Prepare for a Landing

“Not every situation can be foreseen or anticipated. There isn’t a checklist for everything.”

– Captain Chesley B “Sully” Sullenberger

Financial news this quarter was dominated by speculation surrounding the Federal Reserve’s September meeting. A volatile summer in markets with a deep drawdown in early August, inconsistent data on US employment and inflation, and increasingly dovish public statements from Chairman Powell drove substantial intrigue leading up to the meeting around the scope of potential rate cuts. Many market participants perceived the size of the cut as signaling the Fed’s opinions on the overall health of the US economy. A cut of 0.25% was perceived to imply that the Fed felt that the job market and growth prospects remained strong and that inflation was under control, while a larger cut would imply concerns that the labor market was showing signs of stress and needed more rapid support.

Ultimately Chairman Powell somewhat split the difference by delivering an aggressive cut of 0.50% coupled with a speech that made clear the market should not expect additional large cuts and that the committee was comfortable with the path for inflation and the health of the labor picture. Markets digested the action smoothly. They now reflect an expected path of the standard 0.25% cuts at the next few central bank meetings and have largely priced in a “soft-landing” scenario wherein the US avoids a recession while enjoying lower inflation.

Given the aggressive interest rate hikes executed in 2022 and 2023, the likelihood of a soft-landing has been widely questioned. When the Fed is forced to implement such harsh measures, recessions involving spikes in unemployment and diminished corporate earnings are likely outcomes. For a variety of reasons unique to our current situation, the economy seems more resilient to higher short-term interest rates in this cycle. One driver of this economic resilience is likely the long-term, low fixed-rate debt that corporations and homeowners were able to lock in prior to rate increases by the Fed, which has shielded them from the full brunt of higher interest expenses. However, this resiliency may limit the positive impact from future rate cuts if the transmission mechanism from the Fed to the broader economy is mitigated by this prevalence of long-term, low fixed-rate debt, and this may influence the Fed’s approach over the next few quarters.

The path forward remains uncertain, with no landing, soft landing, and hard landing scenarios all still in play. Our goal is not to declare which path will occur, but to evaluate the likelihood of each scenario and the ensuing impacts on portfolios in order to best position them for success over as wide range a range of potential outcomes as possible. Unfortunately, there is no single standard operating procedure to cover all possible series of events, but evaluating the conditions and assessing the best approach vector can provide the safest landing possible.

Recent Market Activity 

In our second quarter letter, we noted how calm markets had been over the first half of the year, but that beneath the surface, there were indications of growing uncertainty as markets seemed priced for perfection. It may be difficult to remember now, but shortly after we published that letter, global markets hit a patch of turbulence.

The Bank of Japan surprised analysts by increasing interest rates, which caused a sharp rally in the Yen and hurt leveraged funds short that currency, and a sluggish US labor report spooked equity investors. As a result, the S&P 500 was down over 6% in the first four trading days of August, and the volatility index, the VIX, more than doubled. Fortunately, markets quickly stabilized as additional US economic data indicated continued growth, and Federal Reserve Board members began to signal in speeches that a rate-cutting cycle was imminent. That short but sharp episode is a reminder that markets can react quickly to surprises and that the catalyst for a correction can be unrelated to US equity markets.

As the market began to recover from the brief correction, investors enjoyed a broadening of returns in the stock market. The main driver of US returns in this cycle have been the mega-cap technology companies such as Microsoft, Alphabet, Apple, and Nvidia, but in the third quarter the technology and communication services sectors only returned +1.6% and +1.7% each while financials (+10.7%), industrials (+11.5%), and consumer staples (+9.0%) enjoyed robust returns. This broadening included value beating growth by 6.2%, while US small caps, international developed markets, and emerging markets all outperformed the Russell 1000 US growth index, a rare feat in the past few years. We have been advocating for a balance between the mega-cap stocks and other strategies and that positioning was rewarded in this past quarter. This broadening trend will need to continue for the market to push significantly higher in the next few years from its current point.

Fixed-income markets enjoyed solid returns for the quarter as yields declined in anticipation of Fed rate cuts. The ten-year US Treasury yield declined from 4.4% to 3.8%, while shorter-term rates plunged from 4.8% to 3.6% in just three months. This substantial drop in the two-year Treasury rate brought the yield curve out of an 18 month stretch in an inverted state. An inverted yield curve occurs when short rates are higher than long-term yields, and it is often interpreted as a signal of a looming recession. That signal does not appear to have been correct in this cycle.

Commodity markets, as measured by the Goldman Sachs Commodity Index (GSCI), which includes energy, metals, and agriculture products, were down -7.86% for the quarter, driven by substantially lower oil prices that were offset slightly by a strong rally in gold. The drop in the commodity price index has contributed to the slower inflation readings we have seen this year in the US.

Conditions As We Prepare for Landing

Before we consider the most likely landing scenarios, it is essential to check the overall macro environment. Understanding the macro overlay will help us adjust as we approach the runway.

In reviewing these four key statistics, it is remarkable how steady GDP growth and the unemployment rate have remained given the stunning increase in the Fed Funds rate from 0% to over 5% in less than a year. Inflation has decreased but is still running above the 2% target. If the economy continues to display this resilience and the labor market remains tight, it is possible that inflation could remain stubbornly above the Fed’s target and prevent rate cuts as aggressive as markets may be expecting. The Fed will almost certainly need to keep the overnight rate above the rate of inflation, barring a significant economic shock requiring emergency intervention. This implies that short-term rates will likely drop to the 3% – 3.5% range in this easing cycle. This range for the neutral Federal Funds rate is in line with historical norms, but it is well above the zero bound that has been tested in the last 15 years. We may be landing in an environment that will require slightly higher yields than many are accustomed to experiencing.

Landing Scenarios

After assessing the conditions, we can now briefly assess the three most likely landing scenarios.

1) No Landing

2) A Soft Landing

3) A Hard Landing