Fed Pause, Mid-Cycle Slowdown, Banks’ Liquidity Crisis With James Foord, Lawrence Fuller

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This is an abridged conversation from Seeking Alpha’s Investing Experts podcast. Recorded on May 11, 2023.

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Transcript

James Foord: All right. So we’ve had quite an interesting week in markets. Obviously, we had that Fed meeting with that 25-rate hike. We’ve also had a lot of movement in regional bank stocks, with some more bank failures coming in. So definitely a very interesting time. Let’s begin by dialing in with a simple question. Do you think that was the last rate hike? Has the Fed paused?

Lawrence Fuller: Absolutely. I think absolutely. I don’t think they needed another rate hike. But what the Fed typically does is what the market expects, in particular, this Chairman, Jerome Powell is very market friendly as we know, or has been over the past five years. So I just use the Fed Funds Futures as a guide for where our short-term rates are going to be. And if the market is, let’s say, given all this regional bank turmoil, we saw Fed Fund futures predict a 75% chance there’d be no rate hike. I don’t think the Fed will raise rates.

So, they really kind of operate, let the market guide them. And in the very short term, but in the long term, they still play this rhetoric game, which is where they want to try to manage expectations. They don’t want the market, or consumers for that matter to be concerned that prices are not going to come down.

So these Fed Governors are deployed like soldiers to go out and give speeches and talk about how they’re going to remain vigilant. And they’re going to keep raising rates. They’re going to hold them higher for longer. But if you look at where, for example, the two-year treasury yield has plunged from, over five to now, in the high3s, that’s telling you, the Fed is going to cut rates. They may not know it yet, or want to admit it, but they’ll probably be cutting rates.

I hope they don’t cut rates too soon, because that would mean they’re really having some serious economic stress. But I think they’ll be able to gradually lower rates as we get into the, let’s say, the fourth quarter of next year, because inflation is coming down closer to target more. We’re skirting with very low, below trend growth in the economy. So…

JF: Yeah, definitely you talk about that, as Fed Funds Futures, and a lot of — it does seem — the market does seem to be already pricing in substantial amount of Fed rate cuts already this year. Is that then — would you agree with that assessment? Like you say that, even if they don’t know it, they are going to be forced to cut?

LF: Yeah, and people will — a lot of the bear consensus out there will argue that they’re going to have to keep rates higher. But if you go back to when they first started raising rates, when short term when Fed Funds was zero, the very short-term treasury yields were soaring. And well, in anticipation of a significant spike in Fed funds rate.

And they at that time were denying that they were going to have to raise rates much at all. So they’re really — that’s almost the reverse situation, but it’s the same thing playing out where they’re going to follow the market, pause and listen to the market, but they’re not going to admit to it, because they don’t want to cause a panic, but they also — they always want to manage expectations and as far as inflation is concerned expectations is half the game.

And they seem to be fairly contained at this point. If you look at five-year, 10-year inflation expectations, even three year they’re coming down, maybe not so much in the next 12 months, but they will. I’m not too concerned.

JF: Okay. So in terms of inflation, you don’t see that being a problem moving forward.

LF: I’ve said since last summer that I thought the rate would fall as fast as it rose. So in about 18 months, we went from two — it depends and you can talk about CPI or the PCE, which is what the Fed focuses on, but if you just use the CPI, we went from 2 to 9.1, in June of last year. And if you look at the deceleration in the rate, the decline in the rate, we’re about halfway through nine months now and we’ve cut the rate in half.

And so, I think we’ll get in this argument, well, do we need to be at 2%? What’s funny is that if you go back a decade, when we came out of the housing crisis, the great financial crisis, the Fed was battling to get inflation up to 2%. They never could, they never could. So they were talking about, well, we want to be in a range.

We want to get through within an average of 2%. And I think that as we come down to Bernanke — Powell will change his tone and talk about, we want to see an average of 2%, which means that if we’re a little over, it’s okay, because if we go into another economic downturn, we’re going to fall below 2%. And so we smooth out over the long term, I think that’s why we can get down to below 3. And that will be enough for the Fed to be comfortable again, so…

JF: And now, as we were talking before, you would call yourself a little bit of a contrarian obviously, I think bear sentiment is quite high right now. I was actually showing my subscribers some charts where bet like short positions, actually at all-time highs, which not that, surprisingly, it often acts as a kind of a signal that it’s time to buy.

LF: Yeah, I mean, unfortunate, I think, that sentiment, whether it’s consumer or investor, indicators have lost a little bit of their validity, in my view in the last several years. And I mean, I started in the business in 1993. So it’s about 30 years and watched three big cycles come through, and I hate to say, hate to inject little politics into the sentiment indicators.

