Wall Street is betting hard on rate cuts … but why? … two scenarios for rate-cuts in 2023 … why investors might prefer the bearish rate-cut scenario
We’re back to Wall Street not believing the Fed.In his post-FOMC press conference last week, Federal Reserve Chairman Jerome Powell said that zero rate cuts are expected this year. Plus, in the Fed’s updated Dot Plot, no Fed president projected a rate cut this year. Wall Street isn’t having any of it. According to the CME Group’s FedWatch Tool, there’s a 97.4% expectation among traders that rates will be below today’s target level after this coming December Fed meeting. Now, there’s an interesting follow-up that I wish the FedWatch Tool revealed… Why do these traders expect lower rates? Specifically, is it because they envision bullish or bearish conditions? Let’s look at each rate-cut hypothetical.
The dovish case for rate-cuts in 2023
Before we jump in, let’s be clear – we’re specifically talking about rate cuts, not rate pauses.A rate pause does zero to help the economy. It does not improve things; it merely stops ratcheting up the pain. So, theoretically, the Fed could pause rates tomorrow, but if it holds them steady throughout the rest of 2023, our economy will deteriorate as those rates strangle business activity and consumer health. With that caveat behind us, on to the case for a bullish rate cut… Over the next six-to-nine months, inflation plummets… the banking sector firms up… the economy stabilizes… U.S. consumers find their economic footing… and the Fed feels confident enough about the future and weakening inflation that it gives the “all clear” on our economy and cuts interest rates. This isn’t “pie in the sky.” We’ve seen tremendous progress on goods inflation. This is manifesting in all sorts of economic numbers and data, from elements of the Consumer Price Index, to various Fed manufacturing surveys, to falling home and apartment rental prices (with the expectation of far steeper price-drops to come this spring). Our own Luke Lango has done a fantastic job of cataloguing the progress so far on inflation. We could dig into many specifics here, but for brevity, let’s arrive at the takeaway – disinflation is happening in many parts of our economy, specifically on goods inflation. This is great news, and we should be pleased. But while we celebrate that, let’s get to the more important question: “Is this progress enough to get the Fed to begin cutting rates later this year as part of a broader bullish take on our economy?”
To answer that, we have to remember what’s important to the Fed, and goods inflation is only part of it
From CNBC after last week’s Fed decision:
The reason for the continued inflation focus, more than anything else, was always in plain sight: the job market is still too hot and wage growth, while cooling, hasn’t cooled enough for comfort.Fed Chair Powell’s focus on the labor market has been consistent in the months leading up to Wednesday’s rate hike decision, and when asked at the post-FOMC meeting press conference whether the central bank considered a pause in rate hikes given the concerns about global financial system fragility, his initial response went straight to the labor market. “Labor market data came in stronger than expected,” Powell said.
In terms of the labor force, today’s unemployment rate is near historic lows. In February, it came in at 3.6%, which is only slightly worse than January’s 3.4%, which equals the lowest level since 1969.How likely is it the Fed will want to cut rates anytime soon into this labor market strength? As to wage growth, below, we look at the Wage Growth Tracker from the Atlanta Fed. As you can see, we are, in fact, making progress, but wage growth remains at nosebleed levels.
Here again, how likely is it the Fed will want to slash rates a few months from now in light of this?There’s even more reason for skepticism… Last week, Powell highlighted another variable we have to address. Though we can celebrate the gains on goods inflation, what about services inflation? Back to CNBC:
[Powell] added that there are not enough signs of progress in the key non-housing services sector inflation being driven by labor conditions.“That’s 56% percent of the index and the story is pretty much same … the data we got pointed to stronger inflation,” he said.
Put it all together, and we can conclude that yes, we are making progress on inflation. And yes, we’re moving in the right direction in terms of cooling wage growth and the hot jobs market. But believing that these gains are enough to coax Powell to slash rates because economic conditions have returned to normal (and bullish) conditions requires a leap of faith.Remember, February CPI came in at 6%. This is literally 3X the Fed’s target inflation goal of 2%. And we just looked at the unemployment and wage growth numbers. Now, there’s a logical pushback…
“But Jeff, the issue isn’t about cutting rate today, or next month. It’s about the likelihood of rate-cuts in, say, Q4 based on the cooling trajectory of inflation today.”
That’s fair. Let’s talk about that.
