Over the past few months there has been a growing prevailing bias that equities would enter a “crash up” or “melt-up” phase if weak macro data caused the Fed to cut rates. The big picture problem is that this bias is counter to historical experience. In every major rate cutting cycle since the 1970s equities tend to correct around 23% on average in the first 9 months following the first rate cut. The context, as we have noted for some time, is the extremely narrow equity premium or compensation for risk. Stated differently, equities are very sensitive to a potential growth scare or downgrade cycle should that occur. The Fed will probably only commence a meaningful easing cycle if there is also a material deterioration in growth.
The other challenge for the disinflationary “melt-up” prevailing bias is the resilient US labour market. US non-farm payrolls gained 272,000 in May. This was more than 100,000 above consensus. Average hourly earnings growth also rose to 4.1% from 4.0% year on year in April. Curiously, the household survey reported a 408,000 decline in employment and a rise in the unemployment rate to 4.0% from 3.9%. Also note that payroll gains were driven by part time employment. By contrast, full time employment declined sharply in May.
However, the way price responded to news suggests that the labour market was sufficiently strong that it could revive discussion as to whether the Fed will need to hike again in this cycle. Treasury yields increased sharply across the curve and the odds of a rate cut by December 2024 are now close to zero. We fear that remains a risk for assets that “hope” or “need” lower interest rates such as commercial real estate.
As Gerard Minack has noted, there has been a wide gap between the establishment (payroll) and household survey of employment for some time. It might be that the Bureau of Labour (BLS) is underestimating population growth. Therefore, the household survey may be underestimating employment growth. The labour market data is often subject to material revisions. However, historically trends in the unemployment rate tend to be a better reflection of strength in the labour market through the cycle. A major turn in the labour market has also often coincided with a phase of cross asset volatility as it implies a deterioration in growth and profits (chart 1).
Chart 1
Given the greater variability and estimation errors in the household survey, the Fed and the markets have tended to focus on the payroll (establishment) survey. Incidentally, former New York Fed President Bill Dudley noted earlier last week that the neutral rate might be closer to 5%. That would suggest policy is only modestly restrictive at current levels. From our humble perch, the policy rate has only recently matched nominal GDP. Moreover, broad financial conditions also suggest that policy is not particularly restrictive.
In this context, the key challenge for investors is extremely narrow equity, credit risk compensation and low implied volatility. While a further “melt-up” in equities and credit is plausible while liquidity remains plentiful, a major rate cutting cycle is typically not bullish for equities. The disinflationary impulse that has contributed to the reflexive or self-reinforcing rally in financial conditions since October last year is probably in the latter stages. We are reducing net long equity risk today.
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