The Federal Reserve’s signaling to the market that its next move will be rate cuts actually makes it more difficult to cut rates. The signal to the market about rate cuts leads to a loosening of financial conditions, pushing stock prices higher and tightening credit spreads, which in turn puts more upward pressure on growth and inflation.
Inflation
From August 2023 to August 2024, the Consumer Price Index for All Urban Consumers (CPI-U) rose 2.5%, the smallest over-the-year increase since the 12 months ending March 2021. The annual core inflation rate for the 12 months ending in August was 3.2%, the same as in July. The decline in inflation, along with the slowing labor market, provided the Fed the room it needed to lower the Fed funds rate by 50 basis points on Sept. 18. The Fed’s new Summary of Economic Projections showed policymakers see the Fed’s benchmark rate, now at 4.75%-5.0%, falling by another half of a percentage point by the end of this year, another full percentage point in 2025 and a final half of a percentage point in 2026 to end in a 2.75%-3.00% range.
Consumer Confidence
U.S. consumer sentiment continued to rise in late September, reaching a five-month high on more optimism about the economy after the Federal Reserve’s interest-rate cut. The University of Michigan’s final September sentiment index rose to 70.1 from the 69 preliminary reading released earlier this month. The latest figure issued Friday follows an August index of 67.9.
Labor
Total nonfarm payroll employment increased by 142,000 in August, while the unemployment rate fell slightly from 4.3% to 4.2%. The number of unemployed remained at about 7.1 million. U.S. job openings fell in July from 7.91 million to 7.67 million, the lowest since the start of 2021, and layoffs rose, consistent with other signs of slowing demand for workers.
The quits rate has fallen to 2.1%, the ratio of openings to unemployed has fallen from 2:1 in 2022 to 1.1, pay increases when changing jobs have slowed, wage growth is slowing, and the unemployment rate is higher. However, the unemployment rate rose because of an increase in the supply of labor (due to rising immigration), not because of increased job layoffs. That is the reason why the Sahm rule, named after Claudia Sahm, a macroeconomist who worked at the Federal Reserve and the White House Council of Economic Advisers, may not work. The Sahm rule (the early stages of a recession are signaled when the three-month moving average of the U.S. unemployment rate is half a percentage point or more above the lowest three-month moving average unemployment rate over the previous 12 months) was designed for a decline in labor demand, not a rise in immigration. Those factors provide the Federal Reserve with more room to cut rates.
Housing
The Case-Shiller national measure of prices rose 5.4% in June from a year earlier compared to a 5.9% annual increase in May.
U.S. housing inventories are extremely tight, whether measured against the pace of sales or against the housing stock. One reason for the tight supply is federal, state and local governments’ extensive regulations on home construction, making it harder and more expensive to build. Other constraining factors include environmental rules, zoning limits, historic preservation, and the promotion of “smart growth” or “affordable housing.” The bottom line is that the construction trend has been very uneven and well below the levels of late 2023.
On the demand side, while high interest rates, rising (though still low) unemployment and high home prices constrain demand, strong wage growth, strong income growth, high stock prices and high cash flows for owners of fixed-income assets provide support.
Commercial Real Estate
Office values in U.S. central business districts have plunged 52% from their highs. However, nationally, the drop in values from the peak is much smaller—18%— in U.S. markets classified as suburban or areas that are outside the traditional core.
Looking forward, yields are down (cap rates are down), borrowing spreads are down, and construction is way down (limiting future supply). Prices have bottomed out, and it looks like it is setting up for a good environment except for Class B and C office space.
Capital Expenditures (Capex)
Capex spending is currently much less sensitive to interest rates because of massive investments in artificial intelligence. The massive spending on AI and the infrastructure needed to support it is providing a tailwind to economic growth.
Manufacturing
US manufacturing activity shrank in August for a fifth month, reflecting faster rate declines in orders and production. The measure of production slid for a fifth month—deeper into contraction territory—to the lowest level since May 2020.
Industrial Production
August’s 0.8% increase in production at factories, mines and utilities followed a downwardly revised 0.9% decline a month earlier (negatively impacted by Hurricane Beryl), and capacity utilization at factories, a measure of potential output being used, rose to 77.2% from 76.6%. The overall industrial utilization rate increased to 78%.