But because we’ve become such a divisive country on the political front, instead of, when people are asked questions about economics and pocketbook issues, even if they’re doing well, depending on what side of the aisle they’re on, instead being sort of 55-45 split, it’s become this 90-10, 95-5 split. And both sides do it.

And so, it’s, I think it’s thwarted a little bit of the effectiveness of sentiment indicators and how in the world you explain all-time low unemployment rate? So normally, we have very good, very strong range growth. And in consumer sentiment, that’s not much higher than it was, post great financial crisis.

You have tremendous amount of wealth out there. So it doesn’t make a whole lot of sense to me, that, at least on the consumer side, you will be so negative. I understand the inflation. But the thing that people don’t recognize is that, while inflation was rising so were incomes.

So we didn’t spend a whole lot of time where people were necessarily — I mean, I know there’s always going to be certain cases, certain demographics suffer a lot more than others, but in a broad sense, people have had phenomenal wage growth, especially actually the lowest quartile, the lowest wage income earners have realized the highest wage gains. They have also received the largest amount of fiscal stimulus funds. And so that really offset the spike and now that inflation is coming down, those wage gains are holding up. The cash surplus, excess cash out there is still — it’s declining, but it’s still helping support spending, which is why we’ve averted a recession. So…

JF: Yeah, it’s definitely a little bit different this time in that sense that people are talking about that kind of the more of a white-collar crisis. Nowhere you get the people in the tech space losing their jobs rather than more general layoffs. So in terms of this recession which they’re calling now the most anticipated recession of all time, you would then believe that there is — we’ve avoided the recession, that it’s not coming anytime soon, or that it’s going to come eventually. But well, I guess a recession will always come eventually. But

LF: It always comes eventually. I mean, I just don’t see — the recessions that — I don’t I think that the first recession I experienced was in ‘91, coming out of school, and not being able to find a job, not understanding why. And then the other ones were obviously bubbles. We had a tech bubble, lot of over investment in that industry. But that was a relatively mild consumer recession. And then obviously, the housing bubble.

But if you look at this particular cycle, what’s so different about it is that you go back to — the pandemic really threw a monkey wrench in everything. But we had all these bubbles, if you went back to pre-pandemic days, and they kind of burst one by one, but not simultaneously.

Now we had a bubble in cryptocurrencies. That was a $2 trillion industry. It burst. A bubble in SPACs, we had a bubble in different parts of the market at different times deflated, without — instead of it creating a panic and – a trickle effect across markets, it sort of was like whack a mole.

And so we took out these excesses one by one over time. And even we’re doing the same thing now with the housing market. But the thing about the housing market, prices and rents soared, housing prices got a little bit insane again, but there’s no supply.

JF: Right.

LF: So it’s sort of — it’s holding prices up. And they’re deflating in terms of their increases on a year-over-year basis, but they’re not declining in any way that people are going to get concerned or feel that they’ve lost a whole bunch of wealth. So I think the recession comes, but we need to see — I don’t really even see a recession next year.

I think this is a mid-cycle slowdown, is what it is. And I know that you talk about soft landings and the last one we have was arguably in the mid-1990s. I just started in financial business at that point, I really didn’t even know what a soft landing was. But it seems like we’re — that’s what we’re due for this time around. But recessions are a lot about psychology. The only thing I get worried about is that this bearish consensus become so dominant, that they start to sway the way consumers respond.

And so, at that point, it hasn’t happened yet. And then also the businesses that I talked to, some are struggling. I talked to a good friend of mine who is working with a trucking company, and they’re having a horrible time. And that’s a very difficult industry right now. You look at other businesses, and look at like the restaurant business and they’re doing extremely well. I go to hotel, I’ve been traveling a lot last month in hotels and airports and restaurants, bars, packed. It’s just not — it’s not what you typically see when you’re on the cusp of an economic downturn. So…

JF: Yeah, that makes a lot of sense. It does kind of clash a lot with basically what you — what we’ve been seeing lately in the financial media, especially when it comes to banks, right, because that’s also kind of a psychological element to it. So we were concerned about bank footfall, and rightfully so, because we have had some of the regional banks obviously struggle following all those rate hikes. How do you feel that fits in? I mean, are you concerned about this at all? How do you think it fits into the upcoming months?

