Above the Noise: Getting back to normal

I’m declaring an end to the COVID-19 environment. Bold comment, right? Admittedly, it feels like a lifetime ago that we were living in quarantine, but the ramifications of the pandemic have persisted. Such is life when policymakers flood the global economy with money at precisely the moment that businesses are cutting workers and slashing inventories. That’s not a criticism of policymakers. I believe that true global calamity was averted. Nonetheless, inflation, policy tightening, and fears of recession followed. Some pundits even posited that a new era of inflation — or even worse, stagflation — was upon us. It was only earlier this month when a prominent bank executive warned that interest rates were going to 7%. Or higher! As the gamblers might say, I’ll take the under.

My view was reaffirmed with the 2.75% annual change in the core Personal Consumption Expenditures Price Index in May.¹ That’s price stability in my book and within what I’ve always perceived to be the Federal Reserve’s “comfort zone.” It also suggests that the current 5.25%‒5.50% federal funds target² is likely too tight for the inflation environment. An easing cycle appears to be forthcoming, and with it I anticipate the normalization of the US Treasury yield curve, following 19 months of inversion.³ Normalization is the operative word, even if it has been eons since I last shoved a cotton swab into my brain.

It may be confirmation bias, but…

…the US stock market, on average, has historically performed well in the early stages of a Fed easing cycle.⁴ That is, if the economy is already in a recession before the easing cycle commences or if no recession occurs. Easing cycles that predate recessions have been less conducive to investors. I suppose that’s still a possibility, however our preferred recession indicators, including corporate bond spreads⁵ and bank lending standards,⁶ aren’t flashing recession warning signals.

It was said

"I think we're going to see the S&P go down 86% from the top, and the Nasdaq 92%.”
– Economist Harry Dent⁷

A friend once told me to make outlandish comments to make headlines. It’s never been my goal to make headlines. Personally, I want investors to remain above the noise so that their emotions don’t have them deviating from their investment plans.

Harry Dent certainly made news with his comment earlier this month. I’ve even been asked if I give credence to his views. My response is that I put as much credibility in this comment as I did when Dent predicted a prolonged Great Depression starting in 2009 and a plummeting of the Dow Jones Industrial Average beginning in 2012. Also, remember Dent’s spending wave theory? It was the idea that baby boomers would sharply reduce their spending between the ages of 48 and 63, resulting in extreme financial market duress. Take it from someone who’s 48 and raising two teenage daughters that the spending wave theory is, as President Biden might say, “malarkey.”

Phone a friend

I’ve received a lot of questions about the future independence of the US Federal Reserve. Allies of former President Trump have circulated a 10-page document outlining a vision for the central bank that included the president being consulted on monetary policy decisions. A perceived lack of monetary policy independence could have significant consequences for US rates and the US dollar.

I asked Jen Flitton, Head of US Government Affairs at Invesco to opine. Her response:

“The system is structured to make it very difficult to disrupt the Fed’s independence. Any formal changes to the operations and/or independence of the US Federal Reserve would require Congressional approval to amend the Federal Reserve Act. Such a change to the statute would need 60 votes in the Senate, an exceedingly high hurdle. Even if the Republicans win the trifecta in November, meaning the presidential election as well as victories in the House and Senate, they will not have the party line votes in the Senate to make any significant changes to how the Fed operates.

That said, you only need 51 votes in the Senate to confirm a new Fed chair. It is possible that in 2026, when Jerome Powell’s term ends, if Trump is president, then a new Fed chair could be more beholden to the White House. Nonetheless, five of the 12 officials on the Federal Open Market Committee will not have been appointed by the winner of the 2024 election.”

Since you asked (part 1)

Q: What would have to change for the US stock market to become less concentrated?

A: Market performance at the end of 2023 might provide useful context for thinking about the future. Smaller-capitalization stocks, as represented by the Russell 2000 Index, advanced by more than 20% in the two months ended Dec. 31, 2023.⁸ The equal-weight S&P 500 Index outperformed the market-cap weighted S&P 500 Index by more than 3% during the same period.⁹ The outperformance occurred as investor expectations for rate cuts in 2024 increased from three to six. It wasn’t to be. US equity performance was increasingly more concentrated in the first half of 2024 as rate cut expectations were tempered.

Going forward, the expectation of an easing cycle and the normalization of the yield curve could help to again broaden market participation.

Since you asked (part 2)

Q: Are you concerned that a US president may take the country out of North Atlantic Treaty Organization (NATO)?

A: No. The National Defense Authorization Act for Fiscal Year 2024 prohibits the president from unilaterally withdrawing from NATO without approval of a two-third Senate super-majority or an act of Congress. In addition, 23 members of NATO (including France and Germany) are likely to meet NATO’s 2%-of-gross domestic product military spending commitment this year, up from 11 in 2023 and just three in 2014.¹⁰

Everyone has a podcast

Kristina Hooper, Chief Global Market Strategist at Invesco, joined the Greater Possibilities podcast to discuss the midyear outlook. Kristina has held fast to her beliefs that the US economy would be resilient and that the US Federal Reserve would lower interest rates this year, perhaps more than once. Her views have had her on the right side of markets, and she continues to favor exposure to risk assets in the second half of 2024.

Explore the midyear investment outlook.

Automate my job?

Each month I pose a question to ChatGPT — the artificial intelligence-driven chatbot — and assess the response.

Q: Do high yield bonds perform poorly when corporate bond spreads are tight?

A: Yes, high yield bonds tend to perform poorly when spreads are tight. This is because tight spreads indicate that investors are demanding less compensation for the additional risk of holding lower-rated bonds. When spreads are narrow, there’s less room for compensation, and the risk of default becomes more significant relative to the potential return. As a result, the total return on high yield bonds may be lower during periods of tight spreads compared to periods when spreads are wider, and the risk-return tradeoff is more favorable.

It's a reasonable answer, ChatGPT. I’d prefer investors, however, to regard the yield as a reasonable assessment of the five-year forward return, irrespective of the spread environment. The chart below demonstrates that in many different situations, much of the return comes from the yield. Currently, the yield of the Bloomberg US Corporate High Yield Bond Index is 8%.¹¹ That’s potentially a global equity-like return, without the historical volatility of equities.¹² I’m not sure I’d want to eschew an 8% yield simply because spreads are tight.

On the road again

My travels took me to Minneapolis to meet with financial professionals. I was asked in a side conversation to opine on the new petrodollar agreement. Embarrassingly, I was stumped by the question. I hadn’t heard anything about it and admitted as such. It turns out there was good reason that I missed it. The viral story claimed that a 50-year agreement between the US and Saudi Arabia requiring the latter to sell its crude oil exports in US dollars had expired. Social media was ablaze with speculation that it would result in a fatal blow to the US dollar. I can understand the concern but for the fact that the story circulating on social media was fake. In hindsight, I’m happy that my minimal social media use left me flummoxed by the question.

Here's how I would have answered the question had I known then what I have since read:

• Saudi Arabia and the US never had a secret 50-year agreement to sell oil in US dollars. It simply benefited both countries to do so.
• Saudi Arabia has indicated its openness to sell oil in other currencies as well.
• Saudi Arabia has continued to prefer US dollars given its close economic and military ties to the US coupled with the kingdom’s need for dollars to transport and insure its oil exports.
• Don’t believe everything that you read!