Inflation-Driven Fed Re-Posturing Alters 2025 Investment Narrative
I recall running into a man of 50 and his 20-year-old son on the summit cone of Mt. Washington in June of 2009, the Father exhausted and slightly hypothermic. The pair were dressed in cotton and lost, and with temps at 48, a steady side wind blowing at 15-mph, and light rain, it was clear any number of slightly deteriorating weather conditions might quickly take the father’s life. In October 2022, stocks were oversold, but today stocks are historically expensive, which means any number of slightly deteriorating market conditions might trigger a painful reduction in stock multiples, including this week’s repudiation of the ‘Fed narrative’ of contained inflation, declining interest rates, and a soft economic landing. What are the market’s true conditions, and how should they affect capital allocations as we approach the new year?
The market concerns itself primarily with corporate earnings, interest rates, and inflation, and the many dynamics associated with these three primary issues. While ‘the Fed’ has been touting the aforementioned narrative and cutting rates, the economy has shown no need for cheaper credit, earnings have remained strong, and inflation has been rising for three months. ‘The Fed’ has been cutting rates absent an earnings recession as inflation rises; that’s like a climber eating 75% of his food for a week-long expedition on Day 1! The bond market first rebuked Powell & Co. with surging l/t bond yields, and this week Powell confessed inflation isn’t really contained and further rate reductions are questionable. We should also bear to mind the lag in the effects of each rate reduction, and, therefore, the possibility ‘the Fed’ has stoked already rising inflation in ways yet imperceivable. Soft energy and real estate prices may offset the pain of Powell’s recent misbehavior, but as you can see, the weather conditions for this climb are far more complicated than Mr. Powell has been indicating.
What are the Pro’s and Con’s of the condition set of a resilient economy, moderately rising inflation, and neutral interest rates? On the negative side stocks will likely find equilibrium at a lower multiple as the market descends from a rosier narrative and digests the possibility inflation may force ‘the Fed’ to raise rates in 2025. Inflation acts as a tax, so there’s a risk it will hamper ‘all-important’ consumer spending. The positives of an ongoing bull market and a resilient and stable economy with low unemployment, especially with rates close to what the market itself would set, is impressive and for now outweighs the negatives. False narratives removed, I believe once stocks find the new, lower multiple they now seek, and providing ‘the Fed’ can avoid becoming another problem right away, it’ll be all about the U.S. economy in 2025; specifically, whether it can elude an earnings recession without causing inflation to accelerate.
Eradicate politics, geo-politics, and macro-economics from your investment decision-making process, and use tools to prevent your emotions from finding another way in. Make adjustments to your investment portfolio, not sweeping changes; lean, don’t jump. Raise some cash by taking profits from highly appreciated securities trading at extreme multiples. Concentrate on ownership of high-quality businesses, but limit equity exposure to your personal risk tolerance level. Concentrate on short duration bonds, and realize cash is still attractive at 4.3% interest. Own some inflation and chaos hedges via alternatives but stay away from the speculative frenzy!
The two thoughts that come to mind in this market environment are “stay nimble”, and “exercise prudence”. May God bless the Christmas in our hearts this year.
Shaun.
“For God so loved the world, that he gave his only Son, that whoever believes in him should not perish but have eternal life.” ~John 3:16
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