nor shrinking. The year-over-year growth trend in the payroll data is still slowing, and the internals of the Establishment Survey remain full of cautionary signals – e.g., the decline in the number of temporary workers persists, and a large percentage of the job gains over the past year have been generated by the government and private education & health services sectors (historically an indicator of economic weakness). The Household Survey also continues to show no growth in total employment over the past year and shrinking full-time employment.
Nevertheless, the recent economic data supports expectations for solid earnings growth in the third quarter. Beyond that, continued economic strength will be essential for companies to achieve the anticipated growth in profits over the next year; even then, it may not be enough to fulfill the hopes and dreams imbedded in the stock market’s current valuation.
Source: YCharts, https://fred.stlouisfed.org/ , www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , AOWM Calculations
Bean Counters | Find some missing beans
September 30, 2024
The economic data has been confusingly conflicting for some time. The Bureau of Economic Analysis (BEA) fixed part of that problem last week with its latest annual update of the National Economic Accounts. Gross Domestic Income (GDI) had been indicating a less robust economy than Gross Domestic Product (GDP) with the statistical discrepancy between the twin measures of the economy having grown to a historically wide level. The BEA reconciled that by unexpectedly – and not particularly explicably – increasing its estimate of GDI by a historically large amount.
GDP and GDI now tell a consistent story of an economy growing briskly. With the unemployment rate still low (if rising) and inflation falling (if still higher than desired), the economy appears to be in a goldilocks state, which could support the strong earnings growth baked into current stock prices.
And yet, fixed income investors still expect deep interest rate cuts by the Fed over the next year - which would be odd if the latest revisions to the National Accounts are accurate. Consumer sentiment also continues to languish at an unusually low level given the apparent strength of the economy, and employment growth is incongruently low for an economy reportedly growing above its long-run potential. All the mysteries have not been solved and in some ways have been made more mysterious by the new uniformity of the GDP and GDI data. We but see in a mirror dimly.
Source: YCharts, https://fred.stlouisfed.org/ , www.bea.gov/data/gdp/gross-domestic-product , https://data.sca.isr.umich.edu/ , AOWM Calculations
Asset Prices & Monetary Policy | Unspoken dilemma
September 23, 2024
On September 18, 2024, the Fed lowered its target overnight interest rate from 5.33% to 4.83% after having held rates steady for nearly 14 months. On September 18, 2007, the Fed lowered its target rate from 5.25% to 4.75% after having held rates steady for a little more than 14 months. Central bankers are clearly not afraid of letting the present more than rhyme with an unpleasant past.
Given the ineffectiveness of historical analogs to predict anything in recent years, policymakers likely feel they are safe. In fact, while their first 50 basis point move was on the high side of market expectations and they increased their anticipated pace of rate cuts in coming months, Fed officials remain more sanguine than fixed income investors who continue to project recession-esque monetary easing taking the fed funds rate below 3% over the next year. Far from forecasting a recession, policymakers foresee tranquil sailing for the economy with steady 2% growth over the next few years accompanied by a stable unemployment rate and inflation close to their 2% target. The odds of the future being so perfectly placid are low.
Whether the monetary powers-that-be are overstimulating a strong economy or trying to prop up a stalling one, time will tell. There is ample data to support both possibilities. Over the past three decades, employment growth has never been as weak and GDP growth has never been as strong at the start of a Fed easing cycle as today. Also on the side of potentially overheating, though policymakers are rarely quizzed about it these days, asset valuations have never been so uniformly elevated as they currently are when the Fed has begun reducing rates in the past.
Volumes have been written on whether central bankers should take asset prices into account when setting policy. After forty years of market friendly monetary policy, the question is assumed answered. However, the dilemma still exists even if it is left unspoken. While policymakers are ill-advised to attempt to use monetary policy to normalize elevated asset valuations, ignoring frothy market conditions is also questionable.
