The celebration over the Nvidia earnings report started to run out of steam Friday. The news was great and the celebration well deserved. But now it’s on to the next set of factors likely to move stock and bond prices. For now, the composite expectations related to the growth of artificial intelligence use have been efficiently priced into market prices. Those forecasts are unlikely to change over the next several weeks. The focus is likely to shift back to the pace of inflation with a PCE report due this week, followed by a slew of data leading to the conclusion of the next FOMC meeting on March 20.
10-year Treasury yields, which spiked to about 4.35% last week, have started to settle back and now sit near 4.25%. Those yields will move based on the data coming over the next 2-3 weeks and will likely be the driver for both stock and bond prices over that interim. There will be few earnings reports from here on until we get to the start of first quarter earnings season in mid-April.
Since March 2022, the Fed has been in a tightening mode trying to bring inflation back down to 2%, following a spike caused by a combination of supply chain snarls, excessive fiscal spending, and the release of pent-up consumer demand post-Covid. Supply chains have largely healed, the level of deficits is either plateauing or in decline, and there are some signs that consumers are starting to spend more reluctantly. 20%+ interest rates on credit card balances have a way of stifling demand. The Fed stopped raising rates last July. Everyone is looking for the first cut. But the Fed tends to move slowly. After cutting rates to near zero during the financial crisis of 2008-2009, it took over half a decade before it instituted its first rate increase. It won’t take that long for the first rate cut. But as the January CPI report showed, bringing inflation all the way back to 2% isn’t going to be simple. A soft landing, the Fed’s goal, requires growth to continue as inflation steadily falls. But without much slack in the economy and a tight labor market, getting price increases for labor-intensive services to recede toward the 2% target, will take time and may require fiscal restraint longer than markets expect.
After the January CPI report, markets have quickly adjusted expectations. Whereas a few months ago 6 or more rate cuts were anticipated in 2024, that number has been cut in half. Now both markets and the Fed anticipate 3 cuts this year. While both agree for the first time in recent memory, that doesn’t mean both are correct. In fact, the opposite is true. Both markets and the Fed have been notoriously bad predictors of both near term inflation and interest rate trends. As Fed Chair Jerome Powell likes to point out, policy will depend on data. The Fed’s inflation target is 2%, not something close to 2%. It won’t wait until 2% is reached to adjust policy, but it will have to increase confidence that the 2% goal will be achieved or exceeded within 2-3 years.
Thus, the first step will be to monitor data and the glide path of inflation. Clearly, the CPI report for January was disturbing. Any way one slices the data, services related inflation was too hot. That includes with and without housing numbers. PCE numbers due out this week may alter that picture. The Fed is more attentive to PCE data than CPI data.
One month doesn’t constitute a trend. All eyes will be on the next CPI report due in about 2 weeks. Everyone expects moderation in shelter costs. But with rising long-term rates, higher home prices, and rents starting to creep up again, the housing component, which is about 40% of core CPI, is likely to stay above 2% for an extended period. But even if that is so, inflationary trends are still moving lower. That should allow the Fed to start cutting rates this year. No one is expecting a cut in March. That would require a very favorable and outlier report on consumer prices in a couple of weeks. Even that would not likely move the needle. At the moment, the best guess for a first cut is sometime this summer. Once the first cut happens, expect the Fed to set a pattern for future cuts, perhaps one 25-basis point adjustment every subsequent 2 or even 3 meetings. Barring a recession, which undoubtedly would accelerate both rate cuts and the downward path of inflation, there is little reason for the Fed to opt for a pace of rate cuts that is too fast and might have to be reversed.
Perhaps the best way to look at future Fed policy with a long-term lens, is to pinpoint what a neutral rate might be, assuming inflation can be brought back to 2%, and how long it might take to get there. Using 2% as the short and long-term target for inflation, the base Fed Funds rate has to be somewhat higher. If we have learned nothing else over the past two decades, it is that when rates are forcibly reduced to a level well below inflation, making money free to the borrower in real terms, unintended consequences result. There are crisis moments when the need to stabilize markets takes precedence over the concerns over unintended consequences. But when crisis passes, it’s time to put the lid back on the cookie jar. The Fed didn’t do that after the Internet bubble burst leading to the mortgage crisis of 2008 and beyond. It didn’t do that after the financial crisis of 2008-2009 setting the seeds for ensuing inflation. It doesn’t want to make the same mistake again. If there is one certainty, barring a severe recession or another financial crisis, the Fed has no intention to take the Fed Funds rate back below long-term inflation expectations.
What will the future curve look like? I think one should start with two likely markers. Short-term rates in a neutral setting are likely to be about 3%, a bit more or less depending on the size of future fiscal deficits. The 10-year Treasury yield should approximate nomimal growth. Again, assuming 2% inflation and adding real growth of 2%, that would suggest a target of 4%. The real growth will be impacted by future changes in productivity and population growth. The latter will be largely influenced by immigration policies, now in seemingly total disarray. Thus, one shouldn’t take a 3% Fed Funds rate or a 4% 10-year Treasury rate with any precision. Rather, based on history, both are logical centerpoints for world of stable non-inflationary growth.
What are the investment implications? On the bond side, most of the significant movement is likely to be at the short end of the curve. The Fed Funds rate is now 5.25-5.50%. Getting that to 3%, even if it takes a couple of years, will impact money market fund yields. Money market fund balances are now at record levels with yields over 5%. Yields closer to 3% will likely create a shift away from money market funds. Will money go to longer duration debt securities to lock in yield or will it go to higher risk assets to chase higher potential returns? History suggests a little of both.
As for the stock market, a relatively stable 10-year yield suggests future stock prices will be more dependent on earnings than on changes in interest rates or P/E ratios. Composite earnings growth rates may impact the overall market but the disparity of future earnings growth rates by company and industry will be wide. In my head, there are four buckets. Bucket one is the high growth, high risk one that everyone has been chasing over the past year. So far, fundamentals have rewarded those investing in this bucket. Future success depends on whether future growth lives up to the hype. But even more important is the ability to choose the right company in which to invest. A lot of companies will chase the AI dream and come up empty. Everyone is chasing the future AI winners. Thus, there is a large penalty for betting on pretenders. The second bucket is the core growth bucket. This is filled with the best of the rest, those companies that are market leaders that simply execute better than the competition. They are dependable and, over time, will reward investors presuming they stay on top of their game. The third bucket, probably the largest in terms of number of companies, are solid businesses that make good money but whose growth rates are highly influenced by macro-economic factors. These include cyclicals like auto and industrial names. But it also includes basic companies like utilities, consumer staples, retailers and banks. It’s a big bucket. There are good short-term opportunities here depending on market sector, management quality, and other external factors that change from cycle to cycle. Finally, there is the fourth bucket comprised of companies that have either lost their way or whose businesses are being obsoleted or disrupted by new technology. We all can name companies that fit into this bucket. The bottom line is to avoid investing here. Ideally, one wants to be invested mostly in the first two buckets keeping an eye on valuation. Bucket three offers opportunities but mostly over a cycle, not long-term. Macro factors change those opportunities. It’s a bit like going to a flea market. If you know what you are looking for, you can find some of the best bargains here.
Today, singer Michael Bolton is 71.
James M. Meyer, CFA 610-260-2220