A lot of bad news has been ignored by Wall Street on the assumption that the Fed will ‘pivot” and begin lowering interest rates this year. The market is annualizing three and six-month inflation, which is generating a lower inflation number than by comparing the last twelve months. For example, the Fed’s preferred inflation measure, the “core PCE” still shows annual inflation at 3.2%, while the six-month measure is now at 1.9%. This is leading many market participants to expect a significant amount of easing from the Fed. In fact, the futures market is expecting the Fed cut its short-term interest rates by 1.7% between now and the end of the year. Based on recent comments by Fed members, it seems that rate cuts will be slow and steady as long as there is a “soft landing” in the economy. If there is evidence of weak economic data ahead, the Fed may ease rates more quickly. Atlanta Fed Chairman Raphael Bostic said last week that he doesn’t see the need to cut interest rates until the third quarter, unless there is “convincing” evidence of a surprise decline in inflation. At present, it is unclear how soon the Fed will move given the inflation scenario, and it is unclear by how much they will cut rates. In an election year, the Feds decisions always become more politicized.
The stock market’s runup last year was in anticipation of these rate cuts. The stock market refused to listen to the Fed’s rhetoric over trying to slow the economy, and most thought that higher interest rates were only temporary. And yet, while the stock market has been flashing green, underlying trends in the economy have been flashing red. While employment remains robust, leading indicators are contracting and signaling a recession. The Leading Economic Index just declined for the 21st month in a row. The Conference Board, a Manhattan based economic research bureau, is now forecasting US GDP growth to turn negative in Q2 and Q3 of 2024. As the following chart demonstrates, when there is a “hard landing” followed by rate cuts, the stock market can be vulnerable.
Economic growth as measured by GDP can be misleading if not adjusted for inflation. Currently, GDP growth is at an impressive 6.2%, but adjusted for inflation, that number becomes 1.9%. Retail sales, when adjusted for inflation, have been flatlining for thirty months, whereas over the past year that figure, unadjusted for inflation, was up 3.9%.Stock valuations are expensive. On January 1st, 2023, the S&P traded at a forward P/E of 17 times, in the 56th percentile of “expensiveness”. By year’s end, the same index was at 20 times, its 90th percentile. Corporate insiders have been selling shares in their own companies while retail investors have been heavily entering the market.
This could be because of a challenging set of comparisons relative to last year on corporate earnings. S&P 500 earnings are forecast to gain 12% this year. Enormous leverage has led to a vulnerability to higher interest rates which has not really manifested itself yet.
The greatest number of consumer and corporate delinquencies, as well as bank failures took place last year since the Great Financial crisis. A record number of Americans did not pay their federal taxes in 2023. Some 40% of student debt holders have not begun repaying their loans after their requirement to do so on October 1st. Subprime auto loans delinquencies are at a record high. Credit card debt is at an all-time high ($1.08 trillion) paying on average, 23% interest. US housing affordability is worse today than at its peak during the last housing bubble. The median US household now needs to spend 45.3% of its income to afford a median priced home, another record high.
And yet, the economy looks strong, despite deteriorating credit quality.
Federal debt has just bypassed $34 trillion, and is on schedule to add to that number by $2 trillion per year, with large government deficits and no plans to cut them in an election year. As a result, the US Treasury is issuing increasing amounts of Treasury bonds. Heavy treasury issuance is driving up long term bond yields based simply on supply. This year, the US Treasury is on track to issue around $4 trillion of bonds, a record. If 10-year yields continue to rise from their current level of 4.14%, this acts as a brake to further stock market gains. A surge in US Treasury bond issuance in the second half of last year helped to drive Treasury yields to their highest levels in decades. As a counterpoint, the Fed has recently hinted that a pause in their program of reducing the balance sheet (quantitative tightening) may be brought forward. This would provide a temporary reprieve on bond market pressures, but keep in mind that the Fed still has $7.2 trillion on its balance sheet, down from $9 trillion at its peak. Interestingly, US corporates are issuing bonds in 2024 at the fastest year-to-date pace in over thirty years, indicating that they think bond yields are going higher.
Nor is this problem confined to the US. Emerging market bond issuance is out of control, and expected to surge again this year. The U.K, which is also in an election year, is expected to issue three times more debt than its ten-year average. In Europe, net bond issuance is expected to rise by 18%.
Since the Fed began raising interest rates in March 2022, money market funds have seen large inflows, and now equal a record $6 trillion. If interest rates begin to decrease, some of this sidelined cash could find itself rotating into the stock market. If the Fed does embark upon an easing cycle, the US dollar should weaken, which favors gold and precious metals.
One thing is clear: Expect volatility in 2024. The possibility of supply chain pressure from the Middle East could threaten input costs and oil prices. Ukraine, the war in Gaza, and the threat of a Chinese invasion of Taiwan all present obvious risks. More than 90% of all advanced microchips are made in Taiwan, and a Chinese attack would threaten the world’s supply of semiconductor components.
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