Powell Paves The Way To A Year-End Rally

Yesterday, I asserted that the only thing standing in front of our year-end rally would be Chairman Powell’s press conference, because investors have been interpreting his balanced approach to commentary on future monetary policy as consistently hawkish. As usual, he acknowledged the progress we have made so far in returning to stable prices, while also leaving the door open to an additional rate hike if progress is derailed. There were no meaningful changes in what he has been saying repeatedly, but it seems that investors are finally starting to realize that the rate-hike cycle is over, regardless of what he or other Fed officials say. As a result, bond yields across the curve plunged, and stock prices rose for a third consecutive day. It looks like Powell has paved the runway for our year-end rally.

There was a very small change to the Fed’s official statement with the addition of the word “financial” when indicating “tighter financial and credit conditions,” were likely to slow the rate of economic growth. The Fed is acknowledging that the Goldman Sachs US Financial Conditions Index has risen to its highest (tightest) level in a year over the past six weeks. According to Goldman’s economists, that increase is the equivalent of four quarter-point rate increases in the Fed funds rate. I think this is the Fed’s subliminal way of acknowledging that rising long-term rates have probably concluded its rate-hike cycle without saying it outright. That was clearly the market’s interpretation yesterday.

My crystal ball tells me that the same cohort of bears who have been warning us about “higher for longer” interest rates, which will collapse the economy and markets, will soon shift to the narrative of “lower and sooner.” In other words, the Fed will need to cut rates as the rate of economic growth begins to slow more rapidly to stave off a recession. I think that warnings will fall as flat as the first. Understand that we want to see growth cool to return inflation to 2%, but its occurrence will undoubtedly be used to stir fears of an economic contraction that results in another bear market. For example, after yesterday’s close Airbnb (ABNB) followed its stellar earnings report for the third quarter with a warning that the fourth quarter has started to soften with dampening travel demand. This should be no surprise!

We are coming off a quarter in which the economy grew at a blistering 4.9%, led by consumer spending, while excess savings continue to erode, and higher borrowing costs are making it more expensive to finance purchases. That does not mean a recession is inevitable. Yet when growth falls from 4.9% to a below trend 1-2% it may feel like a recession is upon us. Yet the consumer is in much better shape than critics are willing to acknowledge.

Granted, loan delinquency rates have risen meaningfully this year, but only to pre-pandemic levels after falling to historically low ones in the two years after the pandemic. Some 40 million students will also have to start making payments on their loans again this month after forbearance programs ended. Undoubtedly, the post-pandemic party days are over, and we will be inundated with anecdotal instances of financial hardship in the news stories, as we return to normalcy. I see them in large numbers now.

I focus on the trend in aggregate numbers, and when it comes to the health of the consumer I think the most important number is the percentage of a household’s disposable income required to service that household’s outstanding debt.

As you can see in the chart above, that percentage at 9.8% remains at a multi-decade low apart from the pandemic period. This is largely due to most households refinancing mortgages and paying down debt during the pandemic. It clearly has room to rise without reaching alarming levels that would indicate financial stress, especially with real wages now increasing for the first time in nearly two years.

This is one of the most important factors in my outlook for a soft landing in 2024. The consumer should be able absorb tighter financial conditions until the rate of inflation falls to the Fed’s target, allowing the central bank to start easing again. The consensus on Wall Street does not agree with me, but that’s good news if my outlook is accurate.

Bank of America’s “Sell-Side Indicator,” which measures Wall Street strategists’ recommended allocation to stocks has fallen to levels so bearish that history shows it is now bullish from a contrarian standpoint. When this indicator has fallen to current levels or lower, the S&P 500 has been higher one year later 95% of the time with a median gain of 21%. I like those odds for a year-end rally. I like them even more based on the probability for a soft landing in 2024.