The more likely scenario for a Q4 rate hike
If the Fed holds rates steady until Q4, that is another six months minimum (April through September) of economic strangulation thanks to today’s target rate of 4.75% to 5%.Plus, that assumes the Fed doesn’t hike again at its next meeting, which isn’t guaranteed. The big question we must wrestle with is what happens to the economy during six more months of 5% interest rates? Regular Digest readers will have to forgive me for the merciless way in which I frequently beat the following dead horse, but it’s necessary. There is a six-to-eight-month lag between when the Fed hikes rates and when we feel the feel impact of those rates in the economy. With this in mind, let’s zero in on last September 21, which was when the Fed held its September FOMC meeting six months ago. At that time, the Fed took rates to 3.25%. As you know, last week, the Fed raised rates to 4.75% to 5.00%. Over the last few months – which reflect much lower interest rate levels than today – we’ve seen…
- Banking failures from Silvergate, Silicon Valley, Signature Bank, First Republic, Credit Suisse, and wobbling from Deutsche Bank
- The housing market grind to a halt
- A wave of high-profile commercial real estate foreclosures including Columbia Property Trust default on $1.7 billion in floating-rate loans and Brookfield Asset Management default on more than $750 million in debt in Los Angeles
- The U.S. consumer set records for credit card debt spending
Six more months of even higher interest rates seems likely to result in new damages.And that brings us to the “bearish” hypothetical that could lead to rate cuts this year… The “fastest and highest” rate-hike campaign in U.S. history continues to damage the balance sheets of regional banks… continues to wreck the profitability of the commercial real estate sector leading to snowballing defaults … continues to wreck the purchasing power of the U.S. consumer who is increasingly funding everyday expenses with debt at nosebleed interest rates… and eventually, the weight is too great, there’s a crash, and the Fed is forced to slash rates as a form of economic triage.
While this doesn’t sound great, might it actually be the better long-term outcome?
Apologies to any investors who have a shorter-term investment horizon. I’m now speaking broadly.When it comes to investing, the more robust and longer the bull market, the better, right? Well, those robust, long bull markets typically begin when two dynamics are present… 1) low valuations, and 2) things being very bad in the economy, meaning the likeliest direction is “better” Neither of those characteristics are present today. Recently in the Digest, we profiled how at a price-to-earnings ratio of 21, today’s market doesn’t enjoy a low valuation. In fact, we’re miles higher than the average PE ratio at which a bull market begins, which is 13 according to the research shop Bespoke. And what about the economy? What does it suggest for a new bull market? Well, for context, in a past Digest, we featured this quote from Sam Stovall, chief investment strategist at CFRA Research. It offers some blunt timing advice on this interplay between stocks and a recession:
Prices lead fundamentals—therefore the stock market falling into a decline is traditionally an indication that most investors believe we are headed for a recession.When we do finally fall into a recession, that’s usually a good time to get back into the market.
I’ve read other analyses suggesting that the best time to buy into stocks is roughly halfway through a recession (which no one can time perfectly).Either way, the overall idea is that an actual recession is a painful-yet-necessary part of the overall economic/investment cycle that births new, robust bull markets. However, today, you’re hearing Treasury Secretary Janet Yellen saying we could see a “soft landing,” meaning we’ll avoid a recession. Many bulls have picked up on this and included it in their forecasts. But if we assume we avoid a recession and any further economic damage from high interest rates, then we’re essentially saying “let’s begin a new, great bull market at overinflated valuations combined with one of the strongest labor markets in history, which leaves little room for improvement.”
That doesn’t feel realistic to me
How do we get a robust, long-legs bull market without the recessionary origins that usually launch robust, long-legs bull markets?How do we get multi-year market gains without the humble stock valuations that usually launch multi-year market gains?
“Jeff, we’ll do it by earnings expansion. As earnings increase this year and next, it will warrant higher stock market prices.”
Anything is possible, but look at the chart below of the S&P’s GAAP earnings over the last 10 years.Do they look like they’re coming in a low level, ready to explode higher?
“Jeff, this is trailing earnings. Forward-looking earnings are low relative to prices. That’s how we’ll grow.”
Even if we use the forward price-to-earnings ratio, and we assume earnings predictions are accurate, it comes in at roughly 17.The chart below from earnings data analytics company FactSet shows that a level of 17 is just barely beneath the 10-year average forward price-to-earnings ratio. And more importantly, it’s about 31% overvalued relative to the forward price-to-earnings ratio of roughly 13, which is where the S&P began its bull runs after the Global Financial Crisis, the 2018 flash crash, and the 2020 pandemic. See for yourself.
But here’s the good news…
If the Fed holds rates at 5% for the next six months, the odds increase there will be a new economic breakage of some kind. Based on that, we’ll likely see two things happen…The stock market will drop, and the broader economy will suffer. While that will be painful, it will also pave the way for the robust, long-legs bull market that we all want. A bit like a forest fire that clears out overgrowth and debris, enabling new healthy growth. So, what do you do with this? Well, if you see opportunities for short-term profits, great, jump on them. They’re out there. Our experts Louis Navellier, Eric Fry, and Luke Lango have all been recommending various shorter-term investment opportunities that are generating strong returns despite today’s challenging market. And we recently profiled huge gains coming from the biotech sector thanks to research provided by our CEO, Brian Hunt. But beyond that, having some dry powder on hand would be wise. After all, a bearish environment that requires the Fed to slash rates will likely create some of the best buying conditions in years. Have a good evening, Jeff Remsburg