1. In March, global equity markets rose sharply for the second consecutive month.
This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), and IWM (iShares Russell 2000 ETF in grey).
Since the end of October 2023, U.S. stocks have sizzled. Emerging markets have been dragged down by China.
This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), IWM (iShares Russell 2000 ETF in grey), and MCHI (iShares MSCI China ETF in red).
2. Will the real federal funds rate please stand up? Inflation remains the most important story for markets. Increased uncertainty over the FOMC’s reaction function adds a new element.
(reader note: real federal funds rate = effective federal funds rate – inflation rate
The headline inflation rate has dropped to about 1% above pre-pandemic levels.
The “core” inflation rate (excludes food and energy) remains 2% above pre-pandemic levels.
The improvement (downtrend) in the rate of inflation has stalled over the last several months. As a result, the FOMC has sat on the sidelines and the effective federal funds rate has sat at 5.33% for the last eight months.
What gives?
From a supply perspective, labor force and energy supply have been the big constraints.
Ongoing skills mismatches have led to high wage growth in certain industries, e.g., pilots and machine workers.
Higher energy and electricity costs are a result of years of underinvestment in oil exploration and production and nuclear energy generation.
On the margin, other constraints have limited supply, in particular:
Underinvestment in infrastructure.
Increasing regulation in various industries.
Incoherent immigration policy.
Geopolitical frictions.
From a demand perspective, there have been two “surprises”.
The “long and variable lag” of monetary policy tightening in reducing economic demand has been quite long versus historical precedent and not as impactful as projected.
Many large corporations extended debt maturities when interest rates were low pre-2022.
Since the U.S. housing market is largely financed with 15-year and 30-year fixed rate mortgages, most existing homeowners have not faced re-financing risk.
Many household and business had significant cash holdings or built-up cash holdings during the pandemic and have benefitted from higher interest income.
The U.S. federal government has engaged in an unprecedented spending spree over the last several years, which has boosted demand but has not boosted supply.
The deflationary forces of globalization, competition and technology innovation have yet to win out. Maybe they will.
In the meantime, what is the Federal Reserve (FOMC) to do?
The FOMC has three official mandates, namely maintain full employment, keep prices stable, and serve as lender of last resort in a crisis. The FOMC has also operated as if it has a fourth mandate, namely support risky asset prices. Over the last four decades, the Fed has not had to worry about price stability. Globalization was a strong deflationary force.
Now it faces the challenge of balancing its mandates.
Maintaining full employment is particularly important in an election year.
After a strong rally, U.S. large cap equity valuation multiples appear to be factoring in federal funds rate cuts.
Many banks are facing the prospect of credit losses on commercial real estate loans (mostly offices in urban centers) and credit losses on leveraged loans as the rise in short term interest rates starts to bite. On the other hand, financial conditions remain loose, according to the Chicago Fed’s National Financial Conditions Index.
Inflation, especially services inflation, has proven sticky. Wage growth in the services sectors is still hovering around a 5% annual growth rate. The Atlanta Fed's sticky-price consumer price index (CPI), a weighted basket of items that change price relatively slowly was up 4.4% on a year-over-year basis in February.
Investors keep changing their expectation for rate cuts. In October, investors were pricing in three rate cuts (using the upper end of current federal funds rate range of 5.25% to 5.50%). By January, they were pricing in seven rate cuts. By the end of March, they are back to pricing in three rate cuts.
The options market has detected the lack of a clear signal about near term FOMC policy actions.
In the Federal Reserve’s December 2023 note “Elevated Option-Implied Interest Rate Volatility and Downside Risks to Economic Activity”, author Cisil Sarisoy commented on the rise in uncertainty about short term interest rates.
“Measures of uncertainty about U.S. short maturity interest rates derived from options have risen sharply since October 2021, reaching their highest levels in more than a decade. This note first uses survey-based measures of economic uncertainty to argue that this increase in option-implied measures likely reflect higher uncertainty about inflation, the associated monetary policy response, and the perceived resulting downside risks to economic activity. It further shows that increases in implied volatility over the past twenty years have generally been associated with lower future economic activity and larger downside risks.”
3. Credit markets will likely be the canary in the coal mine, as the typically are, if a sustained economic contraction, is forthcoming and large federal funds rate cuts are on the horizon.
At month end March 2024. high yield bond spreads remained subdued and had settled around 1.5% below long-term averages and well below recent peaks.
U.S. leveraged loan default rates also remained subdued, per data from PitchBook | LCD.