Highlights:
• Monetary policy is attempting to ease off the brakes to prevent a hard landing.
• Fed unlikely to hike rates in the future lifts precious metals and bitcoin.
• Fed slowing balance sheet runoff but doesn't want that to signal game-on for risk assets.
• Fed is concerned over equity valuations, and this could be a more prominent communication in future Fed meetings.
• Slowdown in inflation, ISM figures, and employment lowers rates and supports stocks. Rocky slope if they deteriorate drastically.
• If we have earnings growth, P/E multiples can be supported. Prospects look good if soft landing is the base case scenario given growth in technology infrastructure.
The two primary drivers of the market these days are news related to inflation and developments in artificial intelligence (AI). Inflation is particularly significant because it influences the Federal Reserve's monetary policy decisions. The Fed is prioritizing inflation control over unemployment and economic growth. Additionally, with it being an election year, fiscal policy from the government is expected to remain loose, further fueling inflationary pressures. These monetary policies, whether restrictive or loose, in turn, affect the prices of precious metals and bitcoin.
The second major market driver in 2023 is news about earnings and companies' plans to invest in AI and expand their technological infrastructure. This trend has primarily benefited companies like Nvidia and AMD, which produce accelerated processing units, as well as data centers that provide the necessary computing power. The ripple effect extends to companies supplying components for these chips and maintaining data centers, including those involved in power, cooling, network infrastructure, hardware, and data center management tools. Some market strategists compare the transformative potential of AI to the advent of the internet in the 1990s and 2000s.
These two catalysts, inflation and AI, continue to drive performance in the stock, bond, and commodity markets. However, the question remains: is there another significant driver on the horizon? In this Big Picture, I want to focus on monetary policy and its effect on precious metals and bitcoin, and whether the Fed has more work to do. Consider this the first part in a series of articles to address major investment themes for the remainder of 2024.
Monetary Policy
Inflation has been the word on the street for a couple of years now. At its peak year-over-year rate-of-change, the Consumer Price Index—a measure of a basket of goods and services—was at a high of 9.1% in June 2022. The Federal Reserve began to raise short-term interest rates—the rates that banks borrow when they need money—in March of that year. It was a late start to combat inflation, but many forget that the country’s Gross Domestic Product (GDP), which measures the market value of all goods and services a country produces, was contracting at the time (-2%). The dual mandate of the Federal Reserve is to foster full employment at a 2.0% inflation target. At the time, Fed officials were concerned about keeping the economy running post the supply-chain disruption and job losses of the pandemic era.
Consumer Price Index 12-month Change (20 years)
Fed Funds Rate
Since March of 2022, the Federal Reserve has raised short-term interest rates 11 times with the last hike in July of 2023 at a target fed funds rate of 5.25-5.50%. It did so aggressively because it was so far behind the job of managing inflation. The goal was to weaken the job market, slow lending, and restrict the economy. It worked in many ways. Bankrate.com held a survey of 2,483 adults between January and February and found half that applied for loans were turned down. According to a USA Today article, “Rising debt means more would-be borrowers are getting turned down for loans” (March 6, 2024). Recent economic data shows that the jobless rate has started to go up with April’s unemployment rate at 3.9%, half a percent higher than a year ago, according to the Bureau of Labor Statistics (BLS). Current data shows that the GDP of the U.S. slowed in the first quarter to 1.6%, which was a decrease from a growth of 3.4% in the previous quarter, according to the BLS. Is the interest rate at such a point that inflation has been reduced by being restrictive enough, yet not too much to send the economy into recession? That could be the case; however, the recent policy statement suggests that there’s been a lack of progress toward the 2% goal for inflation. The Committee decided that it is not appropriate yet to cut rates.
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Fed policy has puzzled many since the beginning of the year about when the first rate cut may occur. In my November article to subscribers, “If it Ain’t Broke”, I attributed the stock market bottoming out and the fall in interest rates to Fed Chair Jerome Powell’s acknowledgment that the Fed had significantly raised interest rates and that the risks of doing too little or too much were balanced, unlike the predominantly cautious stance of 2022. Essentially, Powell suggested that it was time for the Fed to wait and be guided by data. In 2024, we are still in a holding pattern. The prospect of a rate cut soon was dashed in January when investors were expecting five or six rate cuts for the year. Fed officials quickly dismissed those expectations, and here in May, there is still no rate cut in sight. However, Powell did provide some optimism for bullish investors. On the May 1st policy decision date, Powell stated, "I think it’s unlikely that the next policy move will be a hike. I’d say it’s unlikely." Since then, stock indices have reached record highs. The CME FedWatch tool, which tracks Fed fund futures contracts, is now anticipating only one rate cut by the end of this year—but in the mind of the bulls, at least it’s not going to be a rate hike. The Fed has pivoted in their minds and the next move is a cut, which is what risk assets favor.
