Cut To The Chase

Powell’s pivot

After launching an all-out battle against inflation thirty months ago, driving borrowing costs to a two-decade high, the Fed reversed course in mid-September. With inflation nearing the 2% target and continuing to moderate, the central bank has moved into a new phase of its battle, now focused on unwinding earlier tightening to protect a cooling labor market.

The Fed’s ability to engineer a so-called soft landing will have significant implications for households, businesses, and financial markets. A soft landing refers to recalibrating interest rate policy to reduce inflation without triggering a sharp rise in unemployment or pushing the economy into recession.

Policymakers voted to reduce short-term interest rates by half a percentage point, signaling the beginning of the end to the tightest monetary policy regime in recent memory. While this shift was widely anticipated, the size of the move surprised many observers. To some, the magnitude of the initial cut suggests that the Fed has become concerned that it is falling behind the curve.

Economic turning points are notoriously difficult to judge, and monetary policy is hard to recalibrate due to policy lags. The Fed previously faced considerable scrutiny for being late to tighten policy after the pandemic, having initially underestimated inflation’s threat. Fed Chair Powell pushed back against the notion that they are again tardy, countering that the ½-point cut can be taken “as a sign of our commitment not to get behind.” Time will tell.

Yellow signals

The labor market has slowed this year but, so far, the slippage has been fairly mild. Businesses appear hesitant to let workers go, but they are also not hiring aggressively. Between March and July, the unemployment rate moved up from 3.8% to 4.3%. While the number of unemployed has risen, workers entering the labor force have driven much of the overall increase in the unemployment rate. Job openings have dropped sharply but remain above pre-pandemic levels and still exceed the number of unemployed.

Newton’s First Law of Motion states that an object in motion stays in motion unless acted upon by an unbalanced force. While the economy does not follow physical laws, the unemployment rate tends to keep rising once it begins to climb. Other labor market signals have also been cautionary, such as fewer Americans quitting their jobs and more people finding only part-time work.

The Fed aims to be that ‘unbalanced force’, preventing further labor market deterioration. Though not robust, the economy retains decent momentum. Second quarter GDP growth was revised up to a 3% annualized rate and forecasts for the third quarter suggest a 2% to 3% growth rate. Economic data released since the Fed ratcheted down interest rates reinforces this outlook. In September, employers added 254,000 jobs — 100,000 more than expected — while the unemployment rate ticked down for the second month to 4.1%.

Street cred

During previous Fed easing cycles, the stock market has typically produced positive returns over the twelve-month period after an initial interest-rate cut. However, some periods have been followed by significant stock market weakness. The distinguishing factor is whether the Fed is proactively cutting rates from a position of strength or reacting to economic weakness.

For example, in the rate-cut cycles of 2001 and 2007, the central bank’s easing came too late to forestall recessions. Economic contractions led to sharply lower corporate earnings and stock prices. But both of those periods were associated with major imbalances — the dot.com implosion and housing/banking crisis, respectively. Today’s economic environment does not resemble those times, even accounting for some of the euphoria around artificial intelligence.

If investors continue to view the Federal Reserve as credible and in control, capable of managing a soft landing, stock prices should have support. In contrast, if investors perceive the central bank as reactionary, slashing rates amid the threat of recession, market sentiment will shift. While many hope for swift and substantial rate cuts, such a scenario would actually signal more imminent risk to the economy and stock prices. Ideally, the Fed will have the flexibility to gradually normalize policy.

Kick the can

Lost in the excitement over Fed rate cuts, the Congressional Budget Office (CBO) just reported that the U.S. budget deficit topped $1.8 trillion in fiscal 2024. Said another way, federal government expenditures exceeded tax collections by almost $2 trillion last year.

By design, deficits typically widen during recessions as tax revenues fall and spending jumps due to economic stabilizers such as unemployment benefits. The COVID-19 pandemic caused a surge in deficits in 2020-21, but the federal deficit has been in a significant structural uptrend since 2016.

The U.S. government last achieved a budget surplus in 2001. Decades of accumulating deficits have required the nation to issue increasing amounts of Treasury bonds to cover the gaps. As bonds come due, the U.S. Treasury issues new ones to roll over the debt. The department must also issue additional bonds to finance the most recent budget deficit.

Debt tipping point

Federal debt held by the public currently stands at $27 trillion, roughly equivalent to the nation’s gross domestic product. In 2007, the debt level was only about one-third of GDP. Despite this worsening trend, politicians have so far avoided a reckoning because the government has managed to service its debt. But that may not always be the case. In 2024, the United States paid $950 billion in net interest on the debt, a 34% increase driven largely by higher rates. Interest payments now consume 14% of total federal spending, surpassing defense spending. Net interest and other mandatory spending such as Social Security and Medicare are on a path to demand an ever-greater share of government revenues.

The CBO projects that under current law, government debt will exceed 120% of GDP in the next decade. Politicians in both major parties often talk about reducing budget deficits but they sharply disagree on the methods. Unfortunately, tax and spending proposals from the Harris and Trump campaigns suggest that both candidates’ programs would add to the deficit and worsen the U.S. fiscal position. Down the road, it may ultimately take a bond market revolt — in the form of sharply higher Treasury yields — to force policymakers into difficult decisions.

Elections and the stock market

Historically, the outcome of presidential elections has had less impact on financial markets than media narratives suggest. Over the last 50 years, the S&P 500 produced double-digit annualized returns over the term of every president except George W. Bush. Furthermore, there has been no consistent pattern between the officeholder’s party affiliation and the performance of specific asset classes or industry sectors.

In the short-term, sentiment often drives market movements, but over longer periods, fundamental factors such as earnings growth, interest rates, and valuations dictate the market’s direction. Although valuations seem a bit stretched at the moment, long-term rates have declined, and earnings are expected to rise at a double-digit pace in 2025. The Fed’s quest to extend the economic cycle will be a key to market performance.

– Christopher J. Singleton, CFA, Managing Director

October 16, 2024