Domestic equity and fixed income markets reacted negatively to Fed Day Jerome Powell and the FOMC delivered what was widely interpreted as a “rate cut.” Despite lowering overnight interest rates by 25 basis points, to a range of 4.25% to 4.5%, Powell made it clear that the FOMC’s attention has shifted from the balance of risks posture of recent meetings to a clearer focus on sticky inflation. The updated Summary of Economic Projections (SEP) show just two 25bp rate cuts in 2025, down from four that were projected in September, and Powell’s press conference comments suggest that a near term pause is likely.
Financial markets responded immediately, with rates moving 5-10bp higher across the curve within minutes of the press release, and equities falling. Fed Funds Futures markets are now pricing one or possibly two 25bp cuts next year, roughly consistent with the FOMC’s own projections, but markets are sharply divided as to whether further cuts in 2026 will occur. The glide path to a terminal rate in the neighborhood of 3% is likely to be long and bumpy, with rate hikes a possibility at some point along the way.
Markets got a bit of a reprieve on Friday though, thanks to PCE data for November that came in roughly 10 basis points below consensus across the board. Tech stocks had a strong session on Friday after the PCE print, mitigating a portion of the week’s decline in large cap benchmarks. Despite being slightly better than consensus, however, both core and headline PCE have trended higher on a y/y basis in recent months, which is a source of concern for investors and the Fed. See the Chart of the Week for a PCE time series.
Albion’s “Four Pillars”:
Economy & Earnings
The US economy has been resilient despite the higher interest rate environment. S&P 500 earnings are on track for high single-digit y/y growth in 2024, with consensus calling for an acceleration to double-digit y/y growth in 2025.
Valuation
The S&P 500’s forward P/E of 22x 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 mid single digits.
Interest Rates
After the “hawkish cut” at the December 2024 FOMC meeting, a near term pause on further rate cuts is likely, and the curve has mostly resumed its normal upward slope. Belly and long end rates in the 4% to 5% range may represent the “new normal” given solid economic growth, lingering inflation pressures, and large US fiscal deficits.
Inflation
After the disinflationary trend resumed in the summer of 2024, more recent inflation data has shown some renewed signs of stickiness. Services inflation remains somewhat elevated, in part due to heavily lagged shelter costs.
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