Bad is Good
Renewed enthusiasm for stocks in May was fueled by signs of a cooling economy, which contributed to easing inflation fears and lowered interest rates. Early in the month, the services and manufacturing ISM reports indicated that both sectors slowed in April, despite showing higher prices. Additionally, April's Consumer Confidence declined. Employment data also showed signs of weakness, with job openings dropping, nonfarm payrolls revised down from 315,000 to 175,000, and a slight increase in the unemployment rate to 3.9%. These factors collectively led to a 20-basis point drop in the 2-year Treasury yield, bringing it down to 4.8% in the first week of last month. Mid-May, the Consumer Price Index report for April further boosted investor sentiment by showing a decrease from 3.5% to 3.4%, declining for the first time in six months. In summary, poor economic data has alleviated inflation fears and revived hopes for a rate cut, which has positively impacted stock prices.
The Balance Sheet Runoff
If the Fed isn’t ready to cut rates, and the next change is likely not a hike, what’s next? The balance sheet runoff. The other monetary policy tool, besides short-term interest rates, is the Fed’s ability to buy and sell bonds in the market. This tool either increases the amount of assets on its balance sheet or decreases it due to market activity. The goal is to provide liquidity in the markets and manage rates at the long end of the yield curve. The most recent policy statement has decided to slow the pace of the decline of its securities by reducing the amount of Treasury securities they allow to be redeemed and not renewed. This amount was moved down from $60 billion a month to $25 billion a month—a significant slowdown in the pace of its balance sheet runoff. The committee is still allowing $35 billion of agency debt and agency mortgage-backed securities to runoff. On May 28th, Fed Governor Michelle Bowman at a speech for the Institute for Monetary and Economic Studies in Tokyo, Japan shed some light on her thoughts on the balance sheet runoff:
“It will be appropriate to stop runoff as reserves near an ample level…it will be important to communicate that any future changes to balance sheet runoff do not reflect a change in the FOMC’s monetary policy stance. Not effectively communicating this point might cause the public to interpret the endpoint of QT (quantitative tightening) as a signal that the FOMC would decrease the target range for the federal funds rate, thereby causing financial conditions to inappropriately ease.”
Investors have already got the idea that the Fed has pivoted, and they are acting accordingly. She’s 100% right. The Fed is nowhere near an easing policy stance by slowing down the rate at which the Fed allows its balance sheet to shrink, nor by holding rates steady. However, investors are more concerned about changes, and not raising rates and slowing down the pace of runoff is change. Investors are moving ahead of the Fed’s plans to eventually shift to an easing policy of cutting rates and buying assets to drive down long-term rates.
Playing the Second Derivative
The second derivative of Fed policy is the movement we see in precious metals and bitcoin. The first derivative is the effect the Fed’s policy has on easing or restricting interest rates and the bond market to manipulate liquidity and the profitability of banks. Gold, silver, and bitcoin have all been in an uptrend based on Fed-speak and a shift in that narrative. These areas have been inversely correlated to the Fed lowering or raising interest rates as well as from the rhetoric we hear when that policy is about to change.
All three areas have had a high correlation to each other, trending higher in 2024. That’s because of the anticipation investors have the Fed will lower interest rates and begin reinvesting its bonds when they mature, instead of allowing the bonds to redeem and fall off the balance sheet. The last Summary of Economic Projections from the Fed was in March, and that communicated three rate cuts this year based on the average estimates from all the Fed officials. The latest Consumer Price Index announcement was on May 15th, showing the first sign of disinflation in six months with the year-over-year change in total CPI dropping to 3.4% from 3.5%. The 10-year Treasury yield fell nine basis points to 3.36% and the 2-year Treasury yield (sensitive to Fed policy) fell eight basis points to 4.74% that day. Inflation data helped lower interest rates, improved prospects for a rate cut in September according to the CME FedWatch Tool and lifted stock indices to fresh all-time highs with the S&P 500 breaking 5300 and the Dow Industrial Average to break 40,000 later in the week. We will get an update on the Fed’s projections next month, on the 12th of June, and given the all-time highs in the stock market, I think the market may be in for a rude awakening.
Valuations
One of the key mentions in the FOMC minutes from the May meeting showed that officials had a particular eye on valuations, and with the stock market indices reaching all-time highs recently, this may continue to be a concern they voice at the June meeting, and possibly further if asset prices continue to rise. In the minutes it said, “On balance, the staff continued to characterize the system’s financial vulnerabilities as notable but raised the assessment of vulnerabilities in asset valuations to elevated, as valuations across a range of markets appeared high relative to risk-adjusted cash flows.” Selling had picked up in the market on May 22nd after the minutes were released because of these comments.
