Stock markets in the United States are at all-time highs, despite geopolitical tensions and inflationary pressures.
The market is once again playing the guessing games ahead of the Federal Reserve meeting in November. It expects the Fed to reduce rates by 25 basis points, with certain positive metrics such as a strong September jobs report taming expectations for further rate cuts.
Ed Yardeni is a noted economist and president of Yardeni Research. He has a contrarian viewpoint.
Yardeni shares his thoughts in a free-wheeling discussion with on why the Fed’s rate cut of 50 basis points in September was a “too big, too soon” move and why it is best to put monetary easing on hold for the time being.
Yardeni explains that despite volatility the US economy is resilient, even though current market performance has begun to resemble 1990s style “meltdown”.
He also discusses what he expects the economy to be like after the elections and why small and mid-caps are better avoided, despite the broader rally and the rate cuts. Edited extracts:
Invezz: Stocks plunged two months ago on the back of weak jobs data and carry-trade unwinds. Now, they are at all-time peaks despite slowing growth. Normal?
It’s normal to me. Most people expected a recession, which was logical. You would think that the Federal Reserve would raise the federal funds rate to five and one-quarter per cent in less that two years would cause a depression.
I thought the economy would be resilient.
Baby boomers are key to US economy
I thought that the consumer would continue spending, partly due to an important story about consumers, which is that the so-called “baby boom generation” has been around for many years.
The baby boomers are saving a lot. They have a large amount of money in their portfolios. They’re also retiring.
They have half the net worth of US households. They have assets worth 75 trillion dollars, not billions, but 75 trillion dollars, and are retiring. This means they can’t save because they don’t earn money anymore.
They have retired, but are still spending their retirement income. The US economy has been resilient in part because consumers continue to spend and are spending enough money to drive growth.
The boomers spend a lot of the money they saved for retirement. They also help their younger family members, or children, who may need to pay a downpayment for a home, etc.
The US economy has performed remarkably well. Car sales are up despite the fact that the housing market is in recession.
Capital expenditures are not affected by interest rates. 50% of capital expenditures are on technology. Technology is vital for increasing productivity and staying competitive.
Research and development is another area where a lot of money is spent, something that companies also need.
We were the only ones who said that there wouldn’t be a recession in the last two and a quarter years and that the economy was going to grow.
Not only that, we also said that the inflation would moderate even without a global recession, mainly because China is in recession and exporting a great deal of deflation to the global goods markets.
You asked me if it was normal. I think it’s important to use that word.
I think the economy is now returning to normal. It’s almost like it’s returning to the state before the financial crisis. The interest rates for the bond market were around 4% back then.
Interest rates were near zero during the period between the Great Financial Crisis (and the Great Virus Crisis) and I think that was an anomaly.
I am very comfortable with the economy. We became bullish on the stock markets in late October 2022. We were right.
We are not surprised by the resilience and strength of the economy. We are not surprised that inflation is falling. We are not surprised by the record-breaking performance of the stock market.
Fed’s rate cut in September ‘too soon’
Invezz Is there a mismatch in your reading of the situation and the Fed’s interpretation? Has the Fed picked up any cues which it has incorporated into their actions?
There are many economists who are Fed Watchers. Some of them are even professional Fed watchers.
I’m a Fed Watcher. To understand the economy and the financial markets, you have to be a Fed-watcher. Many Fed watchers are very critical of the Fed.
Some of them want to be the Fed chair, I believe. They like to get lots of press by criticizing the Fed. I’ve always believed that as an investment strategist, my job isn’t to criticize the Fed but to understand their direction.
I’ve decided and bet on the Fed getting it right this time, based on what they’ve done since early 2022.
They were a bit late in combating inflation, but once they realized this, they moved very quickly. They did help to bring down inflation.
I believe that many other factors have caused inflation and lowered inflation. But, until now, I haven’t had any criticisms of what the Fed has done.
I think that the Fed’s 50 basis point cut on September 18th was too much, and too soon. It’s funny, but within a few weeks or days of the Fed reducing the 50 basis points we saw upward revisions to our real GDP.
We saw upward revisions to gross personal income, personal savings, and personal income. We also had very high payroll employment, combined with upward revisions in July and August.
The Fed overreacted by cutting the interest rate by 50 basis points, as they panicked that the economy had weakened and the labor market was cooling too quickly.
Now I think they are ahead of the curve. I don’t believe they need to do this anymore. We have the opposite view that the Fed won’t cut at the November or December meeting, because the data will be strong.
It’s still too early for the Fed declare its mission accomplished.
Inflation is down. It’s close to 2% but not quite there. We know that certain areas of inflation are still very sticky, such as the super core rate of inflation. This is the core service inflation rate excluding housing.
Overstimulating an economy in growth may bring inflation back
We’re not even at 2%. If the Fed stimulates an economy which doesn’t require stimulation; if it provides stimulus to an economic system that is growing well, then the Fed takes the risk that inflation will rebound.
I thought it was a great idea to essentially promise to continue to lower the interest rates. Nothing else.
Nobody knows the outcome of an upcoming election. It’s possible that the Democrats, Republicans, or Trump will have enough power to push their policies through, which will increase the deficit and cause inflation.
I believe the Fed is too focused on its own power, and does not consider fiscal policy.
Fiscal policies were extremely stimulative, and that’s why they got into trouble between 2021 and 2022.
So was monetary policy. Combining the two, we saw a surge in inflation in 2022-2023 that has now finally subsided.
We’ve seen how inflation can rise very quickly when combined with monetary and fiscal stimulus. I think that they are taking this risk.
