After months of obsession, financial markets are all but certain that the Federal Reserve will start cutting rates from its multidecade highs as early as September. However, in a new note, MFS Investment Management’s Robert Almeida says that obsession isn’t going to serve investors over the long term.
VettaFi contributor Dan Mika spoke with Almeida the day after the Fed’s July meeting to find out more.
[This conversation has been edited for clarity and brevity.]
Dan Mika, VettaFi: Why make this call for investors to reframe what questions they’re asking now? The Fed’s decision day was yesterday. Now markets seem extremely confident something will actually happen after about a year of the Fed’s federal funds rate being around 5.25%. Why should investors be refocusing their attention when the Fed seems like it’s going to make a change?
Rob Almeida, MFS Investment Management: I think investors, like humans in general throughout time, are plagued by recency bias. Right now, I think investors and humans are placing too much attention on the most recent event, which is largely the inflation ambush of 2022 and interest rates going from zero to 5%.
This might perhaps be a poor analogy, but it’s like, once the Titanic hits the iceberg, asking, “Are we going to be having steak or chicken for dinner?” Fundamentals drive profits, and profits and cash flows drive asset prices. I think the market believes that central banks create wealth, and by cutting short-term rates, wealth will be created.
We think just the opposite. As the effects of stimulus begin to fade, consumers are faced with making more substitutions. Costs continue to accrue for companies, specifically on labor as well as other inputs. You should start to see different profit and loss profiles and potentially disappointing earnings and disappointing profits. In the piece, I reference the last two cycles: when central banks are cutting rates, it’s usually not a good thing.
VettaFi: You write that the markets are assigning higher multiples for stocks on the idea of the Fed cut without considering the more recent signs of weakness. I’m wondering what investors should think about when the Fed rate also influences things like the labor market. It’s is starting to slow down and [Fed Chairman Jerome] Powell mentioned several times during his press conference. How do you think investors should think about the federal funds rate not just as something that makes corporate borrowing cheaper or more expensive but also has big effects on other macroeconomic forces, such as the labor market, such as making consumer spending more expensive or cheaper?
Almeida: My pushback is, does it? You and I don’t borrow at the Fed funds rate. My company, your company, doesn’t borrow at the Fed funds rate.
You’ve had an inverted yield curve for a year and a half now. As central banks are cutting rates, all it’s probably going to do is normalize the yield curve. I appreciate that 10-year Treasuries have fallen by 20 or 30 basis points leading up to the press conference. I think that’s largely just noise.
In other words, to the extent that you see some normalization of short-term rates, and Fed funds get closer to what the market thinks its terminal value is, call that 2.5%, 3%, maybe 3.5%. If you’re going to get a normal, whatever normal is, but a normal slope yield curve, that still puts your borrowing rate right around 4% or above, which is where the real economy functions.
Profit is ultimately all that matters for what we care about stock prices, bond prices, etc.
The two biggest drivers of profit for the last three decades have been interest rates falling to a 5,000-year low, largely due to artificial suppression of rates by quantitative easing, which I don’t think is coming back, beginning right around 1996. Almost 30 years ago, China forced Western companies to become asset-light businesses. Both those tailwinds are now headwinds. So, interest rates — i.e. borrowing costs — have returned to some semblance of normalcy.
A pandemic, a hot war in Europe, problems that continue to mount in the Middle East. Problems that are probably going to continue to grow between the U.S. and China have combined to reshape supply chains. Capital intensity, which has been falling for 30, maybe 40, years, is now rising. Companies have to spend more to restore supply chains when capital and people cost more.
Ultimately, all that matters is revenues and costs; the delta between the two. Revenues decelerate with inflation, which is what always happens, but costs do not. I’m just arguing that I don’t think we returned to a post-GFC world of massive cost suppression. That leads to a different profit and loss outcome.
VettaFi: You make this final claim: “We’re careening towards the former fundamentals drive valuations rather than the discount rate.” What does that actually look like after more than a decade of interest rates near 0%? For investors, for financial advisors, especially those who prefer to fill their portfolios with ETFs and mutual funds instead of picking individual stocks, what does that actually look like?
Almeida: I think just like how heaven needs the help of Christianity, capitalism needs bankruptcies. We appreciate life because we know there’s a scarcity value to it. We know we’re not going to be here forever. I think for financial intermediaries like you’re describing, or maybe investors in aggregate, perhaps the last 15 years have trained them to look at the wrong KPIs.
In other words, the artificial suppression of interest rates blunted the natural selection process of capitalism and financial markets. The whole point of capitalism is to take money from a bad idea and put it into a good idea by the allocation of resources by the private sector. When interest rates were approaching a 5,000-year low in the 2010s, and then particularly in 2020 and 2021, every idea became a good idea. That’s just not the way the world works. I think investors need to shift their attention. The point I was trying to make by the title of the piece is that they’re seeking the right answers to the wrong questions.
VettaFi: I think the right questions are: What businesses are worth funding? What businesses had projects that they funded that weren’t worth funding?
Almeida: You’re seeing it now play out in the last two earning cycles. Businesses need to mark down bad projects, whether it was a business they acquired, or a new vertical, whatever it is. Similarly, the market will then have to start de-rating those stocks or bonds that were linked to those bad ideas.
I think the shift goes from: “Everything is fungible. You had some projects, some companies with high ROIs” to: “Can the business sustain its double-digit return on equity versus something that goes from a return on equity from 12% to 4%?”
That’s where I think fundamentals reassert themselves. I think as an industry, because of the environment that I think central banks unintentionally created, there was so much focus on geographic investing, or the U.S. outperforming. Or growth outperforming value, large outperforming small. I think all those factors become less relevant.
What will become more relevant is in your value ETF. What will matter a lot more are the types of companies you own, but more importantly, the ones that you don’t own. I think the selection or avoidance of assets that need to de-rate to reflect their true fundamentals. Those are the right questions to ask. I think that’s going to be the theme of the next paradigm or business cycle.
For more news, information, and analysis, visit VettaFi | ETF Trends.