When we talk about valuations, we need to talk about not only price but also earnings since it’s part of the equation. Earnings have been good this second quarter season, but valuations are beginning to show signs of some concern. As long as earnings can continue to grow and prices don’t outpace that growth, the market can continue trending higher. Without growth, prices are likely to fall.
The report card looks decent on the surface for this quarter’s earnings season. FactSet is reporting blended earnings growth (companies that have actual results combined with estimates for the ones that haven’t reported) of 6% year-over-year with 96% of the S&P 500 reporting actual results thus far as of May 24th. This season, the number of companies talking about inflation is down and the number of companies talking about AI is up significantly (199 compared to 80 for the 5-year average) according to FactSet. On the valuation side, FactSet is reporting that the 10-year average forward 12-month price-to-earnings ratio (P/E) for the S&P 500 is 17.8. Today, that ratio is 20.5 as of May 24th. That’s to say that valuations are above average. For comparison, the 12-month forward P/E of the S&P 500 in the year 2000 was near 24 according to Yardeni Research during the technology bubble.
While valuations are starting to get up there, they may be justified because of the growth for some. Below is a chart of the forward P/E of the “Magnificent Seven” companies in the S&P 500 showing current PE ratios compared to forward PE. The difference lies in the consensus analyst estimates for earnings over the next year in the forward PE. If the forward PE is lower than the current PE, that’s because analysts expect the company to grow its earnings. Growth can justify high current PE ratios. The same can’t be said for Tesla which has a much higher forward PE compared to current as analysts expect growth to contract. The two stocks in the magnificent seven that are struggling in performance compared to the other 5 are Apple and Tesla due to their growth prospects.
All of this is to say that growth matters. It matters for the Magnificent Seven and it matters for the S&P 500. It’s been espoused by FactSet this year, that if we take out the top 5 growth companies in the S&P 500, that growth has been anemic for the other 495 members. This may be why investors continue to crowd these fabulous five companies. The combined market weight of the seven companies above makes up 31% of the S&P 500’s weightings with Microsoft at 7.2%, Nvidia at 6.4%, and Apple at 6.24% as of May 30th.
With the first quarter earnings season mostly behind us, we look now to the second quarter. According to FactSet, within the S&P 500, 101 companies have issued forward guidance, and of these, 60 have issued negative guidance while 41 have issued positive guidance with the number of companies issuing negative guidance at the 5-year average – so that’s normal. Analysts expect earnings to grow 9.3% with revenue growth of 4.7%, according to FactSet. If companies report earnings growth above expectations (a common occurrence), growth could be even higher. Growth is what’s important for the S&P 500 index and for the companies above. If earnings continue to grow, it will support higher prices. Below is a picture of projected earnings growth this quarter for the 12 S&P 500 sectors.
In Summary
In this Big Picture article, I focused on inflation and the monetary policy of the Federal Reserve and to answer the question whether the Fed has accomplished its mission to squash inflation and prevent a hard landing for the economy. Economic data continues to influence the Fed's primary focus: inflation. We've had one CPI report showing disinflation in April, the first in six months. While 3.4% is a far cry away from the peak at 9.1%, it may not justify a rate cut soon. The hope for the Fed to cut rates these past several months has supported equity values and suppressed rates since November. Precious metals and Bitcoin have been rising on the idea that the Fed will begin easing its policy. A more accurate statement would be that the Fed is easing off the brakes but hasn't shifted to acceleration. Nonetheless, precious metals and Bitcoin have increased as the narrative has shifted, with rate hikes unlikely and the Fed slowing down the balance sheet runoff.
New language in this month's FOMC minutes indicated the Fed may have new concerns about stock valuations compared to cashflows. We examined current valuations and growth prospects, which look good but are based on extrapolating trends that could be pressured if recent economic softness worsens. It will be important to watch for language in the June 12th Fed meeting suggesting increased concern over valuations, potentially lowering expectations for rate cuts from two to one or none in the latter half of the year.
Part of the reason stock prices are at all-time highs is investor expectations that the Fed will completely ease off the brakes to avoid a hard landing for the economy. This remains uncertain. The Fed is balancing between staving off inflation and not being too tight to cause a hard landing. So far, it’s managing this balance, and it may have accomplished its mission; at some point, the Fed might need to correct investors if they misinterpret its communications. According to Fed Governor Bowman, it's clear the Fed is very concerned about how investors are interpreting its policy, with soaring valuations becoming a potential vulnerability they have recently addressed in the May minutes. If they address this more prominently, we could see precious metals, Bitcoin, and stocks fall as the Fed could manage this with communication and shift rate cut expectations from one to none in 2024. It will be important to listen closely to the Fed meeting in June as well as the readthrough of the Summary of Economic Projections update we’ll get.
In the next Big Picture, I’ll focus on the other two investment themes I wanted to touch on, AI and China. To prevent the writing of War and Peace on the matter, I’ll break it up into one or two more articles.
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