The Fed shows its hawkish resolve: now projecting just one cut in 2024

The Fed made no policy change last week, keeping interest rates steady at 5.25% - 5.50%. In a way, this isn’t surprising. Regular readers may remember our “Fed cuts checklist”, which follows the Fed’s two mandates: stable prices and full employment. Though some key conditions for a first rate cut have been meet – the unemployment rate is now at 4.0%, and long term inflation expectations remain well anchored – others have not. May’s inflation report (more on that below) provided some initial relief, but Fed officials have made it clear they need to see several months of slowing inflation – and likely slower wage growth too – before they consider lowering rates.

As a result, the Fed did throw one slight curveball at the markets last week: it’s now forecasting just one rate cut this year, scaling back from the three cuts it had projected back in March. It seems the Fed is wary of loosening financial conditions too much, and fewer rate cuts could help keep things in check.

This is not your grandfather’s cutting cycle

In past business cycles the time between the last rate hike and first rate cut was shorter. In some cases, that’s because recession came sooner. In others, the Fed made a mistake by cutting rates too early – a mistake the Fed has been clear it wants to avoid in this higher-inflation cycle. The result? Higher rates for longer. For the markets, this is a mixed bag. Resilient growth and corporate earnings have allowed the equity market to climb higher despite the Fed’s incremental adjustments to the hawkish side. But as we’ve written before, the longer that the economy is resilient – and therefore the longer rates are higher – the more disappointed business owners are becoming and the more challenging the eventual credit cycle may be.

One area we feel confident: if labor market conditions worsen in the next couple of months, the Fed can still adjust and cut sooner.

Inflation finally shows some moderation

Core inflation eased for the second month in a row in May, but this needs to become the trend for the Fed after a series of far too hot readings at the start of the year. Despite the overall easing, certain sectors still show robust price increases. Notably, housing inflation hasn't softened, with owners' equivalent rent maintaining 0.4% month-on-month increases for four months straight. Housing inflation will be especially hard to break, in our view, due to the ongoing housing shortage and high mortgage rates. Although new policies are in place and construction is ongoing, we anticipate that housing market will continue to be a problem for the Fed and could dampen economic growth.

Portfolio strategy

The S&P 500 has gained about 14% this year and continues to climb. Below, I discuss the current equity outlook (using a valuations / fundamentals / technical framework) and suggest a possible repositioning strategy for investors:

  • Valuation: Current valuations seem overstretched, with the S&P 500 trading at 25 times earnings, above the long-term average of 20 times. Valuation isn’t a good timing tool, but we think this is something investors should keep in mind, especially if rates push upwards.
  • Fundamentals: As nominal growth slows, achieving double-digit earnings growth becomes more difficult. Historically, when nominal growth is between 4% and 6% - where it stands today – earnings growth averages about 5%. Yet, market projections are currently set at an optimistic 14% for next year. Given the economic backdrop, such expectations may be overly ambitious and could drive a market correction if the market prices in slower growth.
  • Technical: Market dynamics appear out of the ordinary. The correlation between the market-weighted and equal-weighted S&P 500, which typically remains high as market movements generally lift or depress all stocks, has recently decreased. This decline in correlation isn't entirely unexpected due to the dominance of a few tech giants, but it does signal unusual market behavior that doesn't bode well for the broader equity outlook.

In light of these factors, it may be wise for investors to take profits from equities and shift towards high-quality bonds. Traditionally, bonds are considered for price appreciation, but with the ongoing 'higher rates for longer' scenario, it's time for investors view them as sources of income, in our view. We think further outperformance of equities may be difficult. While we prefer short duration bonds given the inverted curve, we think the new Fed projections could reduce volatility in the longer-end of the curve.

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