Fed Cuts, Slaying Dragons and S&P Record

In this video Bernhard Koepp shares his perspective on the highly anticipated Fed rate cut.

Hi there. This is Bernhard Koepp at C.J. Lawrence.

We got the 50 basis points cut out of the Fed yesterday, which was highly anticipated, and the market is celebrating today making an all-time new high for the S&P 500 at 20% plus year-to-date. That’s quite a return. I think this is a good time to review what our thinking is and what we’re seeing in the market and the economy.

Inflation 

Let’s start with inflation. I think the inflation dragon has been slain. There are a couple of pockets left in the inflationary picture. These tend to be in areas like car insurance or in housing when it comes to rents. But even those areas are now rolling over. I think there is relief to come on the inflation side, and that’s also why the Fed felt more comfortable doing 50 basis points rather than 25 basis points, which was what the talking heads on television predicted. 

CNBC and Bloomberg were all saying, “Well, probably there’ll be more of a cautious approach to easing because the Fed is worried about juicing the economy again and creating more inflation.” But I think if you look at the data, certainly core inflation X housing, you now get even below 2% if you look at that data. It really gives the Fed the courage to normalize interest rates back to where they were before all this inflation occurred.

GDP 

Now let’s look at GDP. The third quarter GDP is tracking around 3%. You had some of the more prominent economists and our good friend Ed Hyman, who’s still the number one ranked economist on Wall Street (and who was our colleague for many, many years), taking a hard landing scenario off the table that he had on there for the fourth quarter and the first quarter. The data just no longer supports a hard landing. He is now using a forecast where GDP slows to about 1% on a quarter-on-quarter basis, and then accelerates in the second half of 2025.

That’s a very good scenario for equities, certainly when interest rates and the yield curve is being normalized. If you look at the differential between fed funds and the two-year treasury for example, there was a massive difference between those two rates.

The bond market has been far ahead of the Fed in terms of signaling lower rates. The Fed is playing catch-up here. Of course we are in an election cycle, so the Fed is probably trying to navigate around the election. This was the meeting we had yesterday where they gave us 50 basis points, which is the last meeting before the election. The next meeting is just after the election. By doing 50 basis points now, it’s enough to get the short-term rates down, and then they can do another 50 basis points or whatever the data supports in the week after the election. From a timing point of view, this is a perfect scenario for the Fed.

Housing

There is a lot of obvious correlation between housing activity and mortgage rates. We’ve now seen mortgage rates come down from a peak back in October of ’23 of above 8%. We are now seeing mortgage rates with a five handle, so 5% plus. That certainly provides relief for the housing sector, which is still quite depressed. But we’ve seen month on month growth now for housing starts rise at 9.5%. That’s good news if you’re a first-time home buyer or if you’re looking to refinance your mortgage.

Globally 

Let’s look at the international view briefly. We are in a global easing cycle. You had the ECB also reduced rates just a couple of weeks ago. That was the second time. The European Central Bank has been slightly ahead of the Federal Reserve. The big picture globally is that short-terms are coming down. That’s supportive certainly for evaluations and puts a floor under multiples, whether you are an equity investor or actually puts a floor under bond prices.

US Productivity 

Let’s look at US productivity. We’ve talked a lot about productivity growth in the US economy, which is impressive. As you know, we like to invest in technology and the things that drive productivity in the economy. We’ve talked a lot about generative AI and the magic and the productivity boom that is going to be unleashed by this new technology. We’re seeing that all over the place in the economy, but not just in the technology sector, which is still building out the infrastructure, but we’re seeing it in all sorts of consumer applications. It’s a very exciting time.

If you look at the data on productivity, we’ve now seen four quarters of productivity growth at 2.7%. That’s quite impressive because productivity growth puts downward pressure on inflation and lifts corporate profits. If we’re looking at the outlook for our companies and the margins and profit margins, certainly when you have a slowing economy, there’s a lot of pressure on the top line growth. But if you look at margins, those margins can be sustained if you get lower interest rates, which we’re starting to get now, but also, if you see productivity gains, and those things are very important to maintain the profitability level and earnings per share growth that we so much need for our equity returns.

We are seeing this now play out in the industrial sector.  If you look at the data that just came out on industrial production and manufacturing, we had a very strong August. We had a bounce back in things like auto assemblies, which jumped 17% to 11 million in August. These are all quite good numbers. If we start this easing cycle, we’re paying a lot of attention to the industrial sector because there is a floor under the macro environment here, because the Fed is giving this support of lower rates to the more cyclical part of the economy.

We’re spending a lot of time looking at industrial type companies, especially in the area of power. If you think about all these new technologies that are coming out with generative AI, they need a lot of electricity. So one of the things we’re spending a lot of time on are companies that are solving that problem, either creating more efficiency for industrial companies or manufacturers or the companies that are involved in creating new power solutions. This can be everything from alternative powers like wind and solar, but also in some cases nuclear is coming back. It’s a very interesting environment to be a stock picker. You have to be much more selective now. The easier returns as we said are behind us. Now, the market will broaden and you can find very interesting ideas in the more cyclical side of the economy than before.

If you look at valuations, the S&P 500 is at 23 times earnings. This is certainly not cheap, but if you look at the backdrop of a slowing economy, but a soft landing meaning no recession and normalization of interest rates to where the yield curve will be uninverted, that actually sets up a great market for equities. Look at earnings per share growth. We’ve highlighted this in the past where we have this very rare situation where you have three consecutive years of double-digit earnings per share growth forecast for the S&P 500. If you look at the numbers of the facts today, 2024 is at 10.6% growth, 2025 is at 15.1% growth, and 2026 right now, the forecast is 12.5% growth.

That’s very rare. We’ve only seen this four or five times since the Second World War where you had three consecutive years of double-digit earnings per share growth. These are forecasts. They may be wrong, but still, if you look at the trend, it’s very, very good for equities, very good for corporate earnings, and with inflation coming down and interest rates being normalized, this is a great environment. We expect a further broadening of the market. We’ve seen this already this year. If you look at the difference between a cap-weighted S&P 500 and an equal-weighted S&P 500, the peak was 12%, we’re now at around 6%. We would continue to expect the market to broaden out as the more cyclical parts and smaller companies will start acting better in this environment because the Fed is easing interest rates and making it a bit easier for the cyclical part of the economy to perform.

That’s our summary for where we are. We are at an all-time high in the S&P 500 in the markets, but we think there are more returns ahead. Give me a call at 212-888-6158 or shoot me an email at bkoepp@cjlawrence.com if you have any questions. I hope to see you soon.