The bond market has signaled the Fed to slow monetary easing
Invezz : But market is expecting 25 basis points cut…
At the beginning of the calendar year, the market predicted six to seven rate reductions. That was incorrect. On September 18th we finally got a rate reduction of 50 basis points.
The market still expects rate cuts but this expectation has diminished after recent strong economic data.
The bond market has agreed with me that the yield on bonds went from 3,6% to 4,1% since the Fed reduced the rate.
This is an indication that bond market inflation expectations have risen and that the Fed’s actions are seen as too aggressive.
Inflationary expectations have increased if you compare the difference between the nominal yield on 10 years and the TIPS yield on 10 years.
I think that the market, and especially the bond markets, has voted against them for doing too much, too soon.
Invezz Many economists have published commentaries that highlight the fact that the execution of Trump’s and Harris’s promises will lead to an increase in the fiscal deficit, and will do little to address the debt problem facing the economy…
Both of them are politicians. Both of them are trying to get elected, and they both promise to give voters all kinds gifts.
The economic impact of Trump and Harris’s poll promises
Harris will give gifts that increase the deficit, like child credits. The craziest thing to do is give first-time home buyers $25,000 It’s insane. Trump has also come up with some dramatic ideas. I don’t think either side is concerned about the deficit or the debt.
It doesn’t really matter who wins. It’s just that if Harris wins, you’ll see more government spending which will increase the debt.
If Trump wins, you will get more tax cuts which will increase the deficit.
We’ve seen how fiscal policy is very stimulating. It’s also another reason the economy hasn’t entered a recession.
This is the first time we’ve ever had a fiscal stimulus combined with monetary stimulation.
If we look at next year, and the Fed continues providing monetary stimulus, and if President Obama provides fiscal stimulus, I think we will have to worry again about inflation.
Invezz: It seems that the market rally is broadening. It’s becoming a more inclusive market, and the focus has expanded beyond the Magnificent 7 or just tech stocks. Do you have any suggestions for sectors that investors should consider?
The market has been very excited by the Fed’s multiple interest rate cuts.
This would be a great thing for small and mid-cap companies, since many of them have floating rate debt.
Investing advice for a market rally that is expected to broaden
Lower interest rates could help them a lot.
If we’re correct and interest rates don’t come down as much as the market expects, then it’s still a bear market. But it’s one in the S&P 500.
I think the recent broadening, and the one that will continue, is the expansion of the Magnificent 7 index to the S&P493.
The rest of the market should, I believe, benefit from the market’s expansion. It’ll do this because the economy will be doing well and companies will be solid.
I think this will broaden the market. I believe that the S&P 500 is going to outperform the Russell, small and mid-cap stocks, and the Russell.
Since October 2022 we’ve been bullish, recommending that technology be over-weighted, which has proven to be very successful, including communication services. We also recommend over-weighting the industrials due to on-shoring, fiscal stimulus, and the desire to produce more in-house.
So far, industrials has been a success.
We thought their financials were cheap and they have had a huge rally. We would therefore stay with them.
The energy sector has also been a failure for us, as it has declined. But energy is only a small part of the S&P 500.
It’s easy to over-weight and it’s quite small. Energy is a hedge for geopolitical risks which could cause oil prices to rise.
I also believe that gold makes sense when geopolitical risks are high. So, these are our recommendations.
Watch out for these sectors during the earnings season
Invezz: Earnings Season is also upon us. Do you have any particular sectors that investors should focus on?
Analysts in the industry are actually quite conservative. They only expect earnings to increase 3.5% year-over-year in the third quarter.
We think that it could be at the very least double. There is definitely a possibility for the market to rise on better-than expected earnings.
We wouldn’t change our stance since the beginning bull market.
Over-weight technology, Industrials, Financials, Energy, and keep the small- and mid-caps relatively under-weighted.
They’re cheap but for a good reason. Earnings for small and mid-cap firms have been disappointing.
They seem to be facing a lot. We haven’t seen their earnings grow very much. We have no problem with the Magnificent Seven.
We believe they will continue to perform well. We still think the financials are very good. We think this is what will continue to drive the market higher.
Invezz: By 2030, you predict that the S&P 500 will reach 8,000. What is the approximate figure for the end of this year?
We’ve already surpassed that. We still use 5,800 for the S&P 500. I know that some people have already mentioned 6,100. We’ve been bullish on 2022 since October.
The market has done what we expected. The market is not cheap and valuation multiples are high.
Earnings are good, but we would like to see the market rise based on earnings and not valuation.
A bull market is starting to resemble a meltdown of the 1990s
We think it will happen. Our bottom line is that it’s a market in which the bulls are winning. It could go higher, but at this point it looks like it’s about to melt-up.
We will try to balance our views by presenting three scenarios.
The roaring 20s scenario is a long-term bull run that continues through the end decade, reaches at least 8,000 and the economy does well, without much of a downturn, if there is one, with moderate inflation.
We give it a subjective probability of 50%.
Then a 30% chance of a meltup is a possibility. We like to compare the past with decades.
Instead of the roaring 2040s, we could have a melt-up of the 1990s, where the markets rise too quickly and there is too much irrational optimism.
Then, I don’t think we’ll see a bearish market, but there could be a correction.
I still believe the market will continue to do well over the next decade, but there could be more volatility, with ups and downs, and maybe even a return to the upside. We give this a 30% chance.
We raised it from 20% to 60%. But at 80%, we’re still in a bull market.
The inflation of the 1970s would be the remainder of the remaining percent.
So, we have 50% of the roaring 2020s and 30% of the 1990s melt-up. Then, 20% of 1970s style stagflation, with geopolitical crisis causing oil prices and a recession.
This post Interview with Ed Yardeni: US Fed Cut Interest Rates Too Much, Too Soon may be modified as new developments unfold.
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