BAB - The Fed Flashed A Buy Signal - We Just Need Some Bad News To Reinforce It

2023-11-13 11:45:19 ET

Summary

• The Fed's decision to hold off on rate hikes has led to a relief rally in both stocks and bonds.
• The sustainability of these gains is uncertain, as it depends on future Fed actions and economic projections.
• I recommend owning income-producing securities, such as utilities and corporate/municipal bonds, but advise caution with leverage.

Main Thesis / Background

The purpose of this article is to give my opinion on the current market environment, with my thoughts on how the Fed's statement is driving gains since last week. As readers are surely aware, the Fed held off on another rate hike in their November meeting and - whether they intended to or not - have resulted in calming investor nerves about future hikes going in to 2024. This has led to an "everything rally", with both stocks and bonds seeing sharp gains:

As you can see, fixed income and equities rallied, with investment-grade corporates, junk bonds, and treasuries all participating along with large-cap stocks. This was a welcome relief rally after what had been a tough Fall season so far, but it leads me to question how sustainable these rapid gains are.

In this review I will tackle the why behind the moves and give my assessment on the likelihood of them continuing. I will give some thought on to what macro-environment we will need to see in order to make any potential gains a realistic outcome.

Powell Sparked A Relief Rally

First, let's examine what sent investors in to a buying frenzy of bonds and stocks over the past few trading sessions. In a nutshell, it was a few little words from the Fed Chairman Powell (as well as a relatively oversold market - that didn't hurt either!). Personally, I didn't see the message from the Fed as an overly dovish sign - but the market disagreed with me. What investors found comforting was that the Fed kept rates unchanged for the second meeting in a row - and Powell posed the question on whether or not future hikes would be necessary:

the question we're asking - should we hike more?"

Source: Fed Statement (via YouTube )

Ultimately, the Fed has left the future outcome in doubt. Will we see another hike in December or later? It is unclear. But the market used this as an excuse to load up on risk-on assets and roll back in to debt securities at a level we haven't seen in a while. So, clearly, the market welcomed this uncertainty.

In fairness, the fact that they left rates unchanged for the second time in a row suggests the Fed might leave rates unchanged in December. This could mean the Fed is done for this cycle. But I personally won't declare "victory" on this front without knowing more. But investing is often about expectations, not certainty, and the market has now re-priced the Fed funds rate for 2024 on the basis that this dovish shift in tone is what the Fed was projecting:

While investors had already been anticipating lower rates in 2024, post-November's meeting the forecast is even more dovish. As we know, lower rates makes borrowing cheaper and that can boost corporate profits. Similarly, fixed-income securities rallied as investors moved to lock-in higher current yields since they are not anticipating yields will be lower (and the income less attractive as a result) in the new year. All of this has led to a much brighter investment picture than we had just a few weeks ago.

Is It Really Sustainable? Maybe

The challenge here is whether or not the recent gains were more than just a relief rally, or something more sustainable. If the Fed changes course - or economic projections come in hot enough that investors think the Fed will get hawkish again - we could be in for some trouble. After all, it isn't exactly corporate revenues and profits that are driving this market. It is the prospect of cheaper money and quantitative easing that the investment community has gotten so hooked on over the last decade. If money is cheap, assets can rise in price - and corporate performance can often take a backseat in the analysis.

This begs the question - why am I concerned? To start with, Q3 earnings have been modest across the board. There has been plenty to cheer about, especially at some large-cap names, but the overall tone is one of moderation. For example, the number of companies in the S&P 500 "beating" revenue estimates this quarter is below the 50% mark. This is not an encouraging sign:

This result and the cautionary tone we have had this quarter from many corporate executives could be overly cautious. That is certainly a possibility and brighter days could be ahead.

Or, it could mean that weakness is finally starting to permeate more broadly across the economy and corporate revenues and profits are going to continue to decline in the months and quarters ahead. I'm not going to sit here and claim I can predict the future, but I will say this is a very real headwind that all investors should be considering. If the latter thesis (continued weakness) comes true, then the recent gains we have seen are going to come under pressure.

But the wildcard really is the Fed. Even with economic weakness, or perhaps because of the weakness, then this rally may indeed be sustainable. It all comes down to how the Fed reacts to a less-than-rosy macro-environment. We have seen signs of cooling in the labor and inflation metrics already. The jobs market was over-saturated for a few years, now things have evened-out:

This ties back to my title "we need some bad news". The "bad" news could be a weakening (or at least non-strengthening) labor market. While this can be "bad" because we as a society should want full employment for a variety of reasons, a labor market that is cooling could give the Fed the excuse it needs to hold off on any more rate hikes.

A moderately cooling employment environment, coupled with a dovish Fed, is really a win-win for corporate America. It helps keep labor costs under control and sends borrowing costs lower. Both are net positive for profits, all other things being equal. This is central to why investors really want to see some "bad", or otherwise modest, macro-economic news. It would extend to the Fed's projections and help put us on track for a backdrop where both equities and bonds tend to perform quite well - as the last decade taught us.

