Refilling the punchbowl

Well, they may have left rates unchanged, but that was still a pretty interesting U.S. Federal Reserve (Fed) Meeting last week. According to their Statement of Economic Projections, policymakers are now anticipating three cuts next year, beginning in June (the same as the DWS forecast!). Markets are even more giddy. They are currently pricing in four or five cuts, with a March start. Even the – usually very wary – bond market has capitulated. The ten-year yield dropped below 4% (we’ll see if that sticks), but the message appears to be – the inflation fight is over, and the Fed won.

Here’s my take on all this

I think what the Fed has done is opened the door to easier financial conditions, and that that has lowered the chance of a recession. The downside is that it also increases the risk of inflation lingering. It’s a very tricky tightrope of risks, but one that the Fed seems comfortable walking. The fact is 2023 was a pretty good year from a macro perspective — inflation came down, the economy continued to grow, unemployment remained low. I can well understand Chairman Powell’s point of view, but I am a bit surprised that he didn’t strike a slightly more somber tone, and effectively ask the markets to hold off on assuming cuts were a given next year. After all, if inflation were to reaccelerate he would surely regret this more dovish tone. In any case, I don’t think a March cut is likely, the markets might push for one, as may some members of the Federal Open Market Committee (FOMC), but I suspect June could be the start date for lower rates.

How to play the resulting rally?

Well I still like foreign diversification, and small cap stocks. If we see either more inflation in the U.S., or a recession, either argues for taking some of your beta in foreign markets and smaller companies. I continue to like Japan, but I think owning it on a currency-hedged basis is now the right play. I don’t believe the yen will show much further appreciation, and the Bank of Japan is in no hurry to hike rates (and thereby potentially trigger a stronger yen). In bond world, I’m back to preferring the shorter end of the yield curve, and in corporate credit would lean towards investment grade over high yield, where I think we might see a slight rise in defaults, and some companies finding it tougher to refinance at what are still higher levels. I expect Utilities to grow their earnings by around 6-8% next year, and when investors chase a rally, often it’s with money that comes from Utilities and Staples, so I think this could be a good time to pick up those sectors being a bit overlooked right this moment.

Happy investing in the last few days of 2023, I look forward to sharing many more thoughts next year…

– David