Q3 2024 Market Commentary: The Market Expected At Least Three Rate Cuts by Now. What Happened?
This information is meant to be a commentary regarding Consilio Wealth Advisors’ views on the relative attractiveness of different areas of the market, contrasted with our current asset allocation strategy for the near term, 12-18 months.
These views are always made in the context of a well-diversified portfolio and are not meant to be a recommendation to buy into or sell out of a particular area of the market. These views can and will change as new information becomes available, and we will periodically update this brief to keep you informed of changes.
Last December, I made three predictions that I was sure to be wrong:
The rest of the market will catch up to the Magnificent 7 – Wrong so far
The Fed will not cut rates, rather pause – Right so far
The US dollar will weaken, finally - Wrong so far
The Magnificent 7
The Magnificent 7 became even more magnificent. Their returns are more than double the S&P500 so far. I even left Tesla in there, which is down ~26% during the same period.
The catch-up trade has yet to materialize. Focusing on mid cap and small cap companies, we’ve seen a higher sensitivity to interest rates when compared to the Magnificent 7. We just need the Fed to cut rates…
Rate Cuts
The year started with an expectation of SIX rate cuts. So far, zero. Zero! The expected rate cuts would have brought rates down from 5.5% to about 4%. While I’ll gloat about my correct forecasting skills, this was a prediction I wanted to be wrong. I said we’d see zero cuts this year because inflation would remain sticky.
There hasn’t been much evidence of economic weakening. We didn’t see significant slowdowns in spending until May. Along with strong jobs numbers, the Fed is not seeing enough of a trend to justify cutting yet.
The Fed, while hesitant on cutting rates, removed any doubt about potential rate hikes. This was celebrated by the markets, despite any progress on potential cuts. You can’t cut unless you stop hiking first.
The Strong Dollar
Another prediction I’ve been wrong on so far. The dollar cannot be knocked off its perch. The demand for the US dollar has gotten higher for a myriad of reasons. Things that are hard to predict are geopolitical events. Lately, elections in Mexico and France have shaken currency markets. Both events caused an uptick in US dollar demand.
Stability
Ignore the noise coming from the headlines. The US economy is on good footing. Even if you believe otherwise, compare the US situation to nearly any other country in the world. Give me the US with all its problems.
Political stability will likely persist in the US regardless of the election outcome. Even if the amount of rhetoric ratchets up, our political system of checks and balances should be more stable compared to other countries.
Interest Rates
The Federal Reserve is looking to be the most persistent of central banks to keep rates high. If you’re looking for safe savings with the highest yield, the US is the answer. The Bank of Canada just cut rates by 0.25% in June. The European Central Bank cut rates to 3.75%.
Global savings would seek out the highest paying stable currency and that’s currently the US dollar.
Debt Levels
High debt levels should represent risk to a currency. In the developed world, lower levels of debt are a rarity. Debt levels are worrisome but to really address the issue, major cuts and higher taxes are likely needed. Doing so means political suicide.
The map below is from the International Monetary Fund with data through 2022. The key at the top is the percentage of debt relative to GDP. The US is running an uncomfortable 121% of GDP. It still around that rate today and will likely climb higher.
However, when the US Treasury goes to auction every week, there are still plenty of bidders even as China and Japan have slowed or stopped bond buying. The term is called “catching a bid”. Even with heightened concerns over debt levels, the appetite for US treasury bonds remains healthy.
The bid-to-cover ratio was 2.67 in June, which means that for every $1 billion in treasuries offered, there were $2.67 billion in willing bidders. If Treasury sees the demand drop, it will have to increase the interest rate to entice bidders back to the auction.
Notice that the bid-to-cover ratio jumped to 3.2 right after the housing crisis. Demand for US treasuries was high as investors were seeking safe havens.
The Consumer
The US consumer has this fearless charm that other countries don’t. We spend like tomorrow isn’t guaranteed. While it has kept the economy growing, and our spending strength can turn into a liability. Debt levels and defaults could be a concern in the future. Despite some worrying trends in the near term, the delinquency rates and debt levels are back on the prepandemic trend.
Consumer spending accounts for about 70% of GDP and this leg of the economy has been keeping the engine running for decades.
Outlook
The market should stop treating rates as the sole focus. We’ve been in an environment when rates went up, the market goes down. Rates going up also meant bond prices go down. Since 2022, the correlation between stocks and bond prices have been high. Meaning they’re moving up and down together.
Historically, stocks and bonds prices haven’t moved together so closely. With rates much higher than in 2022, bonds have shown more resiliency with rate movements and should start to behave more like the bonds we’re used to.
If There is a Rate Cut
Whether this year or next, a rate cut will benefit small and mid-cap companies. We already had a preview of this effect last November when the market was pricing in the 6 implied rate cuts to end 2023. Small and mid-cap stormed back. That rally has been damped this year when the market reduced the 6 implied cuts down to 1 (the equivalent of 0.25%).
Mortgage rates could come down which is influenced by the 10-year US treasury rate. When the Fed raised rates the housing market experienced the opposite intended effect of higher rates. We assumed higher rates would force home prices to come down. Instead, it locked people into their current homes because they’re unwilling to let go of their 3% mortgage for a 6% mortgage. The supply of houses came way down while demand stayed the same.
At this point, it’s not a slam dunk that lower rates would cause home prices to go down but I would expect the supply of available homes to improve. There could be pent up demand that would keep home prices high for the time being.
The broader real estate market would benefit from lower rates too. Think industrial, storage, server space, and other commercial uses. This industry is sensitive to rates because it is usually leveraged. The cost of doing business gets more expensive as rates move up.
The dollar should start to weaken. Holding everything else equal, lower rates in the US should start to lower demand. A 0.25% cut isn’t much, but the market always looks ahead. If there’s an obvious trend of cuts coming down the line, investors will make their moves ahead of the event.
A weakening dollar is a tailwind for international and emerging market investments. Foreign companies that covert their home currency to the US should experience better exchange rates from their point of view.
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