Markets are now pricing a roughly 60% chance for a 50 bps rate cut by Chair Powell’s Federal Reserve on Wednesday. Results will be announced at 2 pm EST after the conclusion of the Fed’s September 17/18 FOMC meeting.
We’re scared of this high expectation.
We believe this is a recipe for huge disappointment. In fact, we consider a 25 bps cut by the Federal Reserve more likely. We certainly hope this doesn’t happen but offer this analysis so investors can consider the full range of scenarios as a contrast to our more optimistic views of the Fed’s next move.
The thing is, if Chair Powell goes with a 25 bps cut and doesn’t add language that comforts investors, markets will pull back in a big way.
This could be much worse than the $2+ trillion wipeout the benchmark S&P 500 index witnessed in the first 3 days of August. We see the magnificent 7 – especially high-growth firms like Nvidia – dropping by 10-20% just like they did last month; erasing hundreds of billions of investor money among them. Expect the broader market to see a drop of at least 5% in the next couple of days with the Nasdaq index losing more. The small caps index Russell 2000 is likely to be hit the worst. Smaller companies, on average, have less cash in hand and rely on near-term debt to finance their operations. Higher rates don’t help them. (Do you know how the Trefis HQ strategy, which has outperformed S&P, works with downside protection?)
What’s worse?
Just see what happened last month – the S&P 500 had one of its worst string of days when the market wiped out more than 20% from companies like Nvidia (how low can Nvidia go?), with significant drops across the tech sector for giants like Google and Amazon, and for the S&P 500 as a whole. Investors had nowhere to hide. If the Fed decides to go with a 25 bps rate cut on Wednesday, it will be much worse this time around. Things can turn uglier in a hurry if a few bad jobless claims reports over the coming weeks show increased unemployment and inflation continues to stay flat near-term. This will conjure images of a recession in the minds of investors.
In all of this – what can we learn from history? How low can stocks and ETFs/indices go – from the S&P 500 to tech innovator AAPL to pharma giant Merck, which stocks dropped most during past market crashes? Of course, we believe investors will be better off not being too reactive. However, bad times don’t make for calm participants.
The truth is companies like Alphabet, Nvidia, and Microsoft are fantastic investments in the long run. However, the near-term volatility for individual stocks can be hard to stomach. If you don’t like the rollercoaster ride, learn how the select 30 stocks that constitute the Trefis High Quality portfolio (HQ) strategy have outperformed the S&P 500 – consistently. And how we add downside protection to HQ. HQ has seen >80% return since its Sep 2020 inception. Hint: it’s simple, and right there in the HQ strategy’s performance metrics. It is not just about the size of the companies, but also their defensible revenue growth and margins, strong balance sheets, and other quality criteria.
The Debt Bomb
Bad times also focus the mind on follies. The current U.S. debt situation is not just a folly – in some quarters it’s considered a ticking time bomb. JPMorgan CEO Jamie Dimon recently raised a big red flag about the now $1 trillion in annual interest payments the U.S. owes on its debt. This is unprecedented. It is uncharted territory. The point is near-term unfavorable data in the event of a 25 bps drop can quickly lead to new stories of doom and gloom imagined – adding to the downward spiral in investor sentiments, and the stock market.
The other risk is default on loans. All market crashes happen because someone can’t pay back their loans. For one, commercial real estate has been suffering for a while, Covid’s work-from-home gift was a big curse for the Retail and Office real-estate sector. In addition to an altered demand landscape, commercial real estate loans maturing near-term continue to face high rates and tough refinancing conditions. Things could break, though that hasn’t happened – and with Fed rates finally on the downtrend, it’s less likely.
Finally, there is consumer defaults – personal loans, auto loans, and credit card loans in particular. That makes banks like JPM, Citigroup, and BofA with large credit card books vulnerable (How low can JPM stock go in a market crash?). We hope this risk is transient – because we believe the Fed will do whatever it takes to create a soft landing.
In fact, as we’ve argued in our contrasting scenario of the Fed’s moves – with rates as high as they are currently, the Fed has even more power. There is a lot of room to cut rates and release more liquidity if things go south. They can do a 100 bps cut if things come to that. The Fed can rapidly infuse liquidity if the economy needs a shot for any reason. The big question is – will they do it in the near term?
The sum of it all
All things considered, we believe the short term is likely to be volatile. And we are particularly uncomfortable with high expectations of a 50 bps rate cut by the Federal Reserve. We see a higher chance of more attractive market conditions in the medium term, though, and that’s good for investors.
We’ve developed Trefis strategies to take advantage of such opportunities, especially HQ with downside protection, while carefully managing risk in developing our Trefis portfolio strategies.
Here’s more about Trefis Market Beating Portfolios