Will the Fed Engineer a Sticky Landing?

A bumpy second quarter for stocks and bonds, a Fed weighing both sides of its mandate, and the case for a landing that is neither hard nor soft.

The second quarter remained a bumpy ride in both the equity and fixed income markets. At the start of the quarter, the equity markets came under pressure due to the realization that the Fed wouldn’t cut rates five to seven times this year. With CPI continuing to climb higher throughout Q1, and Q1 GDP dropping to 1.4%, the market started to realize “higher for longer” was here to stay.

Then came the April CPI reading, released in May, noting a 0.1% tick down in inflation, along with the Fed’s dovish comments that the Q1 GDP decline was nothing to worry about. The market used these data points as fuel to reignite the exuberance in the equity markets, primarily in the technology sector.

Longer-duration fixed income continued its high-volatility swings, as the 10-year Treasury started the quarter at 4.32%, jumped to 4.70%, dropped to 4.21% and finally settled at 4.34%. This whipsaw in longer-dated yields affected high-yield bonds, corporate bonds and longer-dated Treasury bonds. Interestingly, in the last two weeks of June the 10-year Treasury started to respond to future inflation concerns related to the recent presidential debate.

Election-year patterns and bond yields

At the start of the year, in the January market update, I pointed to a historical pattern highlighting how U.S. equity markets tend to perform well when the presidential incumbent is projected to win. So far in the first half of 2024, namely within the “Mag 7,” this has held true. However, with presidential polls starting to tilt toward a Republican win after the recent debate, the bond market has begun to price in higher future inflation due to comments made by the candidate. If the tax cuts expiring in 2025 are extended, a 10% tariff is imposed on foreign goods and deficit spending continues to mount, then the Treasury will be forced to issue more debt to fund growth, which will in turn lead to higher long-term bond yields and more bond volatility.

How our strategies are positioned

So how are our investment strategies positioned?

We continue to hold short-term fixed income, energy exposure, AI exposure, defensive stock exposure and some short exposure for most clients. This kind of positioning tends to hold up better during pullbacks, like April’s 5% market decline, and to lag when broad markets recover, as they did in May and June.

Looking forward, we will continue to focus on building out our Core & Explore strategies. Most of the focus will be on energy: energy as it relates to the Core component of the overall strategy, and energy as it relates to the AI Explore exposure. For example, with geopolitical tensions remaining high, oil and natural gas prices are expected to remain elevated (a 12% price increase since June 3). This will present a strong growth opportunity for energy suppliers. On the other hand, if the AI revolution grows at its current rate, the amount of energy required to power it is dramatically understated. In an interview, Mark Zuckerberg stated that AI data centers will require new power plants to be built to sustain AI power requirements. Couple the AI power constraints with the EV power constraints, and the strain on the U.S. power grid and infrastructure will continue to be the limiting factor for future expansion, or Mag 7 profitability. This constraint creates long-term opportunities.

Heading into Q3, we will look to add to defensive equity positions, undervalued equity positions and healthcare, and begin stepping into intermediate-term bonds as the 10-year Treasury approaches 4.5%.

To know how to evaluate market opportunities, and whether to make an investment, it is important to assess the hypothetical outcomes of higher for longer, rising unemployment, sticky inflation and a weakening consumer. The good news: Fed officials are finally acknowledging the pressure of their dual mandate and, while committed to fighting inflation, are keenly aware that a rapidly rising unemployment rate is not good for growth.

Testing the Fed’s dual mandate

For almost a year I have been beating the drum that the U.S. economy is not in great shape and that the “AI boom” disrupted what should have been a typical economic downturn (a recession). Nearly two years after the AI boom started, the fuse is becoming shorter and shorter. While it is unclear if this bubble will go the way of the dot-com bubble, even though there are some similarities, it is the consumer, or more aptly consumer spending, that could take the air out of the bubble.

In May’s market update I noted the Fed’s dual mandate, to maximize employment and drive inflation down to 2%, was going to be tested. If inflation remained stubbornly high and unemployment continued to climb, which mandate would the Fed elect to prioritize? Well, the answer may have just come from one of the more dovish Fed presidents, Mary Daly. In a recent public presentation Ms. Daly stated, “At this point, inflation is not the only risk we face. We will need to keep our eyes on both sides of our mandate – inflation and full employment – as we work to achieve our goals.” Ms. Daly was not the only Fed president to state the need to monitor both inflation and employment. In his June meeting remarks, the Fed chair also mentioned the need to stay vigilant about the risks facing the labor market.

