“The inevitable never happens. It is the unexpected always.” John Maynard Keynes
The inevitable recession that was supposed to materialize since last year as restrictive interest
rates were being implemented never happened. Beside being in line with Keynes’ view of the
inescapable, it is a puzzling outcome.
Typical indicators have been flashing contractionary risks in the economy for a while; the
classic inverted yield curve and a significant correction in the LEI Index (Leading Economic
Indicators) have been flashing red for a while. And recently we added the Sahm Rule, which
posits that a recession is starting when the three-month moving average of the national
unemployment rate rises by 0.50 percentage points or more relative to the minimum of the
three-month averages from the previous 12 months. And yet no real contraction in the
economic landscape.
The Federal Reserve sensing victory in engineering a soft landing (cooling off inflation
without causing a recession) reversed monetary policy at its recent meeting and reduced the
Fed Funds by a mostly unexpected 50 basis points. Decreases larger than the usual 25 bips
are generally used when in a hurry to spur economic activity. In this case, the Fed framed the
decision as a way of normalizing policy as the economy was also normalizing after the
COVID era aftershocks. The pace of additional rate cuts is still up for debate and as per
Powell’s words, data dependent. If labor data come in weaker than expected, the pace of rate
reductions will stay strong, if not we may only see a sequence of 25 basis point cuts until the
“neutral rate” is hit. Projections for rates are now in the range of 3.25%-3.5% by the end of
2025 and around 2.9% by the end of 2026.
This backdrop seems to be favorable to intermediate-maturity bonds by allowing investors
to lock in still attractive yields and by providing a possible positive repricing of the principal.
From the equity side, things are a bit trickier. Clearly, earnings are continuing to come in
strong and this element has supported high valuations. An easing monetary policy, barring a
recession, is also favorable for risky assets. However, valuations are indeed high by historical
reference and earnings are notoriously cyclical. This does not mean equities are about to
crash, but future returns should be expected to be below historical averages.
Lower rates have benefited REITs which were the best performing sector last quarter. A
normalizing monetary policy along with a normalizing “work from home” policy should
continue to be supportive of the space. Health Care related REITs and Data Centers remain
our favorite subsegments.
In terms of sector valuations, the Morningstar Fair Value Model shows that only two sectors
are now actually undervalued: Energy and Communication. Given the turmoil in the Middle
East, energy may provide positive outcomes. In this space, we continue to like energy
infrastructures due to a resilient economy, fair valuations and large distributions backed by
good cash flows.
As always, we would like to thank you for the renewed confidence in our work,
Youri Bujko
Davide Accomazzo