“In the Fed We Trust”: The Great Debate

Rate-cut hopes fade, valuations look stretched, and the Federal Reserve’s two mandates pull in opposite directions. Unemployment or inflation, and what the next leg for markets may look like.

Summertime is upon us (or at least the weather feels that way)! It’s nice to feel the warmth, and yet I miss the springtime weather!

Speaking of changes, the market has finally started to realize the hoped-for interest rate cuts from the Federal Reserve (Fed) are all but a fleeting thought. The 10-year Treasury rate continues to climb back toward 5%. The employment numbers that were forecast to hold strong haven’t been so rosy. Q1 GDP came in much lower than expected (1.6% vs 2.7%). And finally, the health of the economy continues to deteriorate with Q1 earnings struggling to stay in line with expectations; not to mention revenue falling below the prior five-year and 10-year averages. This brings me to April’s Market Update!

In keeping with the prior Market Update layout, this letter provides highlights and an overall summary, followed by the supporting detailed analysis.

This month’s highlights:

• The Great Debate: Unemployment or Inflation?
• The Next Leg (Higher or Lower?)

Summary analysis

For months I have been publishing article after article pointing to the problems underpinning the U.S. economy. Whether it is declining full-time employment, weakening consumer demand, higher consumer debt, sticky inflation, or simply the outperformance of the Magnificent 7 (Mag 7)… it would appear the chickens are coming home to roost, as this month the markets reversed direction. In my last email I said “when the market rallies it takes the escalator up but when it falls it takes the elevator down”. April, and even today, appeared to be the start of an elevator down.

But why now?

Was the market overzealous? Maybe the FOMO of 2023’s Mag 7 led investors in Q4 and Q1 to pile into things that were overvalued? Could it have been the perceived Fed pivot to cutting rates last November?

Whatever the answer, the net result is fairly straightforward… the equity markets are overvalued. Plain and simple. With the market cap-weighted S&P 500 hovering around 20x 2024 projected earnings and the equal-weighted S&P 500 hovering around 18x 2024 projected earnings… valuations across multiple sectors are stretched. If a reversion to the 10-year average were to take place, the market cap-weighted multiple would need to fall to around 17.5x and the equal-weighted multiple would need to fall to around 15x. If this were to happen, we could see almost a 20% decline in stock prices from current levels.

But wait, there’s more…

The aforementioned earnings projections are based on earnings nearly doubling in Q4 from where they are trending in Q1. If earnings falter at all, or if inflation continues to run higher and consumer spending continues to struggle, the aforementioned multiples could be impacted even more.

This brings us to what I am calling “The Great Debate”. The debate centers on the dual mandate of the Federal Reserve: maintain maximum employment or push for an inflation target of 2%. In today’s environment they are diametrically opposed.

Unemployment or inflation

For the last two years the Federal Reserve has been working to fight inflation in a meaningful way. Arguably it has succeeded as inflation has declined from a peak around 9% to where it resides today at 3.5% (April CPI). Unfortunately, as the Fed has expressed multiple times, the longer inflation remains above the 2% target the more ingrained (and acceptable) higher input prices become. This can be seen in a number of industries, but nowhere more than in food, insurance, and gas prices. Higher input prices lead to higher output prices which in turn leads to less money to be spent on discretionary goods/services.

As inflation remains sticky, or even edges higher, the input costs to other areas of the economy dramatically affect the majority of the economy (as defined by those households making less than $100k per year). Effects are felt through average daily spending (e.g., spending $200 a week on groceries that three years ago cost $125 to $150 a week). In order for the Fed to have any impact on these areas (which arguably is very difficult as they are not discretionary items) the Fed needs to slow growth which in turn means the Fed needs to slow spending. However, to slow spending the Fed needs to reduce the amount of money people can spend.

There is only one way to slow growth… take money out of the hands of corporations and consumers. The way they do this is by raising borrowing and financing costs to a point that people cannot afford to divert their money toward discretionary items. When companies cannot afford to borrow for expansion, or consumers cannot afford to borrow for home and car purchases, then the economy slows. Essentially, the Fed needs to remove discretionary cash flow from the economy. Unfortunately they cannot specifically target an item or sector which means mandatory expenses are also impacted by increased borrowing costs.