Commodities
China’s growth is slowing, European growth is slowing and U.S. economic growth is also slowing. As a result, commodity prices are falling. The result is less inflationary pressure, giving the Fed more leeway to lower rates.
U.S. Economic Summary
While the markets seem concerned about the Fed’s “restrictive” monetary policy increasing the risks of a recession, it seems hard to claim the policy is restrictive when the economy is growing at or above its perceived long-term growth rate of about 2%—the Atlanta Federal Reserve’s estimate of real gross domestic product growth in the third quarter is now at 3.1%. It seems more likely that the Federal Reserve will achieve its goal of a “soft landing.”
China’s Economic Growth
High levels of local government debt, along with the real estate market (particularly residential real estate), have negatively weighed on Chinese economic growth. Adding to these problems is China’s economic decoupling from ours.
With the U.S. being the world’s largest economy, historically, China’s business cycle, driven by exports, has been highly correlated with our business cycle. However, there has been a decoupling due to:
- There has been a bust in Chinese home prices while U.S. home prices have been rising due to inflation and a shortage of supply.
- While immigration has fueled the growth of the working-age population in the U.S., China’s historical one-baby policy (the fertility rate is just 1) has led to a decline in theirs. A shrinking population with fewer working-age individuals means fewer taxpayers, more spending on government services for retired people and overcapacity, as companies can no longer fill existing factories with workers.
- For investors, the implication is slower growth, more disinflationary pressures and weaker global demand for commodities.
- U.S. and Europe have imposed tariffs on Chinese imports. Also negatively impacting Chinese exports is the trend toward onshoring supply chains.
The result is that any slowing of U.S. economic growth will only magnify the ongoing slowdown in China.
The slowing of the Chinese economy led to the enactment of a flurry of stimulus measures in late September, including cutting rates, easing reserve requirements and providing support for the struggling real estate sector. The stimulus should help economic growth in the region and should be a positive for stocks.
U.S. Equity Market
We have been in a period with conditions that encourage risk-taking: tight high-yield spreads that lead to high-risk borrowing, subdued volatility that encourages investors to lever up, increasing stock-bond correlation, which makes bonds less useful as a diversifier, and a relatively inverted yield curve which means long-duration government bonds are less attractive.
The research team at Verdad identified eight historically analogous periods and found that four preceded major market crashes within 12 months. “A 50% hit rate for negative forward 12-month S&P 500 returns and a negative average return over all 8 analogs are impressive, considering the S&P 500 has averaged a 9% annual return from 1969 to 2024.”
Summary
For the past two years, we have had a bifurcated economy, with a strong service sector and a weak manufacturing sector. Another unusual bifurcation is that while financial conditions are easy (equity valuations are high and credit spreads are low), borrowing conditions remain tight, especially for consumers. A third bifurcation is that while lower-income and indebted individuals have been negatively impacted by rising interest rates, high-net-worth individuals and savers have benefited from rising equity prices and rising rates on their savings.
The slowing of inflation toward the 2% rate targeted by many central banks should allow for easing of monetary policy around the globe, providing support for equity markets and other risk assets. The “Goldilocks economy” with the Fed likely achieving its goal of a soft landing, coupled with the beginning of a rate-cutting cycle, has investors optimistic, which eases financial conditions. However, geopolitical risks continue at elevated levels around the globe, creating the risk of black swan events with negative implications for risk assets.
No outlook should end without including a discussion of the problem of the fiscal deficit.
Budget Deficits and Debt-to-GDP Unsustainable
The following charts show that the U.S. debt-to-GDP ratio is at a 150-year high (along with notably Japan). They also show the ratios for 17 other developed nations.
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The federal government now pays over $1 trillion in interest expenses annually. Before it spends a dime on the military, social welfare or the tens of thousands of other expenditures, one-third of the government’s tax revenue pays for the interest on the $34 trillion in debt, representing deficits of past years and decades. And it is getting worse as the Treasury has to refinance maturing debt at much higher rates. The Congressional Budget Office warned in its latest projections that U.S. federal government debt is on a path from 97% of GDP last year to 116% by 2034—higher even than in World War II. And under current policies will eventually reach 200%. Adding to the problem is that neither political party seems willing to address the issue.
Election Risks
Whichever side of the political spectrum you are on there are economic risks from the proposed policies of both candidates.
