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November

Per Stirling Capital Outlook – November

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A “soft landing” describes the always sought-after but historically elusive monetary policy outcome, where the Federal Reserve manages to raise interest rates and reduce economic liquidity just enough to slow down the economy and squelch inflation, but not so much that they overtighten policy and catalyze a recession.

The Fed’s ability to engineer this “golden mean” outcome is greatly complicated by what Milton Friedman termed “long and variable lags”.  Specifically, there has historically been a perceived lag of between 9 and 18 months between when the Fed “taps on the brakes” and when that action has its full slowing impact on the economy.  As a result of this extended delay, it has historically proven almost impossible for the Fed to know that it has put too much cumulative pressure on the brake until it is already too late and ends up causing a recession.

We addressed this back in February of this year, when we wrote in our commentaries that the Federal Reserve engineering a “soft landing” in the current environment would be “the monetary policy equivalent of landing a Boeing 747 on an aircraft carrier”.  We viewed it as vaguely possible, but highly unlikely.

We were hardly alone in our skepticism.  After all, in the 78 years since the end of World War II, the Fed has managed to successfully engineer this elusive monetary policy outcome a grand total of one time, in the mid-1990s.1 Every other Federal Reserve tightening cycle has produced at least a modest economic contraction.  You can see this below, where virtually every time that the Federal Reserve has implemented a series of increases in the Federal Funds Rate (shown in red), it has catalyzed a recession (shown as vertical grey bars).

That said, it would hardly be shocking (perhaps even fitting), if this extraordinary economic cycle that was so distorted by pandemic-related government stimulus, and which has thus far defied the recession predicted by many of Wall Street’s best analysts and most reliable indicators, were to produce an outcome that would ultimately be just as extraordinary and unpredictable as the journey has been.

Regardless, this presumed end to the Fed’s interest-rate-hiking cycle combined with expectations of a “soft landing” has certainly put stock and bond investors in a buying mood. 

After peaking at over 5% for the first time since 2007, the yield on the 10-year Treasury note (which moves in the opposite of bond prices) has dropped to a two-month low of around 4.4%2, and bonds of almost all types have rallied strongly over the past month.  Could that have been the peak in rates?

Even if not, in the wake of what has been perhaps the worst bear market in bond market history, intermediate and longer-term debt arguably looks more compelling than it has in over a decade.

One can even argue that “animal spirits” are starting to return to the bond markets, with more than $16 billion of new money flowing into corporate bond funds in just the first three weeks of November (above). 

According to the Financial Times, this is “already a larger net inflow than any full month since July 2020”.3 Notably, a majority of this new money has gone into high-yield (“junk”) bonds, which are among the riskiest and most economically sensitive parts of the bond market.

Arguably even more impressive is the S&P 500’s gain of over 10% from its Oct. 27th lows and that the stock market, at long last, is finally showing signs of broadening out beyond the “Magnificent 7” stocks that have accounted for virtually all of the S&P 500’s year-to-date gains. 

While the past is not necessarily prologue, rapid gains of this ilk have historically proven quite bullish over the shorter term. 

As was noted by Barron’s Magazine, since 1962 “there have been 39 other times that the S&P 500 delivered three-week percentage changes of 9% or more, excluding this most recent run. Following those past three-week surges, the index was still up on average over one-, two-, three-, four- and eight-week periods…The median gain four weeks out is 2.21%, and a figure that jumps to 3.3% at eight weeks.”4 According to Bank of America’s Michael Hartnett, “investors flocked into equities at the fastest pace in almost two years”.5

Yes, investors appear to be all-in on this “best of all worlds” outcome, and they may be right.  Given the current combination of rapidly declining inflation, a moderating but still healthy economic outlook, a still-healthy jobs market and a consumer that continues to spend aggressively, it might be time to start looking at Federal Reserve Chairman Powell as the leading candidate for “Pilot of the Year”.

