Past the Peak but Not All Downhill From Here
Dec 28, 2023“We’re aware of the risk that we would hang on too long. We’re very focused on not making that mistake.”
- Jerome Powell, Fed Chairman
Less than two months ago, I wrote to clients that the pivot was coming over the next year. Little did I know it was coming in a couple of weeks as the market quickly repriced for many cuts in 2024.
I wrote in early November in “The Worse Bonds Do, The Better Their Future Returns”:
We believe we are in a unique situation that won’t last long. These high interest rates are due to the anomaly of excessive spending from the Covid virus. Once inflation from the excessive spending is defeated, interest rates will come down.
After taking the interest rate chair lift up starting in March 2022, Fed Chair Jerome Powell finally put his tips up and got off to start shredding the powder.
In other words, he announced it was time to start to think about cutting rates. Why did he make this announcement?
Going through the release, it was the collapse of the inflation outlook which caused them to lower their projections for the Federal Funds rate – the short-term interest rate the Federal Reserve controls.
Inflation continues to move lower though remains above the Fed’s target. Recent CPI and PPI data, measures of consumer and wholesale inflation, were lower than expected further confirming their thoughts. Additionally, future housing/shelter costs are going lower given that they have huge lags in the data.
So as the Fed Funds rate stays the same (it is currently at 5.50% as of December 28th), and inflation continues to move lower, the real Fed Funds rate (Fed Funds minus inflation) gets larger.
Without doing anything, the Fed is actually tightening monetary policy as real rates increase.
Source: YCharts, as of 12/29/2023. Graph illustrating gap between Fed Funds Rate and CPI Inflation.
In short, without cutting rates, the Fed runs the risk of keeping the screws too tight and hurting the economy too much, causing recession.
In response, long-term interest rates fell sharply with the 10-year yield shedding more than 1.0% since the end of October. This helped our bond portfolios jump in value (remember, bond prices move inversely to interest rates).
Source: YCharts, as of 12/28/2023. Graph illustrating 10 Year Treasury Rate.
2024 is an election year and that tends to throw things for a bit of a loop. While the outcome of the election likely has zero effect on the markets over the long run, the frenzy and the ‘distraction’ could present opportunities.
Most market experts think a recession is unlikely this year but I think the probability is actually much higher than the market is embedding. The tight monetary policy takes a long time to work its way through the economy and we really have only had this very tight monetary environment for six months.
Personally, I think the market has gotten well ahead of the Federal Reserve. Yes, the Fed can likely claim victory in its war on inflation but as we’ve seen over the last four years, the Fed puts out one fire and at the same time is starting another.
So far, the economy has been unbelievably resilient but we are starting to see the labor market weaken quite a bit. The latest report had over 71K of prior month revisions to the downside.[1]
The market is now seeing six cuts this year. I’m a bit skeptical unless we actually go into recession. So in the end, either you think we are going in recession and that will cause the Fed to cut SIX times this year or we don’t and the path to six cuts seems unplausible.
The market is right to try to front run this. It’s just that it creates this price compression where the price gets ahead of itself and then you sort of have to decompress over time as expectations ebb and flow. Right now, as I noted, I just think expectations are a bit out of whack (CFA level 2 term) with where the Fed will be in six to nine months.
View From the Peak
One of the most common questions I field is what do I think the market will do? My response is usually, until when? The time horizon of the question is extremely important. If we are talking about this year then the answer will likely be very different compared to the next decade.
For those that have a long way to go, whether until retirement, life expectancy, the purchase of a home, generational giving, etc., equities are an essential part of the equation. That is especially true for those under the age of 45 who plan on working for another two decades.
Over very long periods of time, stocks do extremely well. If you look at the chart below, the dot com bubble bursting and the Financial Crisis of 2008 are small divots on the blue line relative to the long history.
Source: Jeremy Siegel, Stocks for the Long Run (2022).
When it comes to compounding of wealth, nothing compares to stocks. However, you must be able to weather the volatility.
Amazon.com is one of the largest companies in the world today. It didn’t exist as a public company before 1996. If you invested one dollar in the company then, it would be worth From then until now, you would have had to endure many times were it lost more than one-third of its value (14 times by my count).
During one stretch, you would have had to stick with the stock while it was down 90% from its peak. Just last year it lost nearly 60% of its value.
While equities are great long-term compounders, you have to be able to weather the storms.
We will continue to own equities as our long-term compounding capital. The capital that is on the journey for the long run. However, we will always pair it with a large allocation to bonds that creates the synthetic paycheck for us. Cash flow is king!
Source: YCharts, as of 01/05/2024. Graph highlighting Amazon Performance.
Positioning
Our stance for the first quarter is still to lock in these current interest rates with high-quality individual bonds. In the last few weeks, as the market went ‘risk on’ in a big way, the inventory from which we select our purchases of more bonds dried up. I just don’t expect that to last as volatility edges up.
In two years are 10-year interest rates going to be above or below 4.2%? I think it’s a relatively good bet to think they will be lower.
Our approach will always be to err on the side of conservative and hit the fat pitches when they materialize. The generational opportunity in bonds today is just too good to pass up in our opinion. The ability to earn above 5.5% yields [ICE BofA US Corporate Bond Index Effective Yield on 1/5/24 was 5.44%] cannot be understated.
When we run our financial plans for clients, they typically have assumed net rates of returns of 5.0%. If we are generating above that with the bulk of their money, the chances of success on the plan goes up dramatically.
By locking that yield in, we can insulate the portfolios to achieving their objectives while taking less equity risk.
As always, we appreciate the trust you place in us.
Sincerely,
Mark Asaro, CFA
Author