Source: YCharts, https://fred.stlouisfed.org/ , BLS , shillerdata.com , www.federalreserve.gov/monetarypolicy.htm , https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html , AOWM Calculations
Game-time Decision | Unusual Fed uncertainty
September 16, 2024
Emergency actions aside, usually before Fed policymakers act, they have molded market expectations sufficiently that there is minimal surprise. When the Fed announces its next move on Wednesday, the consensus firmly anticipates a reduction in the target overnight interest rate, but the size of the cut is uncertain.
Perhaps policymakers themselves don’t yet know whether they will reduce their target rate by 25 or 50 basis points. The economic and market data are full of sufficient incongruities to justify making it a game-time decision. However, the size of the initial move is unlikely to be as important to investors as policymakers’ revised projections for the fed funds rate over the next year.
Back in June, policymakers expected to make only one 25 basis point cut this year and for the fed funds rate to still be above 4% by the end of 2025. Investors are currently expecting the overnight interest rate to be below 3% by the end of next year - a velocity of monetary loosening typically only seen during a recession. Needle-threading policymakers will likely project faster rate cuts than they did in June but fewer than the market is expecting in the hopes of not raising suspicions that their soft landing is in doubt.
Source: YCharts, https://fred.stlouisfed.org/ , BLS , https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , www.philadelphiafed.org/surveys-and-data/real-time-data-research/survey-of-professional-forecasters , AOWM Calculations
September | Mr. Market's seasonal mood
September 9, 2024
September is the only month for which the stock market has a losing record. After the first week of the autumnal transition, stocks are not off to a good start for improving that winning percentage this year. Markets are pulling back for the second time in as many months on renewed concerns about the economy and fears that sky-high AI expectations may be too optimistic.
Whether this proves to be merely another seasonal mood or a more prolonged correction will depend on how justified those concerns and fears prove to be. While the Fed will very likely begin lowering its target overnight interest rate next week, economic activity still seems poised to slow in the coming quarters which may make lofty profit expectations hard to achieve.
Following the jobs data released last week, leading indicators and prevailing trends continue to point towards further weakening. That has been true for a long time as the slowdown in the labor market has proceeded at a deliberate pace over the past two years; however, downward momentum is building into a fragile environment.
Source: YCharts, https://fred.stlouisfed.org/ , BLS , AOWM Calculations
Yield Curve | Shifting from watch to warning
September 2, 2024
Last week, for the first time in over two years, the yield on the 2-year Treasury Note fell below the yield on the 10-year Treasury Note. If the inversion of the yield curve is the equivalent of a weather watch for the economy, the reversion of the yield curve to its normal upward sloping shape has historically been the warning of imminent storms.
The yield curve – the line drawn through the interest rates of US Treasury securities with different maturities – is primarily a reflection of expectations for future monetary policy. It is currently indicating a level of monetary easing over the next year that would be unlikely absent a downturn in the economy.
The behavior of the stock market and recent GDP data are greatly at odds with that outlook. However, the latest estimates of Gross Domestic Income and the labor market paint a picture of a weaker economy that could justify expectations for looser monetary policy. In addition, net domestic savings has now remained negative for six straight quarters - a persistent imbalance that will impede economic growth in the coming years.
The early warning signals for the economy are even less precise than those for the weather but still worthy of attention.
Source: YCharts, https://fred.stlouisfed.org/ , BEA , AOWM Calculations
Rate Cuts | The time has come
August 26, 2024
In a speech last week, the Chairman of the Federal Reserve, Jerome Powell, seemed to all but guarantee a reduction in the overnight fed funds rate when policymakers next meet in September. Additional inflation and labor market data will supposedly determine how big the September cut will be and how quickly more cuts will follow. The Fed has already let the labor market weaken more than it has done in recent decades before cutting rates, but inflation also remains higher than it has been historically when the Fed has started to loosen monetary policy.