LF: Well, if it was a credit crisis, I’d be really concerned but it’s not. It’s a liquidity crisis and it’s a liquidity crisis for a handful of banks that didn’t do a great job managing their assets and their liabilities, their balance sheets. And you can even take a heavyweight like Schwab (SCHW), for example is really struggling because of the withdrawal of deposits. People had money in their investment accounts running zero, all of a sudden somebody told wow, you can earn 4% so buy on a money market fund. And I’m sure you have the $2 million, pull the money out, put it there.

So it’s — and credit conditions are going to tighten as a result that they’re already tightening as a result of this, which is another reason like I said it’s done raising interest rates. But I don’t yet see it as something that’s going to be the trigger for a downturn.

I don’t like the way that the Fed didn’t acknowledge, Jerome Powell who did a great job of acknowledging the issue. He kind of swept under the rug that everything’s fine. I had this scary deja vu about when Bernanke said, subprime is contained. Kept me a little nervous. Like, it’s a different issue. It’s like it’s not a credit issue.

So First Republic’s (OTCPK:FRCB) gone, while JPMorgan (JPM) swoops in, basically takes over and nothing’s really changed. Deposits are all recovered. Lending continues, but again, there’s going to be a tightening in lending standards obviously, but I think that yeah, so then we start to watch. It’s a leading indicator, but it has to result in some other factors in order to see a contraction in economic activity.

JF: Yeah. So let’s say then — and I kind of agree to a certain extent, of course, that we are entering, perhaps a more bullish market in equities. Where do you think is the place to be where those gains is going to be found in the next cycle?

LF: I think that you can’t really — I think it’s — first of all, it depends on your timeframe. I mean, I can say, tech’s — the bears will criticize the breadth of this rally and say that it’s only being led by half a dozen techs, the big mega cap tech stocks. And that would be accurate. That’d be accurate over the last three months.

But if you went back six months, you’d see that the rest of the market is what was driving the gains off the October low, we had phenomenal breadth in the market. And that breadth started to wane a bit. And the big mega cap tech stocks have been lagging behind, and all of a sudden, they’ve really — if you look at, they caught up in the last three months. It’s not as though they lead, they were catching up with the rest of the market.

So now I think that in order for us to sort of break out of this range, we’ve been in on the S&P 4,000, 4,200 or so, the mega cap tech need to pass the baton to the remainder of the market when we see breadth start to improve. That’s something I’m anticipating because earnings, which, at the end of the first quarter, the consensus view is S&P earnings declined about 6.7%, 6.8%. And we’re a little more than halfway through now, more than halfway through now, and that decline has narrowed by 50%. Now it’s closer to 3 and change.

And so, earnings are coming in a lot better than expected. And the other issue that bears are pointing to is that when we get these earnings reports, analysts are going to start to lower their forward projections a year out dramatically. That’s not happening. Next quarter is coming down, but next year is actually turning up.

So margins are holding up a lot better than I think they were expecting. And that’s a positive for the market. So that’s why I’m staying invested and staying — I’m not looking for a new all-time high but I think you have to view it as an uptrend even if it’s a modest one.

JF: Yeah, absolutely. I agree with a lot of what you said there. Especially I’ve recently talked about the idea that, like you said that perhaps we will get some of the other assets catching up in this phase. So perhaps maybe seeing something like the Russell 2000 maybe outperforming a little bit. Would you agree with that to an extent?

LF: Yeah, it was outperforming. The Russell bottomed in June of last year, well before the S&P. And it turned up, which was a leading indicator coming out of the October low that the market was getting a lot healthier. And it’s since lagged largely because of there’s a big financial weighting in the Russell 2000. So that’s obviously hurt the index with a lot of the smaller banks struggling and but also — you’ve got highly leveraged companies in there.

And there’s been a real sell off in, especially consumer cyclical type names that are anything that’s leveraged because the cost of money has gone up dramatically. So that weighs on the Russell. But, I think if you — if you’re a long-term investor and you’re looking out over the next couple of years to put money to work, it sounds crazy, but the financial sector is a great place to do it.

And you don’t go and speculate on PacWest (PACW), hope it goes from 5 to 7, okay. But you buy the money center banks, you buy the Bank of Americas (BAC), JPMorgans (JPM), you buy the leaders that are really — at I mean, in fact, I saw something last week that showed the regional bank index now on a price to book basis is right where it was during the great financial crisis. I mean, that’s when General Electric had a credit rating equivalent to Vietnam. That’s how bad it was. Bank of America’s stock had gone from 50 into the single digits. So that’s where we are on a valuation basis for the regionals.

So if you don’t want to pick a regional, there’s obviously — there’s the (KRE), the Regional Bank Index, where you don’t have to worry about picking the wrong name. And I think that is the lowest risk long-term investment you can make in the market right now.

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