Recent comments from members of the Federal Open Market Committee (FOMC) suggest that rate cuts will come much later in September rather than in June or July. With the Federal Reserve (Fed) keeping its foot firmly on the brakes despite evidence of disinflation and a cooling economy, we see increasing risks of yet another policy error.
Accordingly, we are taking advantage of the recent rebound in U.S. equities to downgrade our rating on the S&P 500 Index (SPX) from "Buy" to "Hold". We reiterate our recommendation to rotate equities exposure away from expensive technology names and into value themes to manage the risk of a sharp correction.
We are maintaining our 5,200 year-end target as we see waning bullish momentum at current levels. However, should the Fed fail to commit to a September rate cut by the next FOMC meeting (June 11-12), we would consider further downgrades with a more bearish target on the SPX.
Which Is Worse, 3% Inflation Or A Recession?
From our perspective, keeping interest rates at current restrictive levels demonstrates the Fed's lack of a forward-looking policy approach. By potentially dragging the economy into an unnecessary recession, the Fed risks having to implement more aggressive rate cuts later on. Worse, the Fed may find itself with the challenges of a liquidity trap and monetary policymaking at the zero lower bound, just like it did following the 2008-2009 Global Financial Crisis.
Economists have repeatedly warned about the lagged effects of monetary policy: it may take 12 months or longer for the impact of interest rates to fully pass through to the economy. Yet it is puzzling why this logic only seems to weigh on the FOMC when it comes to hiking rates but not when it comes to cutting them. By that logic, it would be unwise to wait for the economy to be on the brink of a recession or for inflation to be well within the Fed's 2% target before implementing the first rate cut. But that was precisely what members of the FOMC communicated in May:
In the absence of a significant weakening in the labor market, I need to see several more months of good inflation data before I would be comfortable supporting an easing in the stance of monetary policy. - Fed Governor Christopher Waller
I'm not in a hurry to cut rates. We need to make sure that when we start on that path, it's unambiguous that inflation is going to get to 2%... we have to be very cautious about when we do that first move, and it may mean that it has to happen later. - Atlanta Fed President Raphael Bostic
If the FOMC is making decisions based on leading economic indicators (forward-looking indicators), that wouldn't be too much of a problem. But the FOMC's obsession with the latest labour market or CPI data, highlights a concerning problem with its approach. Perhaps this is why the Fed has often been accused of being behind the curve. By the time the Fed realizes that the economy is weakening rapidly, it may already be too late. The economy would likely have been deteriorating for several weeks or months before lagging indicators showed any warning signs.
Krugman Flags Recession Risk
Nobel Prize laureate Paul Krugman, who has been mostly right about the U.S. economy's resilience and the ultimately transitory nature of inflation, has also begun to warn of the risk of a recession.
Below are excerpts from Krugman's latest newsletter on The New York Times titled "Goodbye Inflation, Hello Recession?" - June 4, 2024 :
We may or may not have brought inflation all the way back to the traditional (but arbitrary) target, but inflation really doesn’t look as if it should be a major preoccupation at this point.
I am, however, beginning to get a bit worried about an economic slowdown. There’s nothing out there that screams “imminent recession,” but there are straws in the wind...
So it’s time to stop obsessing about inflation, which increasingly looks like yesterday’s problem, and start worrying about the possibility of a recession as the economy’s strength finally begins to erode under the strain of high interest rates. So yes, I think the Fed should start cutting rates, and soon.
Krugman's warning that the balance of risks has shifted towards a potential recession is timely and contrarian. Most of the Wall Street banks that were previously bearish and certain of a recession in 2023 have recently begun raising their targets on the S&P 500 Index in what seems to be a very late attempt to chase the bull market.
Even some of Wall Street's most notorious bears have given up, perhaps another warning sign that we are near peak optimism.
In Conclusion
We see little reason to chase the SPX at this point, given that sentiment is overwhelmingly bullish and that we see increasing risks of a recession should the Fed delay rate cuts.
Accordingly, we are taking advantage of the recent rebound in U.S. equities to downgrade our rating on the S&P 500 Index from "Buy" to "Hold".
We reiterate our recommendation to rotate equities exposure away from expensive technology names and into value themes to manage the risk of a sharp correction.
Stratos Capital Partners
Stratos Capital Partners (S.C) was established in 2017 by a small team of professionals from the investment industry with a deep passion for financial markets, macroeconomics, and investment strategy. S.C.'s original goal was to focus exclusively and extensively on the research & development of algorithmic trend-following strategies. The implications of our research over the years have not only strengthened our conviction for systematic strategies but have also led to the profound evolution of our philosophy towards a multi-asset and multi-strategy investment model. Author Bio: An original co-founder of S.C., I am also currently a portfolio manager for a family office with more than US$180 million in assets under management. 15 years of experience in the investment industry, of which I have spent 10 years actively managing investment portfolios for ultra-high net worth families. My investment philosophy is firmly anchored to systematic strategies that are evidence-based and applicable to multiple asset classes and across market cycles. Ideally, an investment portfolio should be systematic by design, multi-asset in composition, and multi-strategy in execution. Rigorous risk management is fundamental to this multi-asset and multi-strategy investment model. For equities specifically, I rely heavily on value investing principles alongside other factors that have proven to generate consistent beta across market cycles. Good equity investing, of course, should not be entirely quantitative in approach. Thus, a certain degree of judgment and strategic thinking is required for making qualitative assessments at the individual stock level. ______________________________________________________Disclaimer: Stratos Capital Partners is a pen name adopted solely for the purpose of contributing independent investment and trading analysis for Seeking Alpha. Stratos Capital Partners is not a registered fund and is not licensed by a financial regulator. Stratos Capital Partners does not receive any form of benefit or compensation from companies mentioned in our analyses. However, the author does receive monetary benefits in the form of payment for article views as a content contributor for Seeking Alpha. The author shall not be held responsible for any losses whatsoever that may arise due to the author's analyses. Readers are advised to exercise due diligence when making investment decisions.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of SPY, SPX either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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