Indeed, investors have written off any possibility of further rate hikes, as is reflected by the Fed Funds futures market (above), where the odds of a hike by the Fed are virtually 0% for each of the next three meetings.

Now investor attention is fixated on when they will start lowering rates (an event currently predicted by Fed Funds futures for May of 2024), under the premise that lower short-term rates are bullish. 

The problem with this premise is that the Fed normally only cuts rates in response to significant recessions, large job losses or a financial crisis, none of which are normally bullish for equities (although all three of which would likely be very bullish for high quality bonds, bills, and notes).  In fact, since 1970, more than half of the Fed’s first cuts were followed by S&P 500 declines of more than -20%, and the average S&P return 6 months after the first cut is only 3.4%. 

In contrast, it has historically been better to own equities during the time between the last rate hike and the first rate cut.  According to financial research firm CFRA, “after the Fed’s past six periods of credit tightening, the S&P 500 rose an average of 13% from the final rate hike to the first cut in the following cycle”.6

Indeed, a review of performance twelve months after the last rate hike of the past four rate hiking cycles shows that the period was almost universally bullish, largely without regard to asset class, market capitalization, geographic region, or even the quality of the asset in question.

Meanwhile, members of the Federal Reserve have been trying to dampen these expectations of such an optimistic outcome, partially because numerous risks to this forecast still remain, and partially because a growing belief in such good news tends to raise stock prices, loosen bank lending conditions, weaken the value of the dollar, and narrow the difference in yield between high-quality debt and low-quality debt.  In turn, each of these things tend to stimulate the economy and increase animal spirits at a time when the Fed is trying to slow the economy, lower inflation, and keep animal spirits well under control.

You can actually see this undesirable (from the Fed’s perspective) loosening of financial conditions (shown by a falling line) in the above chart of the Goldman Sachs Financial Conditions Index, which indicates that credit conditions and economic liquidity have become much more stimulative since the end of October, when it first became the consensus view that the Fed was done with rate hikes and that aggressive rate cuts were in store for mid-2024.

It is little wonder that, in a November Speech to the International Monetary Fund, Fed Chairman Powell cautioned that “if it becomes appropriate to tighten policy further, we will not hesitate to do so”, and that the Fed would “continue to move carefully, however, allowing us to address both the risk of being misled by a few good months of data, and the risk of overtightening”.7

The Fed doubled down on this more cautionary perspective in the minutes of the Oct. 31- Nov. 1 Federal Open Market Committee meeting, which “stressed that current inflation remained unacceptably high and well above the committee’s longer-run goal of 2%” and noted “that further evidence would be required for them to be confident that inflation was clearly on a path to the committee’s 2% objective.”8  If that were not clear enough, Fed Chairman Powell, when asked about the prospect for rate cuts in his November 21st press conference, responded “the fact is, the Committee is not thinking about rate cuts right now at all.”9

And yet the markets, as indicated by the Fed Funds futures, are predicting an aggressive four 0.25% rate cuts by the end of next year (green line), which is in sharp contrast to the Fed’s November 10th Summary of Economic Projections (blue line), which anticipates only one potential 0.25% rate cut in 2024.

Admittedly, the Fed has an incentive to keep animal spirits and investor expectations in hand, as it assists them in dampening inflation and economic growth, and the markets may ultimately prove to be right.  That said, we are still taking the Fed’s guidance to heart and, while we do believe that the Fed is probably done with rate hikes, we are concerned that market expectations for rate cuts are overly ambitious.  That is, unless the U.S. sinks into recession.

Whether you consider the CNBC October 31st survey of Wall Street economists10 above or the late October Barron’s Big Money Poll of professional portfolio managers11 below, there appears to be a strong consensus for an impending economic slowdown.

Indeed, it is worth noting that the plurality of respondents (almost 50%) to both polls are anticipating a recession in 2024, which helps to explain why the markets are looking for the Fed to start cutting rates in May of next year.

