Per Stirling Capital Outlook – September
When I started in this industry some forty-plus years ago, the Federal Reserve acted with a level of secrecy more closely associated with secret cults than modern central banks. So clandestine were the Federal Reserve’s operations that they didn’t even disclose what changes in interest rates, if any, had taken place at their meetings. Instead, large investment firms were forced to discern Fed policy by buying and selling securities in sufficient amounts to move short-term interest rates, so they could see at what interest rate levels the Fed would step in and intervene.
That was followed by Alan Greenspan’s extraordinarily long term (1987 to 2006) as Fed Chairman when, instead of simply depriving the markets of any information on monetary policy, he employed a communication style that often seemed designed to confuse everyone within earshot. His preferred means of communicating was dubbed “Greenspeak”, which was sometimes defined as “a method of speaking which produced as many interpretations as there were interpreters”.
Chairman Greenspan was renowned for his nonsensical retorts to politicians, reporters and analysts, such as “I guess that I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said” and (my personal favorite) “I know you think you understand what you thought I said, but I’m not sure you realize that what you heard is not what I meant”.
At least partially because of his mastery of the art of obfuscation, Chairman Greenspan was given the moniker “the Maestro”.
In sharp contrast is the communication style of the modern Fed, starting with Ben Bernanke and Janet Yellen, and continuing with an even more plain-spoken approach under current Fed Chairman Jerome Powell. Powell has not only regularly provided extensive guidance about Fed expectations and future monetary policy but has done so in such a plain-spoken way that linguistic analysis categorizes his word selection as being on the level of a high school student.
Under the leadership of Chairman Powell, obfuscation and mystery have become a thing of the past, and the Federal Reserve has been remarkably clear and understandable in their communication, and particularly generous and open with information and guidance.
For example, on August 25th of 2022, Chairman Powell said in his speech at Jackson Hole, Wyoming that, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses…These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.” 1
This is but one of many examples of Powell being plainspoken and very direct in his messaging, which makes it a little hard to understand why investors have generally disregarded (or at least given little credibility to) his guidance, and the Fed’s stated commitment to the painful process of returning inflation back to its 2% target.
Instead, markets have, at least until the September Fed meeting, consistently priced in less aggressive rate hikes than the Fed has plainly projected and have consistently expected the Fed to reduce interest rates both sooner and more aggressively than what the Fed has suggested.
As a result, the markets went into the September Fed meeting with expectations that the Fed would basically take a bow for their (thus far) successful efforts to bring inflation back down towards their 2% target; that they would announce that they were done raising rates, and that they would be aggressively lowering rates by early next year.
Instead, the Fed very effectively used its September meeting to shift investor expectations away from the idea of imminent and aggressiveness rate cuts and to the recognition and acceptance that rates will probably move somewhat higher by the end of 2023 and will remain higher for an extended period of time.
Importantly, the Fed’s commentary was overwhelmingly good news from an economic perspective, as it highlighted their premise that economic growth will be faster than expected and that unemployment and inflation will be lower than expected. Specifically, the Fed sharply revised upwards their economic growth expectations for this year to 2.1%, which is more than double their June estimate. Fed expectations for the 2024 GDP (economic growth) outlook were raised to 1.5%, from 1.1%.
As noted by CNBC, “The expected inflation rate, as measured by the core personal consumption expenditures price index, also moved lower to 3.7%, down 0.2 percentage point from June, as did the outlook for unemployment, now projected at 3.8%, compared with 4.1% previously.” 2
However, from the market’s perspective, it was a clear example of “good news being bad news”, as it also carried with it a warning that such a robust outlook means that short-term rates will likely remain above 5% through at least the end of 2024. Higher interest rates are historically very detrimental to the prices of both stocks and bonds in general, and so-called “long duration” assets in particular. These include bonds with longer maturities and the equities of innovative companies whose most promising days are years into the future.
Higher interest rates are also normally very challenging for highly valued stocks, such as America’s mega-cap growth stocks. However, 2023 has been a dramatic departure from that historic tendency, as they have produced the overwhelming majority of the market’s year-to-date gains.
Indeed, of the 10.3% year-to-date gains on the S&P 500 (through 9/26/23), 9.6% or 93% of the total gain was attributable solely to 7 stocks: Meta (Facebook), Apple, Amazon, Alphabet (Google), Microsoft, Nvidia and Tesla. The other 492 stocks have only contributed 1.84% to the year-to-date gains.
