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A Pivotal Week

From our perch, the price action last week was pivotal. It was almost as though the Federal Reserve had announced a rate cut last Wednesday at the November FOMC. For equities, it was one of the strongest weekly gains since 2020. The price action was clearly impulsive, rapid, and emotional. While there was clearly an element of short covering (equities are still yet to break the down trend) there was also a fundamental shift in short term interest rate expectations that contributed to the correlated shift in beliefs on the discount rate for equities.

The fundamental shift in the prevailing bias on interest rate expectations was warranted by the recent macro news flow. The weakness in key leading indicators such as ISM new orders, employment and the non-farm payrolls suggests that there is a clear deterioration growth momentum underway. As we have noted for some time, the best leading indicators of the labour market and the Fed’s reaction function have been consistent with a slowdown in demand for labour.

The key point is that the recent weakness is global: growth in many other countries has also surprised to the downside. Second, the duration of the weakness is now over 12 months. Third, the weakness is broad across thirteen industries. Fourth, the weakness was evident in leading sub-components (new orders) and employment. Several of the leading indicators of employment such as job openings, temporary hires, ISM employment (noted above) and consumer confidence surveys are consistent with a meaningful easing in the labour market that would necessitate the Fed to cut rates. The time series below highlights that temporary hires lead aggregate employment at major cycle turning points (chart 1).

While equities have rallied on the prospect of lower short- and long-term interest rates, the implication of rate cuts is a probable contraction in final demand and corporate profits. Put another way, rate cutting cycles are ultimately not bullish for equities if they are the consequence of a growth and profit recession. The relief rally in equities on this basis is not likely to be durable beyond a few months.

Looking forward, if the Federal Reserve is forced to cut the funds rate next year by 200 basis points (or more) bond yields are likely to fall (bond prices rise). While equities might enjoy the decline in yields (and the discount rate) in the initial phase, the implication of the rate cuts is a probable deterioration in growth and profits. In that context, the equity and credit risk premium are probably too narrow in US equities or on the global risk proxy (S&P500). Stated differently, the odds probably favour out-performance of sovereign bonds over equity.

As we noted last week, our sense is that the recent tightening in broad financial conditions has been meaningful given the rise in mortgage rates and corporate debt tied to long rates. While that is not evident to several market participants, the impact is visible in the tightening in lending standards, deterioration in specific segments of the credit markets (CCC, MBS and CMBS spreads) in in the performance of bank and other cyclically sensitive equities. Indeed, based on a few “real economy” variables financial conditions are probably even tighter than what is indicated by market based broad financial conditions indices.

Ironically as we noted recently, the “good outcome” is that the current cycle ends in recession, equity and credit markets crash and there is renewed demand to buy Treasury bonds. The bad outcome might be a renewed phase of inflation with no willing buyers (at the current price) for sovereign bonds and yields rise even further. Our sense is that the former is more likely in the near term and the odds increasingly favour a long-fixed income and duration position. In summary, Treasury yields tend to fall (bond prices rise) when the Fed cuts rates. We have become bullish fixed income (duration) for the first time in over five years.

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