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Written by: Cliff Corso | Advisor Asset Management
Softer inflation numbers for June were met with joy in the markets. The probability of a Fed ease in September rose as high as 90% and Powell’s Fed seems poised to make good on the odds. We wouldn’t argue with the market here, but when we take a step back, we don’t see an environment in which the Fed embarks on a long and large easing cycle for two reasons:
- We see inflation remaining moderately elevated, particularly if we don’t see a meaningful slowdown.
- We must remind ourselves that we are returning to a normal interest rate regime, which means even after easing the longer end of the curve might not rally all that much as the curve steepens. That is ok as a 4% to 5% 10-year yield is not abnormal given the environment.
After 15 years of artificially manipulated rate markets, we are finally in a place where inflation forced the Fed’s hand resulting in our current phase of interest normalization. Normalization is a process and not an instant result, which should be expected after such an unusual decade and a half.
So, here is a key question: When is normalization complete and what does that look like? The answer depends heavily on when and where inflation settles. Inflation is coming down, but it is not yet “mission accomplished.” June’s Consumer Price Index (CPI) results came in lower than expected, but headline CPI is still 3% and Core CPI (ex-food and energy) came in at 3.3%. Progress for sure, but what is interesting, is the dichotomy between what people expect inflation to be vs. the ‘immaculate disinflation’ scenario that seems to be powering the markets. The Fed’s stated goal is 2% inflation but multiple measures around future inflation expectations are “stuck” around 3%.
Source: Strategas
While the Fed is resolute in its statements regarding reaching their 2% inflation target, surveys show a lack of confidence in achieving that result.
If the Fed is truly going to shoot for the 2% target, the implication is that they must keep the real Fed Funds rate elevated for longer than even their dot plot projects in the longer run.
Fed’s Next Move
If we look out 12 months or so into the future, we could see the case for the Fed to have eased four or five times, putting the Fed Funds rate at about 4%. But, if inflation follows the above expectations (sticking around 3%), the Fed may want to pause before moving further as an insurance policy that keeps inflation from drifting up inducing a “stop and start” rate pattern. That said, even if the Fed were to ease another two to three times beyond the first four moves, with the Fed Funds rate at, say 3.5%, where should the 10-year trade? A “normal” non-recessionary curve is typically positively sloped with a 2-year to 10-year spread of about 100 bps (basis points). So, even in this dovish scenario, the longer end of the curve would arguably be fairly priced at about 4.5%. Another way to look at long rates is by correlating the nominal GDP to 10-year rates. That is a rough measure, but generally nominal GDP is close to the 10-year rate. If we assumed consensus GDP at 2% and inflation at 2.5%, we would come up with a similar conclusion.
Market Implications
Sure, a quick rally in long rates likely occurs off the first Fed move or two but, the next moves in the long end might be counterintuitive. Good, steady growth, combined with low-but-sticky inflation augur, rather than “higher for longer” or maybe “higher…period.” Here’s the good news: history shows that markets can do quite well in that scenario. Moderate 2.5% to 3% inflation is ok as long as it is stable. Investors can then understand valuations without the noise of how high rates might go. Lower, shorter rates can help smaller companies that tend to go to private lenders offering loans on a floating rate basis. Although it has been painful, we do think patience and positioning for a broadening market structure will pay off. Albeit only a day, but the market action off the lower CPI prints was forceful. Value trounced growth and smaller companies outperformed. We won’t take anything away from the “Magnificent 7,” but the “S&P 493” has plenty of opportunity, in our opinion.
As for income, lower rates in the front end likely will begin to push cash further out the curve. We have discussed a core theme of “Get Off Your Cash,” and market action this year is a reminder of the opportunity costs in asset allocation. We think moving money into short and intermediate fixed income makes good sense here. The coupons are attractive and even though we might not see a durable long rate rally, booking the real yields makes sense to us. As for equity positioning, we also think diversifying is critical given concentrations in indices. On the topic of diversification, and with the Fed joining the global rate decrease train, the U.S. dollar may begin to lose some steam. There is a good case for international markets and companies that sell products overseas. We also see several secular investible themes that provide a tailwind to growth. Infrastructure, energy, materials and defense industries are poised to capture the tailwind. If rates are stabilizing, real estate starts to look more interesting. A positive yield curve would also benefit the financial sector. Normalization of markets requires a different playbook — the good news is that the opportunities for yield, diversification and return are plentiful.