Whether it turns out to be an actual recession, with an associated deleterious impact on earnings, or a soft landing, with its combination of continued, albeit diminished earnings growth and falling inflation, will likely be all-important to portfolio returns.

In the event of a non-recessionary “soft landing”, we would expect for both stocks and bonds to perform reasonably well, but with equities being a clear outperformer.  In contrast, if the economy dips into an actual recession, particularly a fairly deep one, which history does suggest is at least a reasonably likely outcome, we would expect for all but the highest quality equities to suffer, along with lower quality debt and real estate, while higher quality debt would likely perform admirably.

Only time will tell which camp is right, and we will continue to monitor the economic data very closely.  In the meantime, we think that we have a window of opportunity to make money in most asset classes (including stocks, bonds, securitized real estate), and even in most geographic regions. 

While we have been advocating the use of high-quality stocks and bonds throughout 2023, we suspect that even lower-quality debt and long-duration and more speculative stocks may also have their “time in the sun”, as investors wait for clarity on the “soft landing” versus recession debate.  Of note, in light of how unprecedented this economic cycle has been, between a massive global pandemic, a forced shut-down of the global economy, and the most massive fiscal and monetary stimulus programs in the history of the world, we suspect that it is likely to take longer than the markets seem to be expecting to determine a winner in this debate.

In the meantime, whether you look at the number of news stories that talk about the prospects for a “soft landing”, or how many times the potential of a “soft landing” is discussed in company filings, transcripts and presentations, there seems to be a strong, growing and fairly-consensus view that the Fed will actually manage to produce a “soft landing” this time around.

However, it should be noted that history warns against complacency, as it illustrates that almost every recession in modern history has been preceded by a surge in optimism that the Fed will successfully engineer a “soft landing”, only to have the economy slip into recession before it is all said and done (recessions are shown as grey bars).

While the benevolent outcome that the market is predicting is far from assured, the Fed’s chances of success do appear far better than we would have anticipated even two months ago.

At minimum, recent comments from the Fed suggest that most voting Fed members would prefer not to hike rates again in this cycle, and that the bias has apparently changed such that the Fed will now only raise rates if they are given reasons to do so.  This is a sharp reversal from the previous bias of raising rates unless they are given reasons not to.

We agree that growth is slowing, that inflation is falling and that the labor market may be strong enough to sustain the economy through a slowdown.  We are concerned that the “easy” reductions in inflation have already taken place and that returning inflation to the Fed’s 2% target (something that the Fed currently does not expect until 2026)12 may require a slowdown of some substance to address current tightness in the labor market.

Where we tend to disagree with the consensus is regarding the prospects for aggressive rate cuts in 2024.  The lessons from the 1970s and early 1980s, which Fed Chairman Powell regularly draws comparisons to, as it was the last time that the U.S. economy faced runaway inflation, is that you need to raise rates high and keep them there until inflation actually returns to target.  Otherwise, inflation tends to reignite every time that the Fed lowers rates.

As such, we would only expect aggressive easing in the event of steep job losses, a deep recession, dysfunction in the financial system, or another dramatic drop in inflation that puts “real”, inflation-adjusted yields at undesirably restrictive levels.

The bottom line, at least from our perspective, is that, while there are still some reasons for caution in the intermediate term, the short and longer-term outlook for portfolio values is starting to look better than it has in years.