Before Powell spoke last week, the Bureau of Labor Statistics released its preliminary annual benchmark revision to the March payroll estimate which provided further evidence the labor market is slowing to a crawl. Payrolls in almost all sectors were revised lower, and total payrolls were estimated to be 0.5% smaller in March than previously reported. Given the further deceleration of the labor market in recent months, Fed policymakers are likely growing anxious that the lagged effects of tight monetary policy are beginning to be felt despite other data showing the economy remains strong.
Higher-than-desired inflation may keep the Fed from aggressively reducing short-term rates as long as the economy generally appears healthy. A clearly weakening economy would provide policymakers with the rationale for faster rate cuts even if inflation remains above the Fed’s target and could also provide the cover for an ultimate acceptance of higher long-run inflation - which seems almost inevitable given the fiscal challenges facing the federal government.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.bls.gov/web/empsit/cesprelbmk.htm , https://www.bls.gov/web/empsit/cesbmkarch.htm , AOWM Calculations
Profit Margins | Good news, bad news
August 19, 2024
Annual CPI inflation in July fell below 3.0% for the first time since March 2021, providing fresh support for the soft-landing narrative. The financial markets are now pricing in rapid, deep cuts in the fed funds rate (typically only seen if the economy is entering a recession) and swift growth in corporate profits. For the earnings expectations to be accurate, investors will likely need to once again be proven overly aggressive in their rate cut forecasts.
Earnings growth expectations also continue to appear aggressive in their own right even if the economy remains healthy. Earnings for the S&P 500 have trended sideways for the past three years but are anticipated to resume a strong uptrend in the coming quarters based on profit margins trending higher as well.
Corporate profit margins were a relatively stable, mean-reverting variable during the second half of the last century. However, over the past several decades, corporate America has enjoyed having an increasing amount of revenue fall all the way to the bottom line. It is a trend that would seem unlikely to continue with the tailwinds of declining interest rates and lower taxes having abated.
The good news for investors is that margins may not revert to their 20th century level. The bad news is that may be because higher margins have been justified by the downshift in economic growth experienced over the past 25 years. If the owners of capital are not compensated with growth, they in theory may take a larger piece of the economic pie to achieve their target returns.
Investors are prone to extrapolate the recent trend in profit margins ever higher and to use that growth to justify higher valuations. But if the move to elevated profit margins has been the result of the transition to a slow growth world, margins will not continue to expand (unless economic growth grinds even lower), and valuations may be more stretched than history would suggest.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , https://www.hussmanfunds.com/research/rs240805/ , AOWM Calculations
Global Financial Markets | Signs of fragility
August 12, 2024
The financial markets suffered a brief spasm of concern last week. Continuing the selling pressure from the previous week, global equity markets sold off last Monday with the Japanese stock market down over 12% for the day. Credit spreads on corporate debt began to increase, and the expected volatility in the US stock market spiked to levels only seen during the financial crisis of 2008 and the pandemic. By Friday, however, things had largely returned to where they were before the week began.
On top of the weak jobs report in the US, the apparent spark for the excitement was the Bank of Japan which boldly raised interest rates by 0.15 percentage points, indicated more small hikes may be in the offing and laid out a plan to begin slowly reducing its enormous balance sheet. Real, inflation-adjusted interest rates in Japan are still deeply negative as its monetary policy remains highly accommodative; however, the rate hike was not fully expected by the market and clearly surprised some investors who were counting on Japanese interest rates remaining near zero. Policymakers in Japan quickly provided assurances that they would not be overly hasty in making policy less accommodating if volatility persisted, which calmed the market tantrum.
Central banks around the globe have spent the past several decades suppressing market volatility as much as possible. As last week’s rollercoaster suggests, investors are still betting on them being able to do so going forward. And yet, the recent events in Japan may be an early indication that won’t be the case as central bankers are increasingly caught between a rock and a hard place (partly of their own making) that will prevent them from trying to make every crooked path straight.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.global-rates.com/en/interest-rates/central-banks/9/japanese-boj-overnight-call-rate/ , https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2024/index.htm , AOWM Calculations
Recession Fears | Reawakened
August 5, 2024
Two weeks ago, good GDP and inflation reports offered more hope the Fed would avoid tipping the economy into a recession in its battle to rein in rising consumer prices. Just a week later, markets were gripped with renewed concerns about the strength of the economy as the unemployment rate ticked higher for the fourth consecutive month.
