RealTMOR Asset Mgmt LLC and RealTMOR Apartment Mgmt LLP
Fed Cuts in Front of Us, What Could That Mean?
The Much Anticipated and Awaited Rate Cut
Wall Street is expecting the Federal Reserve to start cutting Fed Funds rates from September 2024. Many analysts and investors are expecting and hoping for a 1% cut by the end of 2024. There may be 2-3 cuts from September to the end of 2024. At this time, the probability of a September rate cut is over 70%. The current investment environment, till August/September 2024, has been exceptionally strong (albeit with some volatility). Gold, equity and US residential real estate are at or close record highs and have been making multiple new highs.
Multiple Central Banks and Their Actions Create Volatility
There was a brief pull-back in equities during August 2024, and it was pronounced in US equities. The primary driver of this pull-back was raising of rates by BOJ at the end of July 2024 from 0-0.1% to 0.25%. This resulted in unwinding of the yen carry trade.
- Yen Carry Trade: is an arbitrage across markets by large institutional investors, i.e. borrow funds in Japan (in JPY) and pay low rates of interest. Invest those funds in other markets, commonly US markets (in USD), which have higher yielding assets. If US yields fall, Japanese yields rise or JPY appreciates against USD then this arbitrage does NOT work and investors will have to sell assets to repay the loans. That is the “unwinding of the carry trade”. That results in cross-border volatility and potential losses.
However, the negative effects of this unwinding were short-lived. The other factors which resulted in creating volatility in US equity markets at the same time were:
- Concerns around slowing economic growth in the US owing to a weaker July jobs report which was released in early August. This coupled with an uptick in unemployment rates and downward revision, by over 800,000 jobs, of 12-month employment numbers (April 2023- March 2024) released by BLS.
- Additionally, investors were/are worried that the Fed would be late in delivering the much awaited and anticipated rate cuts. This would upset the “goldilocks effect” for US markets and the US economy. This, “higher for longer rates” phenomenon, could potentially result in a recession instead of the current hope of a soft landing. The Fed’s target annual inflation number was 2% and as of July 2024 the inflation number was 2.9%, so the target number is close to being “reached”. Further, the current unemployment rate is 4.3% and that is close to the Fed’s target unemployment rate. Hence, the market is worried regarding an increased downside risk of the Fed’s “delayed-action”.
- The US equity markets had hit multiple life-time highs during Q2 and early Q3 of 2024 and this made investors skittish and primed the market for perfection. Minor market pullbacks have to be expected when markets hit milestone highs, this tests highs before markets make the next upward move. The risk associated with Fed “actions/ inaction” exacerbated downward volatility. During July to August 2024, US equity markets experienced a strong pullback, it could even be classified as a “technical correction”. The Nasdaq, S&P 500, Dow and Russell 2000 were down 13%, 8%, 6% and 10% respectively, when they hit lows in August 2024 from highs reached during July 2024
Inflation and the Fed
US Inflation data is cooling and the economy seems like it may NOT have a hard landing i.e. a full-blown recession accompanied by major stock market losses, corporate earnings contractions, financial distress in fixed income markets, significant job losses and major spike in unemployment rates among other negative effects. Residential real estate may experience adverse impacts if the recession is somewhat longer. In 2022, the US economy was in technical recession (two consecutive quarters of negative growth) but it avoided many of the abovementioned
negative effects and thus it did not “feel like a real recession”. Additionally, the inverted yield curve, has been occurring for a while now, is traditionally supposed to indicate an oncoming recession, and this could add to the angst. Many economists classify a “full-blown recession” as a backward-looking event, negative GDP growth is accompanied by other adverse conditions and is identified after it happens. The big fear among investors is that the Fed, which raised rates from March 2022 to July 2023 from 0 to 5.5%, would once again be late in its actions, like its famous delay in raising rates in 2021 and 2022 amid spiking inflation. Many investors believe the Fed got the “transient inflationary pressure” call wrong, and could make the same error for cuts. BOE cut rates in August 2024 by 0.25% to 5% and that increased anxiety among US investors.
Resilience of the US Consumer
The US consumer is showing signs of moderate strength and resilience overall, but the positive aspect of this trend should be tempered. If one looks at the consumer price index, retail economic data and retail stocks as an indicator of the strength of the consumer, there are mixed signals. The overall trend is healthy with pockets of weakness, and inflation slowdown would benefit consumer sentiment. The latest annual GDP growth print for Q2 2024 was 3.0% and that potentially bodes well for the consumer and the economy overall.