 

Disclosures
Advisory services offered through Per Stirling Capital Management, LLC. Securities offered through B. B. Graham & Co., Inc., member FINRA/SIPC. Per Stirling Capital Management, LLC, DBA Per Stirling Private Wealth and B. B. Graham & Co., Inc., are separate and otherwise unrelated companies.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice.  Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor.
This document may contain forward-looking statements based on Per Stirling Capital Management, LLC’s (hereafter PSCM) expectations and projections about the methods by which it expects to invest.  Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions.  In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements.  Such statements are not guarantying future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of PSCM’s Investment Advisor Representatives.
Neither asset allocation nor diversification guarantee a profit or protect against a loss in a declining market.  They are methods that can be used to help manage investment risk.
Past performance is no guarantee of future results.  The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted.
Definitions
The Standard & Poor’s 500 (S&P 500) is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S with each stock’s weight in the index proportionate to its market. It is not an exact list of the top 500 U.S. companies by market capitalization because there are other criteria to be included in the index.
Goldman Sachs Financial Conditions Index is a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP.
 
Citations
  1. “’Soft landings’ are rare for the Fed. Crash landings are more like it.”, Jeffry Bartash, Posted 9/20/2023, https://www.marketwatch.com/livecoverage/fed-decision-markets-await-key-dot-plot-powell-press-conference-with-no-interest-rate-hike-expected/card/-soft-landings-are-rare-for-the-fed-crash-landings-are-more-like-it–Cq9FbOHvUvTC4R2OjP2B?mod=mw_quote_news#:~:text=Since%20World%20War%20Two%2C%20the,cycle%20the%20economy%20has%20crashed
  2. “If You’re in Cash, You Risk Missing Out, Bond Managers of $2.5 Trillion Say”, Michael Mackenzie, Posted 11/21/2023, https://www.bloomberg.com/news/articles/2023-11-21/bond-managers-of-2-5-trillion-make-case-for-leaving-cash-behind#xj4y7vzkg
  3. “Investors pour cash into US corporate debt in bet Fed rates have peaked”, Harriet Clarfelt, Posted 11/22/2023, https://www.ft.com/content/49cf74bd-b298-482f-8bbd-b11cacd9cc51
  4. “Barron’s Review & Preview”, Nicholad Jasinski, Posted 11/20/2023, Barron’s | Financial and Investment News (barrons.com)
  5. “Quick Comments/What We’re Reading”, Jim Bianco, Posted 11/24/2023, https://www.biancoresearch.com/visitor-home/
  6. “Wall St Week Ahead: Last Fed hike tends to aid stocks, but some have doubts this time”, Lewis Krauskopf, Posted 9/15/2023, https://www.reuters.com/markets/us/wall-st-week-ahead-last-fed-hike-tends-aid-stocks-some-have-doubts-this-time-2023-09-15/
  7. “Fed shifts into cautious policy mode as risks become more two-sided”, Howard Schneider, Posted 11/21/2023, https://www.reuters.com/markets/us/fed-minutes-likely-anchor-careful-approach-policy-2023-11-21/
  8. “Fed Minutes Show Unity on Cautious Approach to Future Rate Hikes”, Craig Torres, Posted 11/21/2023, https://www.bloomberg.com/news/articles/2023-11-21/fed-minutes-show-unity-on-cautious-approach-to-further-hikes#xj4y7vzkg
  9. “Fed gave no indication of possible rate cuts at last meeting, minutes show”, Jeff Cox, Posted 11/22/2023, https://www.cnbc.com/2023/11/21/fed-minutes-november-2023.html
  10. “Markets are on board with the Fed’s ‘higher for longer’ policy, CNBC survey shows”, Steve Liesman, Posted 10/31/2023, https://www.cnbc.com/2023/10/31/markets-are-on-board-with-the-feds-higher-for-longer-policy-cnbc-survey-shows.html
  11. “Big Money Pros Are Split on the Outlook for Stocks. But They Are Fans of Bonds.”, Nicholas Jasinski, Posted 10/26/2023, https://www.barrons.com/articles/big-money-poll-stock-market-bonds-economy-outlook-375aebae
  12. “Pulling Off a Soft Landing Depends on the Pilot”, John Authers, Posted 11/16/2023, https://www.bloomberg.com/opinion/articles/2023-11-17/soft-landing-or-hard-it-comes-down-to-the-pilot-the-fed