Summary Points:
Investment narratives changed rapidly around the world in Q3. The quarter began with nervousness over the US employment outlook and thus, the finely balanced risks around moderating economic growth. Helping to allay these fears and some momentary volatility, Chairman Powell proceeded with an impressive 50 basis points easing in late September, while Chinese authorities emerged with a long-awaited bazooka package of stimulus “to turn everything around.”
For today’s generation of investors, price momentum is everything and the initial price reactions—which pushed the S&P 500 Index back to former highs—suggest policymakers are firmly in control. The Fed has shifted its focus to sustaining a resilient economy rather than worrying about inflation. Meanwhile, Chinese authorities are juicing their equity market, hoping to stop the decline in real estate prices (“stop decline, back to stability”) albeit indirectly. The larger question is whether any of these actions matter given what we know about the fundamental landscape.
The Fed’s “jumbo” easing move of 50 basis points—one historically reserved for economic stress—was oddly juxtaposed with Powell’s confidence that the US economy is doing just fine. So, what exactly does an easing cycle produce when employment and utilization rates are near cycle highs amidst no visible financial stress? In these circumstances, liquidity normally finds its way into prices rather than output, yet central bankers are absolutely convinced they have inflation under control.
Powell explains that the real neutral rate of interest is much lower than today's policy rate. Keeping policy rates unchanged would amount to a restrictive stance that central bankers feel is unwarranted. And yet, if there is one thing that the Federal Reserve knows little about, it is the neutral rate of interest—the level that neither hinders nor promotes economic growth. It is guesswork and changes all the time—providing a fig leaf to justify what the central bankers want to do. Are the unions at Boeing or the striking dockworkers incorporating a “real rate” of anything in their demands?
The important message amidst this minutia is the one we never hear: We no longer live in a world of monetary dominance. The obvious explanation for why the Fed’s tightening cycle has negligibly impacted the economic cycle or why the inverted US yield curve has had little forecasting success is that monetary dominance has been replaced by fiscal dominance. A primary US deficit of 6%-plus has been all that really matters, yet no one speaks of the obvious. Central bankers from Volcker onward reminded their audiences of how fiscal policies could dull the monetary toolkit—but not Chairman Powell.
Investors hope that a new easing cycle by the Fed points to a soft landing rather than recession for the US economy. This outcome is hard to judge in advance and may have little to do with Fed policy. Investors should wait until early 2025 (and post-US elections) before hardcoding their economic assumptions. If recession is in the cards, the Fed’s moves will do little to assuage the equity pain that would be inevitable. Slower growth rather than recession is our central case, but divergences across today’s data point to a widening of the tail risks.
The best guide through all of this may be the US 10-year yield. Today’s yield of 3.7% may be near its lows, with the likelihood of a 3.5% to 5.5% range in coming years—a sober thought. Of course, this precludes a deflationary scare, which is the obvious path for much lower yields, but that is precisely our point. The benign scenario that investors assume as their base case must find a way to live with higher rather than lower yields. In contrast, the “softer landings” of modern times were associated with declining US long-term rates well after the Fed started easing.
Amidst the policy drama, the fundamental debates for 2025 have changed little. For the past year, investors have been discounting a soft landing with disinflation, while expectations of a Fed easing cycle have proven correct so far. Recession concerns seem premature, though slower US growth is the central case into 2025. This is not a bad outlook, just one that lacks the upside oomph to justify the S&P 500 forward multiple of around 21 times estimated earnings.
In an absence of economic stress, there are no significant novelties to exploit across the current market landscape. This is why Fed easing may not matter much. Valuation spreads are not at provocative levels, sitting about half a deviation above the mean. Growth stocks, while not in a bubble, are not particularly attractive either and priced similarly to the onset of 2020. The rush to buy China-exposed stocks in recent days is an indication of investor appetite for new narratives to chase when everything else has run its course.
China’s leadership is panicky. Its latest move is an acknowledgment that things are getting worse. Recognizing the nature of the problem is a start, yet the debt restructurings required to resolve the problem are complex and politically charged. Apparently, President Xi is now on the side of entrepreneurs, promising that “mistakes will not be punished.” Price momentum can be powerful for a time, but much of this is wishful thinking because China is not changing its mind on the big issues anytime soon. It will not operate according to Western norms.
Our founder, John Calamos, Sr., served as an US Air Force pilot in the Vietnam War and trained to trust his instruments regardless of what he saw outside the cockpit. Investors are looking for a Fed easing cycle that implies good weather ahead, yet the instruments are flashing amber. Given this complexity, a more diversified approach seems appropriate. There are few large anomalies to exploit, particularly on the upside. This argues for limiting our offense at the stock and industry level while minimizing client exposure to broader market risk.
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The principal risks of investing in the Calamos Phineus Long/Short Fund include: equity securities risk consisting of market prices declining in general, short sale risk consisting of potential for unlimited losses, foreign securities risk, currency risk, geographic concentration risk, other investment companies (including ETFs) risk, derivatives risk, Alternative investments may not be suitable for all investors. The fund takes long positions in companies that are expected to outperform the equity markets, while taking short positions in companies that are expected to underperform the equity markets and for hedging purposes. The fund may lose money should the securities the fund is long decline in value or if the securities the fund has shorted increase in value, but the ultimate goal is to realize returns in both rising and falling equity markets while providing a degree of insulation from increased market volatility.
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