Of course, in addition to being a strong headwind in the face of the stock and bond markets, higher interest rates are a drag on the economy, which Chairman Powell acknowledged in his September press conference, when he dismissed a “soft landing” scenario (a non-recessionary end to high inflation) as his “baseline forecast”. Instead, he responded to a question regarding whether he expected a soft landing by saying, “No, no, I would not do that. I’ve always thought that the soft landing was a plausible outcome, that there was a path to a soft landing… Ultimately this may be decided by factors outside of our control at the end of the day, but I do think it’s possible.” 3
Even more “inflammatory”, according to Bloomberg, was the Fed’s Summary of Economic Projections (SEP), which infers that “the central tendency now suggests that long-term neutral (i.e., the interest rate that is neither stimulative nor restrictive) is about 2.5% to 3.3% in nominal terms, up from 2.5% to 2.8% in June projections and 2.3% to 2.5% at the end of last year”. 4
In other words, the Fed is suggesting that the “base” interest rate could be higher in the future, which could put longer-term, upward pressure on almost all domestic interest rates.
In addition to reiterating the prospects for at least one additional rate hike and higher rates over the longer term, the SEP reduced the number of rate cuts expected by the Fed in 2024 from four to two (from a 1.0% reduction to only a 0.50% reduction). Chairman Powell attributed this change to stronger-than-expected growth and because “the process of getting inflation sustainably down to 2% has a long way to go.” 5
Frankly, none of this bullish economic news/hawkish monetary policy guidance should have been a surprise to anyone who actually took the Fed at their word. As for the markets as a whole, it is a little hard to explain what was different about the Fed’s September meeting that ultimately caused investors to finally take Fed guidance to heart. That said, there is little doubt that markets are finally (and increasingly) giving the Fed’s guidance the credibility that it deserves.
As evidence, “fifty-eight percent of the 172 respondents in the Bloomberg Markets Live Pulse survey conducted after the Fed’s decision said that 2-year Treasury yields have yet to peak, while a plurality expect 10-year yields to climb over 4.5%.” 6 Two-year rates rose to a 17-year high, while 30-year yields climbed to a level last seen in 2011.
The response in the equity markets was no less dramatic. According to Bank of America, investors responded by “dumping equities at the fastest pace since December as the prospect of higher-for-longer interest rates raises the risk of a recession, [and] global equity funds had outflows of $16.9 billion in the week through Sept. 20…. US stock funds led the exodus.” 7
In fairness, while equity investors have been tone-deaf regarding the Fed, bond investors have at least been paying some attention, which helps to explain the current almost three-year-old bear market in bonds. Indeed, with the earnings yield on equities now approximately equal to the dividend yield on debt, it could be argued that equity investors are no longer being fairly compensated for the additional risk that they are taking relative to an investor in bonds.
The good news from an investor’s perspective is arguably that markets are finally starting to price-in the implications of the Fed’s recently reinforced commitment to return inflation to their 2% target, no matter what the cost. This is particularly relevant in regard to equities, which had been pricing in the idea that the Fed was on the verge of lowering interest rates in response to falling inflation, and that Fed monetary policy was about to shift from being a strong headwind to a strong tailwind.
We have viewed this consensus opinion as misguided, as a decline in inflation is historically almost never a catalyst for the Fed to lower rates. Instead, the Fed normally starts cutting rates in response to a sharp rise in unemployment, dysfunction in the financial system, a substantial recession, or some exogenous shock (like the COVID pandemic).
As we noted in last month’s commentary, we thought that markets were “being priced for a much more market-friendly outcome than we are actually likely to see”. As our regular readers know, this very significant concern has kept us relatively cautious, particularly regarding highly valued and aggressive growth stocks, throughout most of 2023.
Indeed, in the face of the most aggressive tightening of Fed policy in four decades, a highly valued stock market, and what was clearly (at least in our opinion) a dramatic misunderstanding of Fed intentions on the part of most investors, it has been hard to get comfortable with the risk-adjusted potential of growth equities.
However, now that the markets seem to be coming to terms with the probable reality of future Fed policy, that process, once complete, should go a long way towards substantially lessening that concern.
Of course, the place where we see the markets’ newfound appreciation for Fed guidance reflected most directly is in the Fed Funds futures markets.
In the above chart, the Fed’s forward-guidance regarding future interest rate policy is reflected by the dark blue line and the market’s expectations (Fed Funds futures) is shown on three different dates and illustrated by the yellow, red and green lines. You will note that the Fed Funds line (an indication of investor opinions) is moving progressively closer and closer to Fed guidance (blue line) with each successive reading, which tells us that market expectations and Fed expectations are becoming increasingly in line with one another. As these lines converge, we believe that it effectively diminishes one of the significant risks in the equity markets.
