Should investors focus on the Fed’s next rate cut?

We don’t need a rate cut right now. On November 1, 2023, the Federal Reserve announced they had seen enough evidence to pause their historical tightening cycle that began in March 2022. As a result, global stocks delivered their best monthly return since November 2020 and global bonds had the best performance since December 2008. Despite this euphoric easing of financial conditions, at the end of 2023, the Federal Reserve suggested they would likely cut rates three times in 2024. As investors turned the page to 2024, jubilant markets were pricing in roughly six full 25 basis point cuts with the March FOMC meeting being 84% priced for the timing of the first cut. With the S&P 500 Index delivering a roughly 10% return in the first quarter, there was some fear that investors were equating stock performance with imminent easing of policy. For us, this was never the case, as our preference for large cap U.S. equity companies with strong free cash flow and quality earnings was not incumbent on a cut in policy rates. Similarly, our preference for high yield credit versus core bonds was being driven by an environment where the U.S. economy was avoiding recession and “carefully and methodically” bringing rates down over the next year, versus the overly aggressive easing that was priced in to start the year. Importantly, after Q1 inflationary readings proved a bit more stubborn than anticipated and the euphoric easing of financial conditions was almost completely priced out, we remain committed to our stock and credit overweight because less or delayed easing of policy is much less troublesome than more tightening.

Why are you so confident about the “no recession” call?

Quite simply, this time is different. When the Fed started raising rates in March 2022, there was a parade of strategists that commented that the Fed would have no choice but to “break the back” of the economy to have any chance of getting inflation down. In fact, 100% of economists surveyed by Bloomberg going into 2023 had either a mild recession or a hard landing as their base case, driven by the cumulative effects of monetary policy tightening. This call was 100% incorrect. Since June 2022, the U.S. economy put up six straight quarters of above-trend growth, the unemployment rate has stayed below 4% for over two years in a row, and headline CPI has moved from a high of 9.1% in June 2022 to 3.5% today. So, what gives? The U.S. economy has proven to be historically interest rate insensitive. In other words, while spikes in rates have historically led to both consumer and business caution, this time has, in fact, been different to the surprise of many investors. This is because of the unique pandemic price action in interest rates combined with shrewd refinancing behavior by homeowners and corporate CFO’s when it mattered most. While many investors were confronted with the violent spike in rates in 2022, 10-year Treasury rates got as low at .48% in July 2020, and stayed below 2% from December 2019 to February 2022. This led to remarkable refinancing activity in the U.S. mortgage market as well as the corporate bond market, cushioning the blow of higher rates in 2022-2023. In fact, as of 3/31/24, the effective rate that U.S. homeowners are paying on their mortgages is only 3.8% despite the prevailing rate for a new mortgage being at 7.25%. This is the widest spread in history on what homeowners are paying currently (effective rate) and what a new mortgage would cost (prevailing rate). Additionally, as illustrated in the chart below, the first time since 1984 that the risk-free rate of 5.5% is higher than the effective mortgage rate of 3.8% highlighting the advantage on what homeowners are earning on their assets versus paying on their liabilities.

Mortgages represent 66% of liabilities on the consumer balance sheet and we are still living in a world of cheap money. This historical anomaly was driven entirely by the sharp move lower in rates during the pandemic and the sharp increase in rates post pandemic. It is also the reason why we avoided recession and will continue to be in a position of strength moving forward. Debt payments as a percentage of disposable income (shown in the chart below) are lower than where we were before the Fed started raising rates, proving consumers have not been weighed down by debt, which is in stark contrast to the 2008 financial crisis.

This refinancing activity was not limited to the consumer mortgage market, as corporate balance sheets have proven to be similarly resilient to higher rates. As seen in the chart below, only 2% of the corporate high yield index matures this year and just under 6% matures next year. In fact, the maturity wall doesn’t peak until 2029. This is entirely driven by the below investment grade corporate refinancing activity that took place in 2020, 2021 and early 2022 when rates were much lower. The fundamental backdrop of growth and lack of refinancing maturing bonds continue to be tailwinds for our high yield credit allocations despite very tight spreads. The bottom line is that the interest rate insensitivity of the U.S. economy not only keeps us out of recession for the foreseeable future, but also allows us to lean into equities without needing a rate cut for growth and earnings delivery.

What keeps you up at night?

While we have confidence in our base case that the U.S. economy will avoid recession and rate cuts will not be needed in the current environment, we need to be mindful of tail risks. In any 12-month forward period, there is a 15% chance of recession. We currently are right around that probability for two consecutive quarters of negative GDP growth and negative job creation over the next 12 months. This could be driven by business caution around rates or geopolitics that lead to systemic layoffs. Given the view around interest rate insensitivity as mentioned earlier, we are assigning a low probability to this tail risk. The somewhat more probable tail risk versus recession is the risk that inflation continues to stay sticky and even accelerate driven by the enormous amount of liquidity that is still in the system – such as the Fed’s $7T balance sheet and the U.S. government’s 7% fiscal deficit – along with the lagged effects of monetary policy taking much longer to bite given the extraordinary post-pandemic refinancing activity. While the Chair of the Federal Reserve Jerome Powell commented in a May FOMC press conference that they would need “persuasive evidence” that policy is not sufficiently restrictive which in effect raised the bar to come back and tighten again, this cannot be ruled out. This cycle has proven remarkably unpredictable, so asset allocation flexibility continues to be essential.