With a Trump victory there are the risks of an increase in tariffs (which risks retaliation) including the imposition of 60% tariff on Chinese goods (up from 20%-25% currently); the repeal of the corporate AMT and buyback tax combined, a large increase in defense spending, and full extension of TCJA tax cuts leading to even wider budget deficit. There is also the risk of militarized mass deportations negatively impacting labor force growth and wage inflation. Perhaps the greatest risk is that Trump has expressed the desire to influence Federal Reserve policy. Were this to happen, or even the threat of it happening, it could create significant downside risks.
The U.S. has long benefited from the dollar’s role as the world’s reserve currency. We have also benefited from our strong rule of law, our having the deepest and most liquid capital markets, and the freedom of capital. Any efforts to control the Fed could undermine the dollar and lead to an increase in the risk premium associated with U.S. debt instruments, raising the cost of our debt and negatively impacting our ability to fund the massive deficits we have accumulated.
With a Harris victory, there are the risks of multitrillion-dollar tax increases (half corporate, half high net worth) to support a multitrillion safety net expansion, widening the deficit as tax collections undershoot estimates while spending exceeds them.
The problem for the economy is that under either a Trump or a Harris presidency it is likely that the U.S. will continue to have a huge spending problem, with expenses running way above revenues. And eventually, lenders may no longer be willing to finance the deficits. If spending is not cut, the alternative solution would be to raise taxes to European levels. However, the result would European type growth rates, which have been much lower than ours. And that would have negative consequences for equities.
The ability of the markets to absorb all that debt could be challenged, especially when concerns over the combination of geopolitical issues and the growing fiscal deficits has resulted in the largest holders of Treasuries (foreigners) continuing to decrease their ownership of U.S. government bonds.
These trends increase the risk of a “Minksy Moment”—a sudden collapse of asset prices after a period of growth and stability—the kind Nassim Taleb (author of The Black Swan) has warned investors about.
Advisors and Investors should be prepared for volatility, especially if Congress is unable to avoid a shutdown of the government next year, trade tensions increase, geopolitical risks increase or we have a financial accident. One way to address the risks, making the portfolio more resilient to “Black Swan” type events, is to diversify exposure to risk assets to include other unique sources of risk that have historically had low to no correlation with the economic cycle risk of stocks and/or the inflation risk of traditional bonds but have also provided risk premiums. The following are alternative assets that may provide diversification benefits. Alternative funds carry their own risks; therefore, investors should consult with their financial advisors about their own circumstances prior to making any adjustments to their portfolio.
- Reinsurance: The asset class looks attractive, as losses in recent years have led to dramatic increases in premiums, and terms (such as increasing deductibles and tougher underwriting standards) have become more favorable. Those changes led to returns being well above historical averages in 2023. Investors can consider such funds as SRRIX, SHRIX, and XILSX
- Private middle market lending (specifically senior, secured, sponsored, corporate debt): This asset class also looks attractive, as base lending rates have risen sharply, credit spreads have widened, lender terms have been enhanced (upfront fees have gone up), and credit standards have tightened (stronger covenants). Investors can consider such funds as CCLFX and CELFX.
- Consumer credit: While credit risks have increased, lending rates have risen sharply, credit spreads have widened and credit standards have tightened. Investors can consider such funds as LENDX.
- Long-short factor funds: Investors can consider such funds as QRPRX and QSPRX.
- Commodities: Investors can consider such funds as DCMSX.
- Trend following (time-series momentum): It tends to perform best when needed most during extended bear markets. Investors can consider funds such as QRMIX.
Cautionary warning
My 50-plus years of experience have taught me that one of the biggest and most common mistakes investors make is that they focus on forecasting the future (which is not only unknowable but also likely filled with future unpredictable large drawdowns) instead of focusing on managing risks. That is why my reviews of the market and economy focus on risks, not specific forecasts. This tendency is a major failure for two reasons. First, investors are on average highly risk averse and because stock returns are not even close to being normally distributed with large losses occurring with much greater frequency than if the distribution of returns was normally distributed. The conclusion investors should draw is that their focus should be on minimizing the risks of large losses, making their portfolios more resilient to “black swan” events—or, as Nassim Nicholas Taleb recommends, building portfolios that are “antifragile.” In order to do that, you need to include a significant allocation to assets whose risks are not highly correlated with the economic and geopolitical risks of equities.
Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich Your Future: The Keys to Successful Investing