As expected, policymakers at the Fed did not lower their overnight interest rate last week but affirmed that they are inclined to do so in September. The stock market initially met that with enthusiasm. Then the jobs report fostered fears that the economy may be weakening faster than the Fed or investors anticipated.
In general, the labor market appears healthy. Payrolls continue to grow, and the unemployment rate remains historically low; however, the trend is negative and suggests the economy is weaker than the GDP data implies. Long-term Treasury yields plunged back to where they were at the end of last year when investors were expecting the Fed to aggressively cut short-term rates this year. That expectation has been revived, but this time with concerns the Fed’s actions may be driven more by a weak economy than benign inflation.
Source: YCharts, https://fred.stlouisfed.org/ , Google, AOWM Calculations
The Fed | To cut or not to cut?
July 29, 2024
Fed officials will meet again this week to contemplate the future direction of monetary policy. The consensus is policymakers will lay the groundwork to begin lowering their target overnight interest rate when they next meet in September. However, a muddled economic picture may prevent them from significantly reducing rates in the coming months even if an initial cut is made in a few weeks.
Weighing in favor of beginning to loosen monetary policy is relatively benign inflation over the past quarter and a weakening labor market. On the other hand, GDP growth appears to be accelerating, inflation remains above the Fed’s 2% target, asset valuations remain elevated, and the current fed funds rate is not excessively restrictive. Thus, the Fed risks another wave of high inflation if it loosens too much too soon.
Policymakers always aim for a soft landing but rarely achieve it because deciphering the direction of the economy in real time is not easy. That is perhaps even more true today than in the past.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Consumers | Beginning to align words and deeds?
July 22, 2024
With the commencement of earnings season, investors' anxiety is again on the rise. Expected market volatility, as implied by options on the S&P 500 Index, spiked higher last week. Earnings reports so far have been generally positive, but it is early, and investors may place more importance on how management teams feel about the rest of the year when earnings are forecasted to grow quickly.
Early indications from management conference calls suggest that consumer spending is slowing. A slowdown has been anticipated for a long time, but consumers have kept on spending despite expressing a dour outlook when surveyed. A softening labor market, dwindling pandemic savings, and high inflation may be starting to align consumers’ words and deeds.
Leading economic indicators also continue to decline and portend an economic slowdown. However, that has also been true for the past two years, and the pace of decline in leading indicators is slowing while current economic data remains largely "resilient". Thus, if there is a recession in the near future, it may be a mild one. But, much as was the case after the market peak in 2000, that may not save an overpriced market - at least not the headline, market-cap-weighted indexes. If the economy keeps motoring, the large portion of the stock market that has been left behind by the mega-cap stocks could shine as they did after the dot-com bubble and once again highlight the long-run benefits of slow and steady.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.conference-board.org/topics/us-leading-indicators , AOWM Calculations
Inflation | Pressing against the glass floor again
July 15, 2024
Inflation cooled in June, falling back to 3% on a year-over-year basis. Annual CPI inflation fell to 3% last June as well, but the Fed’s fight against inflation has failed to make any progress below that level. A couple more good monthly inflation reports that break through the 3% glass floor will likely provide Fed policymakers with sufficient good news to start reducing their target overnight interest rate. That is the clear market expectation as investors fully priced in a Fed rate cut in September after the CPI report last Thursday.
As has happened a few times over the past year, future inflation could once again disappoint optimistic expectations, nevertheless the stock market showed encouraging signs of a broadening rally beyond the mega-cap stocks on hopes of lower inflation and interest rates. If that is to continue, earnings growth will need to broaden as well. The upcoming quarterly earnings reports will be a telling sign of whether that is occurring.