Of course, the Fed will ultimately start lowering rates. When that happens, history suggests that rates will come down very quickly. As the old axiom goes, “interest rates go up the stairs, but come down the elevator”. However, as noted above, another lesson of history is that the Fed starting a rate cutting cycle is probably not something that investors should necessarily look forward to. Recall the normal catalysts for rate hikes: “a sharp rise in unemployment, dysfunction in the financial system, a substantial recession, or some exogenous shock (like the COVID pandemic)”.
When Chairman Powell was asked during his recent press conference what set of conditions would lead him to start cutting rates, he seemed to struggle in identifying a possible catalyst. As he put it, “at some point, and I’m not saying when”, it will be appropriate to cut, but that could be from “real rates rising because inflation is coming down” or because of “all of the factors that we see in the economy” but there is “so much uncertainty” about when that takes place. 8
In his September press conference, Chairman Powell used the words “careful” and/or “carefully” 16 times, and he used the words “uncertain” or “uncertainty” 11 times. He specifically mentioned as reasons for caution the UAW strike and its impact on the economy and wage inflation; a likely government shutdown which could slow the economy and catalyze the last of the three ratings agencies (Moody’s) to downgrade America’s credit rating; higher long-term interest rates, and the recent surge in oil prices to over $90 per barrel. 9
Remarkably, Chairman Powell failed to mention the end of the moratorium on student loan payments, which will impact an estimated 45 million Americans, and the exhaustion of the last of the excess savings created by the massive pandemic-related stimulus, which has helped to keep the American consumer spending in the face of higher interest rates.
Indeed, there is a growing concern that the American consumer, which accounts for approximately 68% of the U.S. economy, may be on the verge of exhausting their savings. To paraphrase Chairman Powell, “uncertain, uncertainty, careful, carefully”.
In such an environment, while we acknowledge that a stronger than expected economy could allow lower-quality investments to outperform, we will likely continue to favor high-quality stocks and bonds until such time when we are confident that the markets have more fully priced in this “higher-for-longer” monetary policy, at which point we expect to position portfolios for the next move higher.
From our perspective, the markets are likely to bottom once they fully comprehend the implications of this more hawkish monetary policy and will not need to wait for the Fed to actually transition to a dovish policy and lower interest rates before they start their next move higher.
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.
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“Powell warns of ‘some pain’ ahead as the Fed fights to bring down inflation”, Jeff Cox, Posted 8/26/2013, https://www.cnbc.com/2022/08/26/powell-warns-of-some-pain-ahead-as-fed-fights-to-lower-inflation.html
“Fed declines to hike, but points to rates staying higher for longer”, Jeff Cox, Posted 9/20/2023, https://www.cnbc.com/2023/09/20/fed-rate-decision-september-2023-.html#:~:text=The%20Federal%20Reserve%20held%20interest,than%20previously%20indicated%20next%20year
“Full recap: Fed chief Powell’s market-moving comments on interest rates, soft landing chances”, Darla Mercado, Posted 9/20/2023, https://www.cnbc.com/2023/09/20/live-updates-fed-decision-september-2023.htmlv
“Fed’s Debate About ‘Neutral’ Is Mostly an Exercise”, Jonathan Levin, Posted 9/20/202, https://www.bloomberg.com/opinion/articles/2023-09-20/federal-reserve-meeting-debate-about-neutral-heats-up-but-is-still-academic#xj4y7vzkg
“Full recap: Fed chief Powell’s market-moving comments on interest rates, soft landing chances”, Federal Reserve Bank of St. Louis, As of 8/25/2023 https://www.cnbc.com/2023/09/20/live-updates-fed-decision-september-2023.html
“Bond Traders See Yields Marching Higher After September Fed Meeting”, Liz Capo McCormick, Michael Mackenzie, Posted 9/20/2023, https://www.bloomberg.com/news/articles/2023-09-20/bond-traders-see-yields-marching-higher-as-fed-message-sinks-in
“BofA Says Rate Worries Spark Biggest Stock Outflows This Year”, Sagarika Jaisinghani, Posted 9/22/2023 https://www.bloomberg.com/news/articles/2023-09-22/bofa-says-investors-flee-from-stocks-as-hard-landing-signs-grow
“The Closer”, Bespoke Investment Group, Posted 9/20/2023, https://www.bespokepremium.com/category/the-closer/
“Market Call: Powell Says Be Careful”, Dr. Ed Yardeni, Posted 9/24/2023, https://www.yardeniquicktakes.com/market-call-be-cautious-like-powell/#:~:text=In%20his%20presser%20last%20Wednesday,advice%20for%20investors%20right%20now.