It’s easy to get caught up in whether the Federal Reserve will raise rates 0.25 or 0.5 percentage point (probably the latter) or whether it will start cutting again by the end of the year (almost certainly not), and invest accordingly. But it is time to step back. Only rarely should investors care about what the Fed says or even what it does at its meetings.
What really matters for long-run returns is getting the direction of travel right, and that comes from the economy, where the Fed’s fine-tuning misses the point. Investors are already looking further ahead. The bull case is that the direction of travel has changed.
Rather than preparing for still-higher interest rates, markets are well along in pricing an economy with lower but fairly sticky inflation, higher-for-longer rates and continued growth. Stocks are up, Treasury yields are broadly stable at what used to count as a high level, and risk premiums on junk bonds are falling fast. These all point in the same direction, and it’s a bullish one.
There is plenty of evidence that the economy is getting better, rather than worse. The Atlanta Fed’s GDPNow estimate of the current quarter drawn from data released so far puts growth close to 2%, way higher than the slight fall economists predicted at the start of April. Consumer sentiment is up, according to preliminary figures from the University of Michigan, while inflation expectations are down. Even the highly interest rate sensitive home-construction market is showing signs of life.
The question is: Did those who waited on the sidelines miss the best part of the recent market rally? And has it gone too far? It certainly has gone a long way: Stocks are up more than 20% from October’s low for one amateurish definition of a new bull market. The extra yield offered by junk bonds over Treasurys is within a whisker of the average for 2019, before the pandemic. And the extra earnings yield (earnings/price) offered by the S&P 500 above Treasurys is shrinking fast.
Sure, there are signs that investors suffering from FOMO, fear of missing out, are rushing to get back into stocks, pushing some of the bets on artificial intelligence to silly levels. And perennial gambling-chip stocks are doing well again, with Tesla up 61%, GameStop up 32% and Plug Power up 20% since the start of May.
Another leg to the bullish story is that the equity rally is broadening out from the seven or eight Big Tech AI plays that held up the S&P 500 for the first five months of the year. The Russell 2000 index of smaller companies and the equal-weighted S&P 500, which minimizes the effect of the huge tech stocks, have both outpaced the Big Tech leaders so far this month.
As investors who were staying out of stocks realize they missed the change of economic direction, there should be more to come.
The bearish story is that FOMO never lasts and that the economic revival is far less of a sure thing than it seems. It isn’t that bears have spotted something everyone else has missed. It is just that many of the same economic concerns that earlier this year led economists to predict recession are still in place:
The lagged effect of rate rises. No one knows how long it will take to hit the economy, but defaults are already ticking up among those most exposed to trouble, notably on credit-card debt, auto loans, parts of commercial real estate and weak companies with variable-rate loans. So far, defaults and delinquencies have merely returned to prepandemic norms, but more debt at higher rates creates the risk of a much higher level of sour loans.
The cash pile that savers built up during the pandemic has mostly run off, the most-likely reason for the rise in defaults. People who have been living off Covid-era savings will have to reduce consumption.
Zombie banks might cut back lending to rebuild their capital buffers, to avoid issuing new shares. They are also likely to pass on higher deposit rates to borrowers, at a time when banks were already tightening lending standards for households and businesses. Less credit is bad for the economy.
Finally, the data aren’t as good as the market mood. Manufacturing surveys show the sector is suffering and might get worse, with inventories rising and new orders falling. The jobs market is still strong, but new weekly claims for unemployment benefits are up almost 50% from September’s low and higher than the highest reached in 2018 or 2019.
I suspect FOMO will keep the rally going a little longer, but the economic direction of travel feels much more uncertain than the price action suggests.
I’ll come back to the question of recession, and in particular the inverted yield curve, in my next column. For now, the trick for investors when assessing the economic data is to ignore the noise about whether it means one or maybe two more Fed hikes to come. What matters is the bigger economic picture. Don’t sweat the small stuff, even from the Fed.