2023-06-19 08:00:00 ET
Summary
- The Federal Reserve made a concerted effort to remain hawkish in tone despite holding rates steady in June.
- We believe that the Federal Reserve is bluffing with its rhetoric and that interest rates are likely headed lower.
- We share why we believe that and discuss the implications for SPY.
The Federal Reserve made a concerted effort to remain hawkish in tone despite holding rates steady in June. However, we believe that the Federal Reserve is bluffing with its rhetoric and that interest rates are likely headed lower. In this article we share why we believe that and discuss the implications for the SPDR S&P 500 ETF Trust ( SPY ).
The Federal Reserve's "Hawkish Pause"
The Federal Reserve voted unanimously at its recent June meeting to hold the Federal Funds Rate steady, pausing interest rate hikes for the first time in 15 months. However, the Federal Reserve tried to communicate to the market that it was far from done fighting inflation.
With Core CPI (CPI minus its more volatile food and energy components) remaining much stickier than overall CPI:
it appears that the Fed's war on inflation is not making nearly the headway that it should be by now given its aggressive pace of rate hikes:
As a result, the Federal Reserve signaled that it will likely hike interest rates two more times this year, with the consensus showing that two more rate hikes for 2023 are likely. Meanwhile, the reasoning behind pausing in June was reportedly to allow time for the Fed to process further data from the economy in the wake of the regional banking crisis earlier this year as well as to let the effect of the Fed's aggressive rate hikes work its way through the economy.
Why We Think The Fed Is Bluffing On Interest Rates
While this sounds plausible and reasonable from the Fed, we think that they will not actually hike interest rates twice more this year and actually likely will not hike interest rates at all. Here is why:
- Until their recent aggressive rate hikes, the Federal Reserve has kept interest rates at historically low levels - and in fact near 0% - ever since the 2008 financial crisis. They cannot afford to raise rates any further - or even keep them at current levels for much longer - without causing devastation to the heavily leveraged economy:
- There is nearly $1.5 trillion of commercial real estate ( VNQ ) debt coming due before the end of 2025. If interest rates remain in their current range for much longer, there could very possibly be a tidal wave of defaults, which in turn could reignite the regional banking ( KRE ) crisis and also decimate the mortgage REIT ( MORT ) sector.
- The U.S. Government continues to deficit spend and borrow at an incredibly high rate. With the arms race going on with China and the ongoing financial demands of funding the war in Ukraine, there is no way that the U.S. Government can afford to pay such high interest rates on its debt for a sustained period of time. With no sign of a change in government spending habits, the burden will fall on the Federal Reserve to cut rates sooner rather than later.
- There is a major election coming up in 2024. It is highly unlikely that the Federal Reserve would be willing to risk an economic crisis right before that election.
Why is the Federal Reserve signaling further hikes are on the way, when we believe that they ultimately won't deliver on them?
- First and foremost, Chairman Powell has emphasized in the past that we should not take the Federal Reserve's dot plot too seriously:
Dots are to be taken with a big, big grain of salt. They’re not a committee forecast, they’re not a plan. The dots are not a great forecaster of future rate moves. And that’s because it’s so highly uncertain.
- Second, the Federal Reserve realizes that the stubbornly high Core CPI remains an item of concern. As a result, they want to continue to sound as hawkish as possible in order to tamp down any inflationary reaction from the broader market, which could push up prices further and continue to inflame inflation.
- Third, housing - which makes up about one-third of CPI and ~40% of Core CPI - is almost certain to see deflationary numbers in the near future. This is because there is a significant lag between on-the-ground real estate date and the CPI's housing data inputs. The CPI data is based on staggered rent data from sample households every six months, meaning that it takes approximately a year for the full data to be incorporated into CPI. With home prices stabilizing and even declining in some markets and rent rate growth also falling, it is almost inevitable that the housing component of CPI trends sharply lower in the coming months. As Mark Zandi, chief economist at Moody’s Analytics, said:
I know this with about as high a degree of confidence as one could have.
SPY Implications
What is the implication of a true end to the Fed's war on inflation for SPY? Overall, in the short-term it is likely a big positive, and the growing expectation that this scenario will play out is likely what is partially driving (along with the growing ascendancy of artificial intelligence) the rally so far:
This is because lower interest rates make stocks more valuable due to lower discount rates being applied to valuation models while also reducing stressors on the economy.
That said, over the medium to long term, the Federal Reserve backing off of its inflation fight a bit prematurely - even if Core CPI does fall some later this year as we expect it will - will likely pose challenges to SPY. This is because inflation will likely remain well above the Fed's target 2% rate if interest rates are cut in the near future for the following reasons:
- There is simply too much debt in the economy and still too much money sloshing around from the near 15 years of extremely easy monetary policy, that if interest rates are meaningfully cut in the next year or two, the real estate bubble will remain inflated, leading to fairly persistent Core CPI.
- Moreover, weak population growth will further aggravate the extremely tight labor market, putting wage pressure on CPI numbers.
- Last, but not least, government regulations and runaway government spending will also put immense pressure on inflationary numbers.
The Federal Reserve is ultimately having to choose between either crushing inflation now (and crushing the economy along with it) or allowing it to run well above its target rate for quite a while. For the reasons already mentioned, we believe that the Fed will err on the side of higher inflation for longer. While this will prop up SPY in the short term, it will also lead to higher cost pressures and less economic stability for SPY's constituents for the long-term, leading to less efficient capital allocation and lower real returns for investors over the long-term.
When you take into account the fact that SPY is already significantly overvalued according to leading valuation models (such as the Buffett Indicator, the Price/Earnings model, the Mean Reversion model, and the Yield Curve model), and that SPY's largest constituents (such as Apple ( AAPL ), NVIDIA ( NVDA ), Microsoft ( MSFT ), Amazon ( AMZN ), Tesla ( TSLA ), Meta ( META ), Alphabet ( GOOG )( GOOGL )) have all largely already raced higher so far this year thanks to the A.I. hype, there is little further room for sustainable multiple expansion. In fact, we would argue that the risk is almost entirely to the downside from here.
Investor Takeaway
SPY has been on a strong bullish rally in recent months despite Core CPI numbers remaining stubbornly elevated and the Federal Reserve continuing to raise rates. However, we think that the Fed's rate hiking days are behind it and that Core CPI will likely decline in the second half of 2023 (though still remaining well above the Fed's target 2% rate).
While this justifies to some extent SPY's year-to-date rally, we think that the longer-term outlook for markets remains negative. Between the significantly overvalued current valuations that would require extremely bullish scenarios playing out for artificial intelligence to justify and the likelihood of inflation remaining stubbornly above the Fed's 2% target rate for the foreseeable future, in our view SPY is doomed to below average real returns in the coming years. As a result, we are avoiding major index funds like SPY and are instead investing in niche areas of the market where we find the best risk-adjusted return profile in what we expect will be a prolonged stagflationary period.
For further details see:
The Fed Is Bluffing And Rates Are Likely Headed Lower: SPY Implications