To accomplish a slowdown in the economy interest rates need to remain high enough for long enough that businesses begin to prioritize capital expenditures differently. For example, if labor costs are typically the largest part of a business’s capital expense structure then electing to lay people off could result in enough of an economic slow down that inflation moves closer to the Fed’s 2% target.

Hence the diametrically opposed mandates! To lower inflation the Fed may need to force a recession as a means to slow the economy. As noted in a prior letter, preceding each of the prior recessions was a jump in unemployment!

This inherently becomes the sticking point. If the Fed keeps rates higher for longer, or even raises them again, then businesses will be forced to lay off more people. With the current NFIB data forecasting small business hiring to be at a multi year low, AND cash flow being sucked out of profits with higher operating costs, it is only a matter of time before full-time employees are laid off in larger quantities.

Unfortunately, as more full- (and part-) time employees are laid off, the higher the unemployment rate becomes. As noted in a prior letter, the 30 year average for unemployment (between 1990 and 2020) was a little more than 5%. This means the Fed can let unemployment drift higher without causing systemic problems… or so we are led to believe.

Historically speaking, when the unemployment rate begins to rapidly climb, the Fed’s maximum employment mandate is no longer achievable. This kicks off a cycle of interest rate cutting as a measure to stimulate the economy thus helping small businesses reduce borrowing costs which in turn allows them to hire more people with their excess capital.

It is important to note that during this roller coaster ride, a recession usually ensues. The dot-com crash led to a mild recession, while the Great Financial Crisis narrowly avoided a depression. In both cases the U.S. equity markets were down more than 35% cumulatively.

Higher or lower from here

It would be wonderful to have a crystal ball. My life would be easier. I would be able to more easily forecast what could happen next in the economy and markets. It may even open the door to solve some of life’s greatest mysteries. Alas I do not have one. However, I can use data to help create a paint by numbers picture.

To read the data, or tea leaves, we need to hear what Chair Powell, and the Board of Governors, will say in tomorrow’s press release. There is growing concern the Fed will need to pivot again, away from easing, to a more hawkish stance. Should this happen, the asset inflation in the stock market over the last five months could continue to be unwound.

Upon reviewing the economic data released over the last year, the charts of various equity markets, and concerns about escalating geopolitical tensions, it is my opinion that “The Next Leg” will be lower. The question becomes how much lower AND are there opportunities along the way to invest in underrated areas? Let’s dive into this question below.

If the economic data correctly reflects an overvalued economy, one that is teetering on a recession within the next six to twelve months, then the U.S. equity markets should begin reacting very soon. Depending on the duration of higher interest rates, and the speed of employment deteriorating, an equity market decline could resemble something comparable to 2022. However, if the Fed is not able to thread the needle between combating inflation while maximizing employment then a market decline could look more like 2008. Fortunately with every market decline opportunities are created.

Where we see opportunity

Recently, after large pullbacks, we have started to take small positions in a number of companies. These companies span the following sectors: technology, consumer goods, and healthcare. Each of these positions has retraced 25%+ since their recent highs, are market pioneers in their respective fields, and have been focused on cutting costs over the past six to twelve months.

Should the equity markets continue to decline, as our research indicates it could, then additional opportunities will arise. We are currently tracking over 50 equity positions (and another 100 ETFs/Mutual Funds) that will allow us to fill out the explore part of our investment thesis in Space/Defense, Metaverse/Artificial Intelligence, and EV/Infrastructure. The core part of our portfolio will continue to focus on “value” strategies in real estate, healthcare, consumer goods, and possibly financials.

Changes to our fixed income approach

I should note, the one change to our investment thesis that will affect all of our portfolio strategies will reside within our fixed income strategy, and overall asset allocation. As the 10-year Treasury approaches, and ideally reaches, 5% we will adjust the asset allocation of all strategies to incorporate a higher weighting to intermediate- and long-term fixed income. The breakdown between corporate and government bonds will be based on our respective investment strategies and client risk profiles.

Our new investment models will seek to pursue long-term growth while offering current income. The type of income will be aligned with the type of account the investment(s) reside in.

Finally, as the U.S. equity market nears a perceived bottom I will officially unwind our short positions and move to be fully invested across U.S. and international markets.