Ironically, as the Fed approaches beginning to loosen monetary policy, the headwind of higher net interest expense for businesses may just be starting to pick up which could hinder earnings. Historically, net interest expense does not peak until well after the Fed has begun cutting its target rate. In aggregate, corporate net interest expense remains well below where it was before the pandemic and before the Fed started raising rates in 2022; however, as companies continue to refinance their debt in a normalized interest rate environment, interest expense will only grow from here. And if the Fed lowers short-term rates, companies with large cash holdings will see their earned interest decline, further pushing the aggregate net interest expense higher as well. The “lagged” effects of monetary policy may yet actually turn out to be just lagged and not non-existent.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Mega-caps vs The Rest | Tails you lose, heads I win
July 8, 2024
In June, the unemployment rate increased for the third consecutive month for the first time since 2016 and ticked above 4% for the first time since late 2021. The news rejuvenated investors’ hopes that the Fed will start lowering its target overnight interest rate in September. This should have bolstered the prospects for the mid-cap and small-cap stocks that would likely benefit most from lower short-term rates and a soft landing for the economy. It did not. Instead, the mega-cap stocks continued to rally, and the rest continued to struggle.
Lower long-term interest rates would help in theory to justify the high valuations of mega-cap growth stocks based on earnings well in the future. However, given how inverted the yield curve is, the Fed would have to significantly reduce the fed funds rate before long-term rates would be much affected, and that won’t happen any time soon without a recession for which the market is not priced.
More than the jobs report or expectations about the Fed’s future rate moves, momentum is likely the primary driver of the market these days, and the mega-cap stocks currently have that in spades. But that can change quickly.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
2024 Predictions | Mid-year update
July 1, 2024
At the start of the year, expectations were for inflation to continue its descent, the labor market to normalize smoothly, the economy to slow but avoid a recession, the Fed to begin swiftly lowering interest rates, and the stock market to respectfully digest its high valuations with modest gains and rapid earnings growth. Halfway through the year, the economy is largely on its projected path, but surprisingly inflation and the stock market have both come in hotter than expected.
High inflation in the first half of the year has led policymakers to reduce expectations for rate cuts this year. Even though lower inflation and lower interest rates were part of the narrative driving stocks higher last year, the reversal of those expectations has not kept the headline S&P 500 Index from leaping past the most optimistic outlooks for the full year after merely six months. However, market prognosticators were not completely wrong as the market has reached historic levels of concentration and most stocks have significantly lagged the headline index.
A lot of hope is still riding on the second half of the year, especially for corporate profits which are anticipated to accelerate over the next two quarters. If earnings come in as forecasted, the non-mega cap stocks may rally to catch up with their ginormous brethren. If they don’t and the economy sputters, things could get rocky for even the largest glamor growth stocks.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html , AOWM Calculations
June 24, 2024
While the lack of breadth in the market’s advance beyond the mega cap growth stocks is a potential warning sign, various indicators of investor sentiment remain strong, which could be its own omen. According to the Federal Reserve’s estimates of the nation’s Financial Accounts, households ended March with their allocation to equities back to the record level reached in the fourth quarter of 2021, and a recent Gallup poll also found the percent of individuals invested in stocks has risen to the highest level since 2007. Other surveys of individual and institutional investors show similar above average equity allocations along with sanguine outlooks for the market.
The momentum of the moment that made Nvidia the most valuable company for a brief moment last week may keep the market spiraling upward. There are fewer and fewer investors brave enough to bet against that. And valuations may yet revisit the craziest highs seen in the past or even surpass those levels. The short-term direction of the market is challenging to predict. What can be said with some realistic optimism and confidence is that in the long run stock prices will rise, but current lofty valuations will depress market returns below their historical norm over the coming decade.
The horizon is a reliable guide by which to chart your course, and focusing on it has the added benefit of alleviating market-induced seasickness.
