Where Do We Go From Here?
Yesterday was the first move of the Federal Open Market Committee (FOMC) in this cycle to cut interest rates. The FOMC cut interest rates by 50 basis points (0.5%). Leading up to this action, there was plenty of discussion and debate amongst economists, strategists, and investment professionals about whether they should cut by 25 or 50 basis points.
Now that the FOMC has started cutting rates, there are all kinds of data points out there suggesting that the markets will surge or that the economy will be in a free fall. Because of the 24/7 news cycle and the proliferation of social media news feeds, we can be assured that the conversation and debate will continue about the state of the economy and the direction of the markets.
The purpose of this blog is to remind investors that history, however it is framed with the best statistics that are out there, does not equal a perfect forecast for the future. It’s also helpful to point out that markets and the economy may follow certain historical patterns. The keyword here is may. Mark Twain has been often credited with the aphorism that “history doesn’t repeat itself, but it often rhymes.”
This is important for long-term investors to remember as market experts that have put too much weight on certain historical or statistical relationships have often been wrong.
We continue to believe that history does often rhyme, but we also need to look at all the facts and judge them individually as well as taken together. Context is very important here, especially given all that we’ve experienced in the last 4 years:
• We went through an unprecedented economic period between 2020 and 2022. This included a global pandemic, a huge spike in unemployment, massive amounts of fiscal and monetary liquidity injected into the economy, supply chain shortages, skyrocketing inflation, and the bursting of a stock and bond bubble.
• The Federal Reserve raised rates at an astonishing speed to combat inflation.
• A few large regional banks failed. This was not due to bad credit risk, but bad balance sheets and assets purchased during an abnormally low long-term interest rate environment.
• Artificial Intelligence and advances in accelerated computing kicked of a new industrial revolution and capital spending race akin to a gold rush.
• Profit margins expanded and earnings grew for most sectors.
• Consumers, companies, and the government continued to spend and hire. Job openings outstrip available workers, at one point by 2-to-1.
• Two ongoing geopolitical conflicts continued to rage on.
• We kicked of a very unusual presidential election season with two very different candidates and circumstances that are unprecedented (two assassination attempts on one candidate, one candidate who is there only because the incumbent candidate bowed out, another candidate who is a former president). We remind investors that markets do well over the long-term, regardless of which party is in office and who controls congress.
Rates remained elevated for more than 400 days until yesterday (see chart below of federal funds target rate). The red bars indicate prior recessions.
Source: Bloomberg
With rates now moving lower and looking at the chart above, some may prematurely conclude that we’re headed for a recession. After all, the last three cutting cycles coincided with recessions. But the reason for cutting rates now is not because economic growth is collapsing. It’s because inflation has come down significantly and the labor market is showing some signs of cooling. The rate cut yesterday was more of a proactive step than a reaction to a bad economy.
Let’s review where we are currently:
• The S&P 500 is near all-time highs, but valuations are not extremely overvalued as they were in early 2000 or in early 2021. The recent bull market was mostly fueled by large technology companies in the beginning of the AI boom but has since brought many other sectors into the mix. We continue to believe that the spending in AI and future productivity and innovation gains will help grow the economy without simultaneously increasing inflation.
• High yield and other credit spreads continue to remain low. This suggests that there is no excessive financial distress hitting or about to hit the credit markets. In other words, outside of a few pockets like where speculative investors bet heavily on the Japanese Yen carry trade, we do not see excessive leverage or unwinding of leverage in the financial system that would lead to a financial crisis or financial contagion.
• Real GDP (Nominal GDP/GDP Deflator) has grown faster in the last 3 ½ years than it did in the 3 ½ years prior to the pandemic. This is after we account for the high inflation that we experienced.
The trend has continued to stay positive (see chart below). Lower rates will likely allow economic growth to continue.
Source: Bloomberg
• The unemployment rate has increased but is still at a historically low level. The increase has been more due to new entrants in the labor force, not due to massive layoffs.
• Lower rates will be good for small business and consumers who need to borrow or refinance debt. Lower rates will not be good for those sitting on large amounts of cash as interest income will decline.
Going forward and looking at all the data, we continue to believe that both the stock and bond markets and the economy can push higher. In today’s economic parlance, that would mean a “soft landing.” We will likely see more cuts in the months ahead. The FOMC
will continue to monitor and evaluate the data, balancing risks between price stability and maximum employment.
As always, we will continue to monitor both the economic and market data carefully and make adjustments to portfolios, always with a lens to reduce unnecessary risk as well as to capitalize on attractive investment opportunities.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through WCG Wealth Advisors, a registered investment advisor. WCG Wealth Advisors and The Wealth Consulting Group are separate entities from LPL Financial. LPL Tracking Number: 637721
All data as of 09/19/24
