Way back in 2009, six months after the equity market bottom, a seminal movie was released by Columbia Pictures entitled Zombieland (it was not, however, about banks, mortgages, or distressed debt, but was about, well, zombies). Zombieland was, essentially, a story of four individuals making their way across the country trying to escape zombies and arrive at Pacific Playland amusement park. In a certain way, this reminds us of the current state of the capital markets – trying to get to Playland (the Fed pivot to lower rates) whilst avoiding zombies (higher rates, tighter credit, earnings contraction, higher defaults, and wider spreads – all of which devour returns).
In the beginning of the movie, one of the main characters (Columbus, played by Jesse Eisenberg) goes through a list of “rules” necessary to survive in the current environment. Among the top five are:
- "Cardio" – You must be in shape if trying to avoid zombies (or chasing shifts in market views), there can be a lot of running involved.
- "Double tap" – Zombies, as you might be aware, are killed by aiming for the head. To ensure they are down, two shots create a margin of safety.
- "Seatbelts" – Simply put, sometimes you must stop quickly.
Let’s look at these rules in order of importance in today’s market.
Double tap – while the Fed has attempted to dispel the markets notion of “lower sooner”, they keep forgetting the “Double Tap” rule and can’t kill the thesis. To wit, we see the following Fed comments:
- Chair Powell (12/1/23): “The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.”
- Governor Michelle Bowman (11/28/23): “…But my baseline economic outlook continues to expect that we will need to increase the federal funds rate further to keep policy sufficiently restrictive to bring inflation down to our 2 percent target in a timely way.
- New York Fed President John Williams (11/30/23): “In balancing these risks…my assessment is that we are at, or near, the peak level of the target range of the federal funds rate… I expect it will be appropriate to maintain a restrictive stance for quite some time to fully restore balance and to bring inflation back to our 2 percent longer-run goal on a sustained basis.”
- Richmond Fed President Thomas Barkin (11/20/23): “Markets have been pricing in rate cuts faster than a lot of the forecasts in the Fed…I can just tell you what I think, which is, I see inflation being stubborn, and that means that makes the case for me for being higher for longer. But other participants in the market have different forecasts.”
Despite Federal Reserve members attempts to put down the lower sooner narrative, the double tap hasn’t occurred, and the market keeps coming with its lower sooner pricing. This can be shown by the table below showing that during the month, expectations for the June 2024 federal funds rate was reduced by nearly one cut, or 22 basis points. Similarly, by the end of 2024 the market is now expecting the federal funds rate to be below 4.20 percent, down from approximately 4.50 percent at the beginning of the month.
Cardio - needed as the market keeps running back and forth between higher/longer, neutral, and lower/sooner, which also coincides with “Goldilocks soft-landing”, “recession”, and “no landing”. Chasing trends can be exhausting and FOMO (fear of missing out) requires a healthy investment cardiovascular system. Investors should be marathon runners, looking at the path ahead of them, not the next footstep.
Thankfully, the lack of the “double tap” propelled November returns and has given (even for the marathon runners) some go-forward energy. As the table below shows, equity market returns near nine percent across the board (except emerging markets and large-cap value), and most fixed income returns of five percent or greater – especially in spread (risk premium) product - have given investors some “good tidings” heading into December and the next holiday season.
Bonds performed well as rates fell, reflecting the new market thesis “lower sooner” and the curve bull flattened with the ten-year Treasury dropping 60 basis points (0.60 percent) in yield:
Within equities, mid-cap growth led the way, as one might expect if there is a “goldilocks/lower sooner” scenario (which is related to our recent publication on small-cap stocks). Mid-caps had fallen 14 percent since making their 2023 high at the end of July:
On an equity sector basis, the information technology and communications sub-index showed it can sprint with the best of them, ending up nearly 13 percent higher than the prior month, and up a whopping 52 percent year-to-date. Surprisingly, real estate kept pace with information technology as the reduction in rates supports real estate valuations and the leaders in the real estate space were technology related communication/infrastructure REITs.
Seatbelts – The market slams on the brakes with each change in the “lower sooner” thesis. Without seatbelts to keep you in your seat, this ride is going to be rough. Should this thesis change, the market will have to revalue lower, and no investor wants to hit the windshield. After a month like November, and the market’s perception of the Fed pivot, many folks might be wondering: “why seatbelts?” The following charts should, in our opinion, help answer that question.
Volatility is resting near its 12-month lows, a condition that does not typically hold for longer periods of time and may suggest market complacency.
The risk of a recession is increasing and, while expected by some market participants, poses a threat to valuations. The amount of the impact will depend on the timing of the recession and the depth. We expect it will occur in the first half of 2024 and will be somewhat shallow, or manageable. A recession, of course, normally leads to the Federal Reserve easing monetary policy, but if it occurs whilst inflation is still above their target in a meaningful way, the Federal Reserve might not respond as quickly as many expect and as historical observations suggest.
The Sahm Recession Indicator, which signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months, is trending towards its recession signal and is now 0.17 percentage points away from its signal.
In short, the single focus of markets (lower sooner) against the “signaling” of the Federal Reserve as to when we will reach Playland (still on theme after all the words and charts/table), presents the risk of revaluation within the financial markets. Whilst we believe that the Fed has ended their rate increase regime, we do not believe that they will pivot in the first half of the year and the total of the rate cuts during 2024 will not be as great as expected in the markets. We are, therefore, cautious going forward, but enjoying the returns generated in the markets in November. We continue to recommend an overweight in fixed income due to its attractive valuation and the reduced risk relative to the equity market. In the equity markets, we recommend rebalancing domestic equities and increasing the weight of mid-caps and small-caps to at least their target weight.
We will now leave you with an ending quote from the movie “Zombieland”: So until next time, remember: cardio, seatbelts, and this really has nothing to do with anything, but a little sunscreen never hurt anybody.”
The views expressed in this publication are those of the author and do not necessarily reflect the views and opinions of Cetera Advisor LLC or Burrows Capital Advisors.
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