The Market Is Getting a Little Too Comfortable

Investors are quick to cast aside their fears...

Back in February, Northwestern Mutual Wealth Management Chief Investment Officer Brent Schutte got in front of a camera – and cried out the mantra that explains a lot of the market's optimism over the past six months...

I can't remember a more well-telegraphed recession.

Schutte believed investors had already priced in any risk of a downturn, since everyone was expecting one. And he implied that when everyone is expecting a recession... that's exactly when there won't be one.

Many point to artificial-intelligence ("AI") mania as the core driver of the stock market this year. But there was a clear shift long after that started, in late May and early June.

Inflation began to show signs of calming... and investors became more confident in the idea of a "soft landing." Maybe the Federal Reserve could scale down inflation without a recession ever happening.

That potential sent the entire market higher through earlier this month. It wasn't just the "Big Six" AI firms rallying. The Russell 2000 small-cap index rose 14% from the end of May to the end of July.

The market was laughing in the face of the most well-telegraphed recession ever. It looked like this time was finally different.

Well... any investor worth their salt should know not to fall into that trap.

People are eager to believe that recession fear is subsiding. They want to think we've already survived the worst of the market's wrath this time around.

But as we'll explain today, it's not a foregone conclusion... There's likely plenty more pain ahead for investors.

It doesn't matter how many economic crises we survive... Some folks just don't learn their lesson.

That's why, only a week before the recent market peak, we laughed when we saw a tweet highlighting this January 2008 Wall Street Journal quote...

It is hard to imagine any time in history when such rampant pessimism about the economy has existed with so little evidence of serious trouble.

When you read headlines like that from right before the Great Recession, warning bells should sound in your head.

Maybe this time isn't that different after all.

That's exactly what the credit markets – and specifically the fed-funds futures market – are warning us.

The fed-funds futures market is where big-money investors go to hedge their credit risk. These are highly liquid markets where more than $500 billion in notional value trades in any given day.

Said another way, this isn't a place where casual punters can push the market around. So when we see extreme signals from them, it's a surefire sign that deep-pocketed investors are telling the market something.

Right now, the fed-funds futures market is predicting that the Fed will have to cut interest rates by 150 basis points ("bps") by 2024. That's six cuts over eight meetings.

Take a look...

The market is betting the Fed's target rate will drop from a range of 525 to 550 bps, down to a range of 375 to 400 bps.

The Fed lowers interest rates when it needs to stimulate the economy...

If the economy has a soft landing, the central bank is going to be much slower to lower rates.

Fed regional presidents and Chair Jerome Powell keep repeating the phrase "higher for longer" when discussing interest rates. They're saying if the economy is doing well, they'll keep rates elevated to make sure inflation is stamped out.

We usually only get significant cuts during recessions, when the economy desperately needs the Fed to step in and encourage spending. As this year's rally shows, equity investors are pretending this won't be the case.

But if we want a reliable recession signal, the last place we'd look is the equity markets. The credit markets are always better at forecasting risk.

Over the next few quarters, credit markets will remain tight and companies will continue struggling to refinance. Signals like this – the fed-funds futures market expecting six rate cuts – confirm our view.

And that's why we keep reminding investors to be cautious and patient when investing in the current environment.

Regards,

Rob Spivey
August 28, 2023