So if the unemployment rate ticked up to 4% in May and inflation continues to be stubbornly sticky (above 3.4%), is there a chance the Fed will stick a soft landing (as measured by cutting rates before a recession starts), or will it be faced with the uncomfortable truth that to get inflation down to 2%, demand needs to fall, which in turn means unemployment needs to rise? In my November 2023 market update I pointed to some key statistics related to small-cap companies. In particular, I noted that the longer rates remained higher, the more these companies were going to have to prioritize expenses, namely labor costs. In that commentary I noted the 30-year (1990–2020) average unemployment rate was 5.5%. With today’s unemployment rate continuing its climb from 3.4% to now 4%, the chance that the Fed needs to worry about employment too much right now is quite low. It can afford to let unemployment drift higher and in turn keep interest rates higher for longer to stamp out sticky inflation. That means more job losses are on the horizon, which will most likely affect those who are paid higher wages.

Recession signals are building

With job openings continuing to decline, initial jobless claims continuing to rise, and continuing claims also rising, it is only a matter of time before the Sahm Rule (the recession indicator created by a former Fed economist) is triggered. If we compound the employment problems with cash reserves being tapped out, consumer debt and interest rates at all-time highs, and consumer goods companies reporting poor performance, then it is easier to see the economic storm isn’t improving.

It does not matter if it is the Schannep Recession Indicator, the Sahm Rule, an inverted yield curve, U.S. equity market valuations near 40-year highs, or the fact that short interest in stocks is at a six-year low (according to JP Morgan): the irrational exuberance that pushes equity markets higher on the promise of a 0.25% rate cut is becoming dangerous. With the Fed pushing out its expectation for 2% inflation to the end of 2025, rates will need to remain higher for MUCH longer, which will only hurt businesses and consumers further, leading to more bankruptcies and charge-offs to come. Therefore, is it possible for the Fed to stick the “soft landing” narrative it has been chasing for almost a year?

The sticky landing outcome

Threading a needle, in any aspect of life, is extremely hard. It’s like landing a plane on an aircraft carrier while being shot at, or skydiving and trying to land on top of a moving vehicle while the wind is gusting. Can it be done? Sure! Does it happen often? Nope! According to the American Economic Association, in the past 60 years the Fed has successfully orchestrated a soft landing only ONE TIME (1994–1995). That is not to say the Fed can’t do it this time. Instead, I want to point out that the Fed was forecast (by Wall Street) to cut rates five to seven times this year AND NOW is forecast to cut once, possibly twice, by year-end. The worst part: the equity markets are brushing off the drop in rate cut expectations as though any rate cut, even one, means borrowing costs will come down quickly, easing economic pain for businesses and consumers. Unfortunately, this is far from reality.

To stick the soft landing, GDP cannot fall below 0% for two back-to-back quarters before the Fed cuts rates. Interestingly, even if the Fed were to cut rates once or twice, or even up to four times, over the next six to twelve months, the cost of borrowing would still remain astronomically high compared with where it was, on average, over the prior 15 years. Typically, as interest rates drop, consumer and business spending increases, BUT in this case the “Have Not” consumers, who represent 67% of America, are being crushed by the debt they have accumulated, which is being compounded by high interest rates. Of course, those in the other 33% could continue to prop up the U.S. economy, but to do that they would need their equity portfolios to remain where they are, if not continue to climb.

If we look at the dot-com crash as a potential proxy for what might happen in the stock market or the U.S. economy, we find that investors lost over 50% of their equity investments from 2000 to 2002, even though the U.S. entered and exited a recession between March 2001 and November 2001. Therefore, even if the Fed is able to “stick the soft landing,” that does not mean a recession will not materialize. It also does not mean the stock market will sidestep a sizable correction. Whether the U.S. can avoid an economic downturn, regardless of whether a soft landing is engineered, is something only time will tell.

For these reasons we remain defensive, but opportunistic, with every market gyration.