Source: YCharts, https://fred.stlouisfed.org/ , shillerdata.com , https://news.gallup.com/poll/645107/stocks-gold-down-americans-best-investment-ratings.aspx , AOWM Calculations
The News | In the eye of the beholder
June 17, 2024
Despite a good CPI inflation report for May, policymakers did a reverse pivot last week, increasing their expectations for inflation and decreasing their outlook for interest rate cuts this year. Bond investors generally seemed to believe the good inflation data more than the Fed’s forward guidance as market expectations for cuts in the fed funds rate ticked higher and long-term interest rates declined to the lowest levels in three months.
In the stock market, the news was well received by the mega cap stocks, but less so by the rest of the market. The three largest stocks – Microsoft, Apple and Nvidia – all ended the week with valuations north of $3.2 trillion as the level of concentration in the stock market has reached record levels. Short-term interest rates staying higher for longer is a bigger fundamental headwind for smaller companies than it is for the market juggernauts flush with cash. At the same time, falling long-term rates help to justify lofty valuations.
The tech giants can’t seem to lose these days, but betting against concentration - and the encapsulated human biases - is still the likely long-run winner.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.marketinout.com/chart/market.php?breadth=advance-decline-line , Federal Reserve, BLS, AOWM Calculations
The Fed | Not expected to follow the crowd... yet
June 10, 2024
The central banks in Canada and Europe both lowered interest rates last week for the first time since the post-Covid global tightening of monetary policy began in 2022. Several central banks around the world have started to ease policy this year. The US is still expected to follow suit before the end of the year, but a stronger than expected jobs report on Friday pushed the consensus view back to anticipating just one 0.25 percentage point cut in November or December.
Some still think that the Fed will lay sufficient groundwork at its meeting this week to prepare the market for an initial rate cut at the end of July. As has been the case for months, the jobs report had enough cautionary findings to potentially warrant loosening monetary policy if inflation behaves.
Despite the strong increase in payrolls reported by the Establishment Survey, the Household Survey continued to paint a picture of a weakening labor market with the unemployment level trending higher and the number of individuals employed full-time trending lower. The unemployment rate increased to 4%, ending its streak of 27 straight months below that level.
While policymakers may desire to follow the pack and lower rates, the Fed may be forced to keep rates higher than other countries to offset the large fiscal deficits being run by the federal government which are significantly larger than in other developed countries and a likely contributor to sticky inflation.
Source: YCharts, https://fred.stlouisfed.org/, BLS, www.global-rates.com/en/interest-rates/central-banks/, www.economist.com/economic-and-financial-indicators/2024/06/06/economic-data-commodities-and-markets, AOWM Calculations
The Economy | Latest news, old news
June 3, 2024
The government’s latest official read on the state of the economy was a continuation of recent trends with steady growth and strong corporate profits belied by statistical discrepancies and cautionary imbalances.
For the second consecutive quarter, the average of Gross Domestic Product (GDP) and Gross Domestic Income (GDI) indicated that the economy expanded by a solid 2.4% over the past year. GDP continues to measure noticeably larger than its twin, GDI; however, the statistical discrepancy is no longer growing and both measures of the economy are now trending in the same direction.
Last week’s report also showed persistent strong corporate profitability with profits continuing to account for an elevated share of national income. Despite corporations’ success in taking more of the economic pie over the past decade, it remains risky to declare that profits have reached a permanent new plateau as a share of national income given rising interest rates and the fiscal imbalances facing the federal government that will likely require higher taxes. Those imbalances are highlighted by the fifth consecutive quarter of negative net domestic savings which threatens to reduce the long-run growth potential of the economy.
One new item of note: nominal year-over-year GDP growth decelerated to 5.38% after the recent revision and is now basically equal to the Fed’s target overnight interest rate. Economic growth and the long-run level of interest rates are linked; thus, it is notable when the fed funds rate crosses paths with GDP growth. Excluding the pandemic, nominal GDP growth has typically fallen below the fed funds rate before or around the start of a recession. That has not happened yet and may not if the Fed starts to lower rates before the end of the year.
