The Federal Reserve has a complex task that is often beyond the intellectual reach or interest of many Americans. To explain the Fed's activities to a populace whose eyes often glaze over at the mention of economics, many commentators have relied on metaphors over the years. The Fed can take away the punchbowl at a raging party, run out of bullets like Butch Cassidy and the Sundance Kid in Bolivia, or use their bazooka to scare the economy straight. Milton Friedman compared their activities to a thermostat, and one of my favorite metaphors compares the Fed to controlling the water supply to a farm.
Among this cornucopia of Fed metaphors, perhaps the greatest white buffalo is the fabled and elusive soft landing. There has been significant Fed activity in the past decades, much of it associated with either policy error or recession. Sometimes the recession has been intentional, like when Volcker raised the Federal Funds rates to unprecedented heights. However, our economy is strong, and Powell's Fed now has its bazooka aimed at maintaining that strength. While there's been a slight slowdown in growth in 2024, growth is expected to continue and accelerate into 2025.
Soft landings, where the economy is in a favorable state by the time of rate cuts, are rare. Many of us have lived through two major market crises, witnessing the Fed conduct emergency cuts to zero more than once. Thus, economists predicting a recession had history on their side when they suggested a soft landing was unlikely. However, the Fed has now cut rates, and the economic environment is positive:
The equal-weighted S&P 500 rose to an all-time high yesterday.
New net highs in the stock market reached their third-highest level of the year.
The Industrials sector just hit all-time highs.
Jobs are still growing, albeit at a slower pace.
GDP was recently revised upward, and economic growth and consumer strength remain robust.
In other words, the Federal Reserve has achieved a soft landing for the ages. The soft landings Jay Powell has noted before (in 1964, 1984, and 1993) all had far higher unemployment rates for most of their duration than we have now. Our economy is decidedly strong, and now we have the Fed working with stocks and risk assets instead of against them.
The economy was largely insulated from higher Fed rates because many households and businesses had locked in lower effective rates on their debt. However, the Fed will be more influential on the way down with rate cuts, partly due to psychology and partly due to the real economic effects of lower interest payments. As shown below, in the post-war period, soft landings have been the rare exception.
Despite the rarity of soft landings, this is indeed the environment we now find ourselves in. The Federal Reserve has conducted its first cut, and the economy is still expanding. Growth has slowed, and the momentum of the labor market has diminished, but job growth remains positive. The Federal Reserve has explicitly stated that they do not wish to see pain in the labor market. Rather than focusing solely on vanquishing inflation, they are now focused on avoiding this pain. This is an incredibly bullish setup for markets, and the pace of cuts is less important than the general direction that rates are now headed.
Another crucial consideration for stocks is whether or not we are in a recession when cuts begin. Historically, stock returns are far better if we are not in a recession when the Fed cutting cycle begins, which is our current situation. GDP is being revised upwards, Industrials just hit an all-time high, and Goldman Sachs recently found that consumer savings are much higher than bears would care to admit.
“.. Our estimates suggest a .. 5.2% saving rate after also accounting for adjustments that align income and spending with cashflow relevant to households .. only slightly below the average saving rate from 1990-2019 (5.8%) and support our view that downside risk to spending is more limited than commonly feared.”-Goldman Sachs Economics Research
Declining rates will alleviate pressure on the multiples of the highest-flying stocks that have been experiencing some headwinds lately. These stocks continue to possess extraordinary earnings power, which will be supportive of price and, given their market caps, of the index as a whole. Earnings strength is considerable across sectors, but it is by far the highest in Technology.
While Technology has taken a breather, the rest of the market has caught up. This breadth of gains is very bullish, and the broad-based strength across sectors is very encouraging. If you look at the gains at the sector level of the market on a year-to-date basis, it certainly doesn't scream recession. Strong markets stay strong, and the diversity of strength across sectors is incredibly encouraging. Once we pass the seasonal bumpiness, we should be entering more favorable seasonals on the back of strong fundamentals and a Fed that is cutting and trying to avoid carnage in the labor market.
There are many risks still facing the market, and some could certainly emerge in a nasty way before the year is over. However, the fundamentals of the market are resilient, and the earnings power of companies that cleared the dead wood in the COVID era is startling. Many companies have emerged as more resilient corporate entities that are more capable of outperforming analyst expectations.
If you look at a jet that weighs many tons coming in to land on an aircraft carrier, it looks like there's simply not enough room for it to land. It looks like it will go right over the side or crash. The physics involved are daunting, and that's why the plane needs some assistance in the form of cables to grab it and absorb momentum when it lands and a catapult to assist it in gaining momentum as it takes off. There have been several countervailing forces in the economy that have made it more resilient and also more difficult to predict. But now that we are officially entering the Fed cutting cycle in a soft landing environment, prepare for stocks to have a joyous holiday season, perhaps after a bit of Halloween fright.
