Written by: David Waddell | Waddell and Associates
Bottom Line:
Chairman Powell delivered for investors this week by confirming that rates have peaked and that we should expect four or more rate cuts in 2024. This triggered panic-buying in the markets and a swift broadening of participation. Small cap stocks that benefit more from falling rates and energy prices outperformed to a historic degree, and even long-derided banks tacked on a 12% advance. Overall, the Fed not only confirmed that they have no intention of causing a recession, they went even further to say that they intend to prevent one by reducing rates well before inflation hits their 2% target. That’s big news. Cue the everything rally!
The Full Story:
On Wednesday, Chairman Powell finally said what most of the investment world has been thinking: With inflation falling convincingly, it’s time to consider rate cuts. Last week, we focused our attention on the chart below:
Currently, the Fed has rates set nearly 2.5% above the CPI inflation rate. Over the past 20 years, this level of policy restriction has preceded recession. Should CPI continue falling, this spread will only widen, increasing recession odds further. Many argue that inflation will soon reignite and that the Fed must remain vigilant to avoid repeating the largess policy mistakes of the 1960s. Are they right?
The chart above deconstructs CPI into broad categories and chronicles contribution. Note that when CPI clocked in at 9%, EVERYTHING was inflating. Today, most categories have flatlined, with energy and used cars actually deflating. Housing remains the only stubborn—and sizable—contributor. In fact, if we calculate CPI without housing inflation, the annual inflation rate falls comfortably below the Fed’s 2% target:
The Fed knows that its housing inflation measure operates with a lag. Comparing the CPI housing inflation rate with actual listed rental rates per Zillow reveals large and lagging disparities:
Specifically, the BLS reported a trailing twelve-month housing inflation rate of 6.53% in November. According to Zillow, observable rental rates have risen half as much at 3.32%. Historically, trend shifts in the Zillow price index front-run changes in the BLS price index by 6-12 months. Given the historical relationship, unless we see a strong increase in listed rental rates, the CPI Shelter inflation measure will continue falling, pulling overall inflation down with it.
The Fed lowered its inflation projections significantly in the FOMC’s Summary of Economic Projections released Wednesday (seen below), sparking a historic market melt-up of 1.5% for the S&P 500 and 4% for the small cap Russell 2000:
By the Fed’s own estimate, the Federal Funds Rate will end 2024 a full percentage point below the current policy rate. That equates to four 0.25% interest rate cuts next year. The futures market now sees even more, increasing projections from 6 to 8 cuts next year. In response, longer-term interest rates have collapsed, with the 10-year and 30-year Treasury yields back down to 4% after breaching 5% mid-October. In sum, things have changed significantly—for the better!
Rally Reach
Remember that falling interest rates lead to rising stock market multiples. Remember also that, as of the third quarter, corporate earnings have resumed their uptrend. The combination of rising P/Es and rising earnings has benefitted the entire stock market. This is a welcome departure from the very narrow gains held aloft by the Magnificent 7 for many years. Take stock of the percentage returns below, year-to-date (YTD) and month-to-date (MTD):
Note that, for the month of December, the NASDAQ 100 (Magnificent 7+) has gained 3.7% so far, while the small cap value index has gained 12.4%. Technology overall rose 3.0%, while financials rose 4.7%. It’s great when the bellwether S&P 500 gains, it’s even GREATER when everything else does. This rally has reach… and we suspect this “rally of the rest” will define 2024.