Steady as she goes

At the risk of sounding immodest, you should know my portfolio has been on a real roll of late.

Now granted, that likely has to do more with a strong run by the markets in general than it does my brilliance. But regardless of the reason, it is fun while it lasts.

This is a bit off-brand for me, but I actually do believe it can last. That said, I also think some investors are making a real mistake right now that could cost them dearly.

The reason for the rally is primarily “big macro.” The Federal Reserve has done a remarkable job to date cooling inflation while not crashing the economy, better than most (myself included) believed they would. The factors that led to the inflation likely made this easier than in a typical cycle, but Jerome Powell & Co. deserve a lot of credit for the work they have done.

Lately, the economic indicators are all pointing in the right direction. Inflation measures appear to be leveling, and employment remains stable. It has been enough for the Fed to at least temporarily hit the brakes on rate hikes, which in turn has led to the recent rally in stocks.

Investors today aren’t just assuming that the Fed is done hiking. They are already buying in ahead of the first rate cut. Fed funds futures are the most straightforward way to see how the conventional wisdom believes rates will move from here. As of this typing, the market is pricing in a 45% chance of a rate cut in March and a 75% chance in late April.

Overall, the market sees about four cuts coming in 2024 worth 100 basis points.

I think the markets are wrong. And even if they are right, I think investors risk drawing the wrong conclusions from it.

The baked in assumption right now is that the Fed is uncomfortable with where rates stand. Political pressure to make sure the economy is functioning well in an election year will tip the scales towards a looser monetary policy, especially with consumer spending coming under pressure now that the pandemic-era savings glut is gone and student loan payments have returned. If employment should falter in the slightest, the Fed would have every justification to reverse course.

It’s worth noting that one of the most important things to come out of 2023 is the Fed now can take action. That’s the value of the rate hikes we have seen. Near-zero rates took a powerful tool out of the Fed’s playbook that it now has back.

I also think employment is the biggest wildcard in the economy right now, and weakness there could be what proves me wrong and causes the Fed to act.

But reading through the minutes of the November Fed meeting, the theme I come back to is “patience.” There was surprising (to me) consensus to remain restrictive, given all that is going on. The minutes show that all participants are comfortable with proceeding cautiously, and all participants agreed rates are likely to remain restrictive for some time. Indeed, the Fed seems as surprised as we are about the economy’s resilience even as signs grow that the rates are having an impact.

And labor, the wild card, is seeing supply and demand “continue to come into better balance.”

Add it up, and the Fed does not appear trigger happy. Based on the current level of patience and the trajectory we appear to be on, it feels like investors should be careful what they wish for when they daydream about rate cuts as soon as March. I dare not think about what would have had to change, and how severe that change would have to be, to cause that to happen.

Back to what I said above, the Fed understands better than anyone how much easier their job is with the Fed Funds rate in the current 4% to 6% range, with ample wiggle room to go up or down from here. They worked hard to regain this tool. They are unlikely to dump it unless they really have to.

For what it is worth I do think the Fed will cut rates in 2024. Perhaps as soon as June, but even if so, it will not be nearly as drastic or as rapid fire as investors seem to hope. And absent a new pandemic or some other similar shock to the system, I can’t imagine rates getting back down to the levels of the go go days of just a few years ago.

Even if rate cuts happen in 2024, I wouldn’t be surprised if the longer-term trend from here continues to be rates in the current range to higher, not lower.

Amazingly, Jerome Powell is trying to tell us all of this, but the market simply doesn’t believe him. Powell was here in Atlanta in recent days, saying in a speech “it would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance.”

There are some trades here, if one is so inclined. I think if the current trajectory holds, we are running out of time to buy a lot of financial services and REIT stocks at silly discounts. If one wishes to go shopping, that’s where my focus would be. There is also a possible really good shorter-term trade on the mortgage REITs, which have been a graveyard over the past decade or so. But be careful there.

The cycle could well be turning, and 2024 right now does appear to be more about stabilization than transition. The mistake investors are making is equating that to the return of free money. Those crowding into stocks that only made sense when rates were near zero are courting sorrow.

As always, play the long game.

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