Reading Between the Lines (On the Direction of Monetary Policy)

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When testifying to the Senate Banking Committee back in 1987, the newly-appointed Fed Chairman, Alan Greenspan, provided some insight into his views on communication: “Since becoming a central banker”, he said, “I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”

His successors have generally tried to be more open with regard to both their opinions and their intentions. However, there are times, when the Fed will want to communicate to financial markets without piquing the interest of either the general public or the administration.

At this Wednesday’s meeting, the Fed may well signal a shallower path for interest rate cuts over the next year or two. The reasons for this will be recent data showing more resilient economic growth and stickier inflation, frothier equity markets and the potential for the policies of the new administration to add to inflation pressures. The Fed will also likely be concerned that if they cut too much and ought to reverse course, they could be bullied into too easy a policy by the incoming administration or, at an extreme, see their independence threatened. They will not want to communicate most of this on Wednesday, so investors will need to read between the lines, and ask themselves whether, given high valuations and market concentration, they are appropriately positioned for a higher path on interest rates and the volatility that could emerge from a period of conflict between monetary and fiscal policy.

The Statement, the Press Conference and the Summary of Economic Projections

As of this morning, futures markets have priced in a roughly 95% chance of a 25-basis-point cut in the federal funds rate this week and this is what the Fed will likely deliver. However, apart from noting this cut, it’s not clear what other edits the FOMC will make to their statement.

They might indicate that recent indicators suggest that economic activity has continued to expand at a “strong” pace, rather than the “solid” pace they mentioned in their November statement. At that time, the Atlanta Fed’s GDPNow model was forecasting 2.5% real GDP growth for the fourth quarter – now that number has climbed to 3.3%. Moreover, the November jobs report showed a strong 227,000 increase in non-farm payrolls, while job openings rose in October. However, the unemployment rate is 4.2% compared to 4.1% in October and wage growth remains muted, so it is still accurate to say that labor market conditions have eased since earlier in the year. Nor will the Fed likely want to change its characterization of inflation progress, at this stage.

However, in his press conference, Jay Powell may be a bit more explicit about the strength in recent economic data. Apart from GDP and jobs data, the stock market has continued to rally, with the S&P500 climbing by a further 2.1% since the last FOMC meeting. This could continue to fuel strong consumer spending, as could further gains in real wages and rising consumer confidence.

In addition, he will have to acknowledge changes to the Fed’s Summary of Economic Projections. For the fourth quarter of 2024, recent data suggest that, relative to their September forecasts, they will have to boost year-over-year real GDP growth from 2.0% to 2.5% and year-over-year PCE inflation from 2.3% to 2.5%, while cutting their estimate of the unemployment rate from 4.4% to 4.2%. Beyond this, forecasts for the next few years may well show somewhat stronger economic growth and inflation and somewhat lower unemployment than they projected in September. They might even increase their estimate of long-term real economic growth from 1.8% to 1.9%, in a nod to recent strong productivity data.

However, the most important piece of information conveyed on Wednesday will be the expected path of the federal funds rate in 2025, 2026 and in the long run. In September, having delivered an initial 50-basis point cut, they projected another 50 basis points in cuts in 2024, 100 basis points in 2025 and 50 basis points in 2026, bringing the rate down to their estimate of the long-run neutral rate of between 2.75% and 3.00%.

Futures markets are now expecting just a further 50 basis points in rate cuts in 2025, following this week’s cut, bringing the rate down to a range of 3.75% to 4.00% by the end of the year, and Fed officials, when putting together their own projections, may be tempted to validate this view. If they do, long-term interest rates could edge higher, as the Fed signals that they expect growth to be too strong and inflation to be too hot for a full normalization of monetary policy.

Valuations and Concentration

Higher long-term rates would obviously be a negative for the stock market. However, investors should also continue to pay attention to valuation and concentration.

Despite a small pullback in the last few days, the S&P500 has seen a spectacular 27% gain year-to-date, following a 24% increase last year. While this has added over $27 trillion to household wealth over the past two years, it has left valuations elevated, with the S&P500 trading at 22.1 times forward earnings – about 1.7 standard deviations above its 30-year average.

Overall index valuations, however, mask some very significant concentration issues. The top 10 stocks in the S&P500 now account for an astonishing 39% of its market cap and sport an average forward P/E ratio of 30.5 times compared to a much more reasonable 18.8 times for the rest of the index. In addition, the P/E range between the 20th and 80th percentiles among S&P500 stocks has now climbed to 17.3 P/E points – wider than it has been 92% of the time over the past 28 years.

Investors have every reason to be concerned about high valuations at a time when the economy is already at full employment, margins are already high and there is limited room for long-term interest rates to fall, in the absence of recession. Sometimes, people argue that it is a TINA market – that There Is No Alternative to continuing to overweight mega-cap U.S. growth stocks. However, there are, in fact, many alternatives.

Within public markets, while large-cap growth stocks have led the way in 2024, all the other styles in the U.S. style-box have provided double-digit returns so far this year, with most of them trading at much cheaper valuations. The dispersion among valuations also suggests that there are plenty of undervalued individual stocks within U.S. indices. Despite a rising U.S. dollar, international equities have also provided nearly double-digit dollar-denominated returns this year and generally have much cheaper valuations. Fixed income, while not cheap by pre-financial crisis standards, does generally offer positive real yields. Finally, a wide swath of alternative investments should be able to add return and income to a portfolio while providing some diversification relative to richly-valued U.S. equity indices.

In short, there are plenty of ways to reallocate within a portfolio to reduce overall risk, although doing so in a tax-efficient manner is, as always, more tricky. The last two years have seen extraordinary returns from one particular sector of global financial markets. However, managing risk, going forward, will require a broader, more diversified approach to investing.

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