The Markets Have Hit Multiple New Highs
The US and International markets have experienced volatility for YTD 2024 (till August 2024), but are still close to their all-time highs. The Nasdaq and S&P 500 are up 22% and 20% YTD 2024, while the Dow and Russell 2000 are up 10% and 13%. The Dow is currently at or close to its life-time high. The Nasdaq and S&P 500 hit their life-time highs in July 2024 and are currently around 5% and 1% below those highs. The midcap/small cap Russell 2000 hit its lifetime highs in October 2021 and the index is currently about 11% away from those levels. The Nifty (India) is currently at or close to its life-time highs. The PSEi (Philippines) hit its life-time highs in Q1 2022 but its currently around 7% from those highs. The European markets (DAX) are close to their life-time highs which were reached in Q2 2024. The Nikkei reached its lifetime
high in July 2024 right before BOJ raised rates in Japan, and since then the market is down but its still around 8% away from those highs. The Indian, European and Japanese equity markets hit multiple highs throughout 2024
The Magnificent 7 Dominate and the Broadening of the potential BULL Market
Significant part of the gains, since 2022, in US indices is attributed to the Magnificent Seven (TSLA has underperformed) and promise of AI is one of the main drivers of this Bull run. The midcaps and small caps (Russell 2000) have been gaining slowly, since 2022. These stocks
provided weak returns for a while since the highs of 2021. But, recently there is evidence of rotation into Russell 2000 stocks and other (non-technology) sectors. There is broadening of the Bull Market.
Once, Fed cuts rates, there is a strong possibility for a further run-up among the broader market (including midcaps and small caps) because of lowering of the implicit “discount rate” to value future free cash flows. The sky-high valuations, high multiples and lofty expectations of the forward revenue and earnings growth rates of large cap technology names could create an environment to broaden out this rally. Lower rates will benefit Magnificent 7 stocks BUT not only them. The evidence of “reticence”, as in over-exposure to mega cap tech stocks, has been on display all through the first 3 days of the week of August 26, 2024, up to the day of release of Nvidia’s earnings (8-28-2024). There was very significant attention from ALL, on the earnings print. After the release of “decently strong but not outrageous” numbers, the markets had a “relief rally” while NVDA stock was down under 5%. Some exposure to Russell 2000 stocks could provide promising gains due to potential “broadening of the rally”.
US Real Estate Will Benefit from Rate Cuts
Residential real estate markets in the USA are at all-time highs, whether it’s the National Index or 10-major city composite. The capital gains nationally from 2023 to H1 2024 are 2%-3% and from 2022-2023 are between 6%-7%. The capital gains from 2020-2023 have been robust and
in the range of 30%. Tier 2 and Tier 3 markets have outperformed Tier 1 markets both in the last 1 year and over last 3 years. Even with high rates, residential real estate markets are maintaining their high prices but growth rates are slowing down and sale timelines have increased. With the expectation that rates will be cut soon, the mortgage rates have declined from their recent highs. Inventory is also improving and price increases are not prohibitive. As rates decline, homeowners that have previous low-rate mortgages could potentially be sellers again and use the proceeds to upgrade their property. This would then create more inventory and overall benefit residential real estate markets (including entry level buyers).
Other Assets
Gold prices have been making life-time highs in 2024 and are currently at or close to life-time highs. Gold prices are up about 25% YTD 2024 and up about 12% from 2022-2023. But gold prices are up about 8% for the 3-year period 2020-2023. Lower US interest rates will benefit gold prices since Gold is a non-income generating asset. If there is a perceived risk of recession or a hard landing or if an adverse event materializes, then Gold will be an obvious hedge.
Presidential Election Effects
Equity markets definitely have risk of volatility associated with the US Presidential election at this time. But that’s going to be transient and short-term and should not really affect longer term broader investment decisions. However, investors really worried about it could make personal decisions that would give them comfort.
CONCLUSION:
The optimal solution always is case by case and depends on an individual’s financial needs, portfolio, wealth levels etc. But, this may be a time where adding risk to ones portfolio in a measured manner would provide medium and long term benefits. Of course, the equity markets contain downside risk, sometimes even violent down moves and could even end up in a bear market or worse. But, on a risk adjusted basis the current environment is more favorable towards US equity and to a lesser extent towards Indian equity. One of the BIG problems related to Indian equity is concurrent currency risk. In the near to medium term, US equities could be a somewhat better proposition to US residential real estate. A great way to get exposure to broader markets and hence optimize risk is through ETFs vs. individual stocks, if one wants to add leverage there are levered ETFs too. In certain times, doing nothing or being overly defensive is also risky.