The lag effects of monetary policy are hard – by definition – to put in the rearview mirror, and as the Federal Reserve has raised interest rates at an aggressive pace to fight inflation those moves have remained core to fears about the eventual effect on the economy and stocks, from a deeper selloff cutting into 2023’s S&P 500 gains even more than a down September already has, to a recession.
The continued slide in the Dow Jones Industrial Average on Tuesday, which took the stock index back into negative territory for the year, reinforced what many top investors warned at last week’s flagship CNBC investor summit, Delivering Alpha. Taking risk right now probably isn’t the best market bet.
On Monday morning, hedge fund manager Bill Ackman said on CNBC that the economy is beginning to slow. Last Thursday, he presented a downbeat view of what’s coming next for the economy at Delivering Alpha, and he was far from alone.
“We’re more bearish than most people about what lies ahead,” said Katie Koch, TCW President & CEO at DA. “Things break when you reprice aggressively,” she said. “We haven’t seen the pain of higher rates, but it’s coming.”
She said a recession is still her base view and investors are not being paid to be aggressive here with cash accounts returning as much as 5%.
“There is a lag and more things are going to break. We’ve already broken a couple of things or almost broken them. We almost broke the UK pension market, and we broke some regional banks. And there’s going to be more dislocation ahead clearly as capital reprices,” she said. “You’re getting paid to be patient right now,” Koch added. “Cash has a good return.”
Some of the market’s biggest stock market investors echoed this view. Brad Gerstner, CEO of Altimeter Capital and a closely followed tech investor, said he has taken down his long equities exposure by 50% relative to short exposure, a move he has made based on analysis of, among other things, consumer data, from housing demand to travel demand and even single big-ticket purchases, like RVs, all caught up in the lag effects from Fed policy.
“I think the risk has increased that the Fed has overshot,” he said. “I’m not certain whether we’re gonna have a hard landing or a soft landing, but I am certain that the probability that we’re going to have meaningful slowing in 2024 has gone up.”
Gerstner spoke about the consumer and corporate debt getting stretched, worries many C-suite officers across the market have voiced throughout the past year amid the surprising resilience of the consumer and economy.
“I mean, think about this. We’ve gone from effectively a 0% interest rate environment, where corporations borrowed for free and consumers borrowed for free, to now we have 8% mortgages; we have 10% car loans; we have 20% credit cards; student loans are about to kick in; the huge bulge of corporate borrowing that occurred at next to nothing, April to December 2020, now has to get re-fied [refinanced] at rates a lot of these companies can’t afford. This is the definition of lag effect and headwinds.”
Ackman said on Monday morning he didn’t expect another rate hike. But the Labor Department’s monthly Job Openings and Labor Turnover Survey released on Tuesday showed a level of open positions that helped to sink the markets and related to fears that, even if it suggests more surprising strength from the economy, will be a key input for the Fed before its November rate decision. The recent market view based on the CME’s FedWatch tool has been aligned with Ackman, with the percentage of respondents expecting no hike in November as high as 83% last week. That’s still the majority view, but was down to 68% on Tuesday at midday.
Gerstner, though, wasn’t so sure at last week’s Delivering Alpha why the majority did not anticipate another hike. “If you just listen to their words, you know, you have to be pretty fearful there’s going to be another rate hike. … So the markets still calling a bit of the bluff of the Fed, but I think there’s a good shot you have one more rate hike, because I think they’re really committed. He [Fed Chair Jerome Powell] wants to be Volcker. He doesn’t want to be remembered as the Fed chair that didn’t slay inflation,” he said.
Another important DA speaker on fixed income and the Fed agreed more with Gerstner than the market. Rick Rieder, the top bond investing executive at the world’s largest asset manager, BlackRock, told the DA audience that the market may be betting wrong on the Fed. Even though he thinks another hike is not needed, he says the Fed seems likely to raise rates once more in November based on his analysis of everything they have communicated. “You’ve got a Fed telling you they’d like to do more, they want to make sure they bolt down inflation,” he said.
Rieder added to a chorus of investors pointing to less risky investments as a sweet spot with what many might consider a boring asset class among his favorite current bets.
“I love commercial paper at 6.5% for one year,” Rieder said. “I know what my return is gonna be for single A issuers, big high-profile issuers and I can just lock in that rate.”
Recent inflation data supported the view of a Fed that might be done, with the Fed’s “favorite” indicator, the PCE, cooler than expected in August. But the labor data just pushed back. “Those numbers need to be supportive,” Rieder had said of inflation data and jobs data including the JOLTS report in an interview with CNBC on the sidelines of DA. The JOLTS data could prove to be an anomaly and Friday’s nonfarm payroll report looms even larger now in providing a key labor market input for the Fed.
Ackman, even betting against another rate hike, has a view of inflation that sees it being persistently higher and placing more pressure on yields. “Our view is really that we’re in a different world. … I would not be shocked to see 30-year [Treasury] rates well into, through the five [percent] barrier, and you could see the ten-year approach five,” he said.
On Tuesday, the 30-year and 10-year treasuries hit their highest levels in 16 years, since 2007.
Even when the Fed starts to cut — Rieder says second half of 2024 — it could be cutting from a higher level than the market anticipated. And while the market is pricing in rate cuts for next year, Gerstner took that as a bearish indicator as his starting point. “The reason the market is pricing in two or three rate cuts next year is because the market is saying the economy is going to be worse than you’re currently forecasting.”
There will be a lot of pain across markets to reach that rate-cutting point, too. Koch, whose firm is a major real estate bondholder, said about a third of the existing supply of office square footage will need to get taken out of the market, led by office properties that aren’t in the top tier.
“A trillion and a half dollars of the CMBS market is going to need to be extended in the next about year,” she said, at significantly higher rates. “We’ve had a few people start to walk away from buildings in Los Angeles, San Francisco, other cities,” she added. “It is a long tailed event.”
Dawn Fitzpatrick, Soros Fund Management CEO & chief investment officer, summed up the mood at DA by citing several fears she has about the consumer, credit delinquencies and bonds. In addition to the CMBS market, she pointed to the hundreds of billions that banks are holding in to-maturity bond portfolios, a pressure that’s being exacerbated by the recent spike in bond rates — as bond yields rose again on Tuesday, regional banks slid, adding to a more than 10% decline over the past month. Fitzpatrick also cited U.S. consumers with trillions of dollars in mortgages that are fixed rate and have not yet adjusted to the new rate reality like the rest of the world’s homeowners had to do in real-time, since floating rate mortgages are the norm in many housing markets outside the U.S.
On Tuesday, mortgages were testing a level not seen since 2000.
“Everything gets harder from here,” Fitzpatrick said.