Weekly Recap:
Last week the FOMC finally launched its much-anticipated pivot, delivering a 50 basis point cut in what will clearly be the first of several reductions in overnight interest rates. How many additional cuts will be delivered, and over what period of time, remain topics of debate amongst market participants. In the official release and during the ensuing press conference, Fed Chair Jerome Powell stressed that despite the 50bp reduction (unusual outside of crisis situations), the US economy remains on solid footing in the eyes of the committee. Notably, Fed Board of Governors member Michelle Bowman dissented, issuing a short statement summarizing her view that with inflation currently above the Fed’s 2% target, a 25 basis point cut would have been more appropriate at this time.
Equity investors largely reacted with enthusiasm, as expected. The S&P 500 and the Dow set fresh all time highs on Thursday and Friday, respectively, thanks to notable strength in cyclicals and growth stocks. Small caps also enjoyed a tailwind.
Rates across much of the curve actually rose following the announcement, rather than falling as some might have expected. 10y Treasury yields ended the week 9bp higher while 30y yields finished up by 10bp, an indication that the bond market may have already fully priced the entire upcoming rate cutting cycle. Rising yields in the belly and long end are helping to restore the curve’s natural upward slope. Normalization in many parts of the economy (growth, margins, consumer, labor, etc.) has been a theme of the post-pandemic economy. As the Fed’s rate cutting cycle unfolds over the coming months, it appears that that theme may finally be applying to rates markets as well.
Albion’s “Four Pillars”:
Economy & Earnings
The US economy has been resilient despite the higher interest rate environment. Analysts are forecasting low double digit EPS growth in 2024; growth of that magnitude will depend on the economy avoiding recession.
Valuation
The S&P 500’s forward P/E of 21x is well above the long run average, so valuations are likely to be a headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Eq Mkt Cap / GDP) suggest that compound annual returns from current levels over the coming decade are likely to be in the single digits.
Interest Rates
Futures markets imply that the Fed will deliver interest rate cuts in each of the last two FOMC meetings of 2024, with additional cuts in 2025. Belly and long end rates are already at or below what are likely to be their post-pandemic equilibrium levels, unless the US economy enters a recession.
Inflation
After becoming sticky in the 3-4% range in the first half of 2024, more recent data has reinforced the disinflationary trend, and the Fed has expressed confidence in the path to its 2% target. Services inflation remains somewhat elevated, in part due to heavily lagged shelter costs.
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