**I am long the Vanguard S&P 500 ETF ( VOO ) and the Invesco S&P 500 Equal Weight ETF ( RSP ).

I Like Bonds Here, But Remain Tight On Leverage

Beyond sticking with large-cap US stocks in this climate, I see plenty of merit to owning income-producing securities now. This includes the Utilities sector, which I timely got bullish on a month ago. This does extend to corporate and municipal bonds as well, as we are certainly near peak rates from the Fed, if not there already.

Of course, the market has gotten the Fed's actions wrong for the better part of a year. So keep this in mind when building positions. This is not an environment to go "all in" on anything - including bonds. If inflation stays hot and/or we see economic surprises to the upside - then the Fed is going to keep hiking and better entry points for bonds will present themselves. This makes a laddering approach look smart in my view.

That said, it is difficult not to see value in municipals and corporates that are yielding in excess of 5% - and often more - especially on a tax-adjusted basis for munis or within the lower-rated corporate issues. Even compared to last year, the income streams look attractive on the surface:

It is fair to say I am in favor of building on positions at these levels. I imagine in a year from now - or less - investors will have wished they locked-in more of their cash in to these types of yields.

But this comes with a catch. Many retail investors (myself included) tend to gravitate towards leveraged CEFs as a way to play fixed-income. This allows us to capture the benefits of an active management team and also to amplify income and performance by borrowing and leveraging for stronger returns. While there continue to be reasons to do this for some investors, I strongly urge readers to evaluate their use of leverage very carefully still.

This is a message I have been projecting for most of 2023 and it remains true to this day. The reason is that while bond prices might rise on the expectation of a more dovish Fed going forward, short-term rates are still higher than long-term rates. This is known as "inversion" and it has punished leveraged funds badly this year. The reason is that borrowing costs have risen why income opportunities among longer-dated securities have been limited. Hence, the usefulness of leverage was mitigated - but that doesn't stop these firms from utilizing extensive leverage. After all, they aren't bearing the cost - we as investors are!

Granted the backdrop isn't nearly as worrisome as it was earlier in the year. The inversion was most pronounced in early May, when yields on 10-year Treasury notes were 1.89% lower than what investors were paid on 3-month Treasury bills. As you can see, the spread has narrowed since then:

The conclusion I draw here is that investors are still not being paid appropriately for taking on leverage. Borrowing costs at the front-end of the curve are too high to justify paying them to invest in longer-term securities that yield less. That will change, with time, but we aren't there yet.

In fairness, there are other reasons to consider leveraged CEFs beyond just borrowing costs. Discounts (as opposed to premiums) to NAV have widened on many popular products as investors have fled this strategy. That can offset this interest rate headwind in a big way. But it still poses a major risk, so I would suggest readers consider non-leveraged ETFs or individual issues for the time being.

**I own the VanEck High Yield Muni ETF ( HYD ) and the Invesco Taxable Municipal Bond ETF ( BAB ). I also suggest "fallen angels" for non-IG rated corporate credit. Two popular options are the iShares Fallen Angels USD Bond ETF ( FALN ) and the VanEck Vectors Fallen Angel High Yield Bond ETF ( ANGL ).

Don't Forget To Keep A Long View

I have tried to emphasize what has sparked the recent rally and why it is on shaky ground in my opinion. There is a very real chance we lose these gains but, if the economic conditions hit a sweet-spot, the Fed could pause (or reverse course) and the rally could proceed further. This will be the push-pull dynamic for the rest of the year, and likely will extend in to 2024 as well.

I do think this is an important reality to consider as we move forward. But let's put this in perspective. The market always has risks both short and long term. This is the reality of investing and, as retail investors, we really should be taking a longer view. There are certainly times to rotate some exposure and/or raise cash - I do it all the time. But I am always more invested than not and that will remain the case. The support for this is that developed market equities - which I exclusively invest in - offer returns too strong to ignore. The US, in particular, tends to beat the rest of the world:

What I take away from this is that, over time, staying the course is rewarded. That doesn't mean every day is a great buying day, but it does mean that we shouldn't panic over headlines or make aggressive moves on any singular event. We will probably regret it later if we do.

Bottom Line

As 2023 comes to a close that is a lot to consider. Equities are up, but index gains are being driven by a handful of big names. By contrast, bonds have taken it on the chin and the economy's "resilience" - which we have heard about for months - is actually responsible for much of the weakness because it has kept the Fed on a rate-hiking course. This has moderated over the past two meetings, but the Fed's next move remains in question with under two months to go until 2024.

But readers shouldn't be alarmed here. I believe there is value emerging in both large-cap stocks and in fixed-income securities - especially those like munis and junk bonds that are offering income streams higher than savings accounts/CDs. Further, the US continues to draw in global investors, especially as China struggles to attract outside capital. As a result, I see this as an opportune time to make some tactical moves, and I hope this review serves readers well going forward.

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