The price action over the past two weeks while we have been out meeting investors has been fascinating. We are not surprised that there has been a relief rally in equities given the shift in consensus beliefs on inflation and rates. The first 50 basis points fall in long rates reduces tension on the equity risk premium and eases broad financial conditions in a reflexive or self-reinforcing way by putting downward pressure on the dollar and upward pressure on equity prices. However, the first 50 basis points (or so) are like a drug addict’s first hit. It’s all thrills. The following 50-100 basis point drop in rates is likely to signal recession and the addict’s (stock market) descent into a long tunnel of pain.
The shift in the prevailing bias on rates since late October has been modest. The December 2024 Implied SOFR Yield is only down by 40 basis points from peak. That’s not a proper rate cutting cycle (not a knife) if there is a recession in 2024. More likely, the Fed will be forced to cut the funds rate by 250-300 basis points. Of course, the consensus belief on rate cuts is mild because most investors believe in a “soft landing” according to the Bank of America Fund Manager Survey.
As we noted before, human beings are not particularly good at non-linear thinking. From our perch, a key reason why there is resistance to consider extreme (or non-linear) outcomes like monetary policy reversals, inflation persistence, acknowledgement of higher neutral rates, depletion of inventories and wars is that most investors are short convexity. The real world is not linear and systemic risk can increase at an accelerating rate as correlation moves to one in a major episode. It also generally benefits most financial market participants when asset prices rise, not when they fall.
While a “soft landing” is plausible, the weakness in key macro news flow has been broad (across thirteen industries in the ISM surveys) and in the key leading indicators on the labour market. The US Conference Board Leading Index remains extremely weak (chart 1). It has only been weaker in the 2008 episode. As we noted recently, several of the leading indicators of employment such as job openings, temporary hires, ISM employment, change in the unemployment rate (+0.5% from the record of low 3.4%) and consumer confidence surveys are consistent with a meaningful easing in the labour market that would necessitate the Fed to cut rates. If the Fed is going to cut rates, it is more likely to be by 250-300 basis points.
For markets, the potential for much deeper rate cuts from further disinflation and a meaningful rise in unemployment has improved the reward-for-risk on long duration Treasuries. We added a position in the US long bond (via TLT) at the start of November for the first time in over 5 years. Tactically, we also scaled back the size of our short consumer discretionary position and increased the weight in Asia Tech (equities) in late October. Following a 12% rally in Asia Technology so far in November (and more from the low) we reduced the size of that position on Wednesday this week. While that sector remains inexpensive given potential growth, the rapid and impulsive rally in the global risk proxy counter to the trend in macro news flow (economic surprises and earnings revisions) warrants some caution (chart 2). A modest fall in the discount rate is bullish for equities. However, a large decline in rates would likely coincide with catastrophic declines in corporate earnings.