A Green Light for Fed Easing? ft. Warren Pies & Andreas Steno

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0:58A green light for Fed easing ahead in September. Welcome to this macro deep dive here at Real Vision. My name is Andreas Steno and I'll be your host for the next 45 to 60 minutes. And I'm pleased to be joined by not only a friend of mine, but also the founder of 314 Research. It's great to see you, Warren. Yeah, great to be here and always fun to talk. Warren Pais, it's always a pleasure to host you. And now also the portfolio manager of the FCTE ETF. Congratulations on the launch of the ETF earlier this month, Warren. Thank you very much. It's our first foray into asset management. And so we'll see how it goes.

1:40It's a new adventure for us. Indeed it is, Warren. And we're currently amidst a pretty heated discussion on the macro landscape in the US economy. We've seen a very soft CPI report out last week, and then all of a sudden we got a major rebound in the retail sales report today. what do you make of the current macro landscape? Are we approaching some sort of recessionary environment or what's your takeaways here? Well, I mean, I think that the economy and economic growth is decelerating in many ways, but that does not mean that we're going into a recession necessarily. I think we were having this conversation before we got on.

2:21And in my mind, this is just what a soft landing looks like. You know, this ebb and flow in the data. you have you know a portion of commentators who are calling for a recession you know you can find things that look sort of contractionary and they're definitely on the lower end of the consumer i think it's feeling the pain and that's been a big part of our theories that this is a bifurcated consumer a bifurcated economy and ultimately a bifurcated market and so i mean you can certainly if that's your tilt you can find things that point towards a recession but at the same time you know just big picture it's very difficult to have a a true slowdown when you're running seven percent deficits you know we've never quite we've never seen a recession emerge with this high of deficits bending in the united states uh it hasn't been close so i think the closest we ever came got if the closest we came was back in 91 i think we were running like a three and a half percent uh deficit as a percentage of GDP.

3:27And you got to remember that that recession came about because we had the Gulf War in a massive spike in the price of oil. So even with that size deficit, we needed an exogenous shock to push us into recession. So I just think that's the setup. I mean, it's like putting your thumb very heavily on the no recession scale whenever you have that kind of deficit on an ongoing basis. And so I'm still, we came into the year in a soft landing camp. There hasn't really been anything that I've seen that dissuades me from that. That doesn't mean that we won't have inflation as a problem down the road. And that will just continue to grow indefinitely.

4:08I think there's problems that if you extrapolate out far enough to be there, but if the Fed starts cutting and just the right mix, which I'm sure we'll talk about, kicks off, I still think we're on track for what I would classify as a soft landing. So Warren, in the context of this discussion on Fed rate cuts, we got this soft CPI report last week, especially the housing inflation softened relative to what we've grown accustomed to over the past couple of years. So what do you make of the housing inflation and the prospects fall rate cuts amidst that? Well, our view was that we were going to have a couple of things.

4:47Number one, we've been saying we thought shelter inflation would remain sticky and elevated throughout the year. And this looks like a real break in the data. It's a head scratcher, and I can talk about the details on that. But putting that aside, even with that sticky shelter inflation, our view was that the second half of the year was set up to have a pretty strong disinflationary tailwind. And so we would end up with the first cut in September. This is what we wrote back in June in our second half outlook, which I sent a copy over to you. And so we've been on that kick. And that really goes back to that, I guess it was the May CPI report when we saw Supercore go negative month over month.

5:27That was a big tell to me. And that CPI report, we did get a slight reacceleration in shelter inflation. And I think shelter added like 18 basis points month over month, but everything else, we had goods, outright deflation, super core, outright deflation. And so when you looked at that, I could see PCE was going to be light, which it was extremely light. The lighter you get a PCE reading up front here, it improves, it widens your path to cuts into disinflation or better PCE prints throughout the year. And so at this point in time, PCE needs to print at our math is 19 basis points month over month on average for the rest of the year to hit the Fed's 2.8 % core PCE target that they outlined in the June summary of economic projections.

6:15And so that's your, I would call that your bogey, ultimately. And if you can get underneath that, then you're going to, I think, start to pull forward cuts and bring forward dovish Fed speak. And then on the other hand, I think the Fed's looking at the unemployment rate, the household survey. There's a lot of issues with household establishment survey, and everyone's talked about that. We've talked about that. But the Fed projects the household survey. Household survey is at 4.1%. Their SEP was at 4 % through year end. So we have a setup where unemployment rate is above the Fed's forecast. And with each one of these ice cold CPI and PCE prints, we broaden the path to undershooting their core PCE forecast by year end.

7:06And so when I put that all together, I think we're going to get cuts. Now, shelter specifically, all that analysis, we did all that analysis with the assumption that shelter would be sticky. if you end up with a stair-step lower in shelter inflation, which is what we saw in this last report, then the math becomes that much easier. And some of these prints could become aggressively disinflationary. Now, I mean, that's what the data suggests from this last report. When I step back, like I said, it's a head scratcher. It doesn't make sense to me. We've looked at shelter stuff from a lot of different angles and it doesn't make sense that we would have seen this kind of a move lower.

7:48We've investigated seasonal adjustments. I think the only piece of evidence that looks like shelter is disinflated is that new tenant renewed rent index, which the Cleveland Fed puts out. And that doesn't align, number one, that doesn't align with anything in the market. And what's telling you about market rents, whether you look at what the national REITs are reporting or CoreLogic single family or anything in the Zillow universe, all that stuff doesn't align with new tenant renewed rent index. And moreover, if you do the math, it's a little complicated to explain. But if you make this assumption, which we have made based off BLS papers, if you make this assumption that CPI rent is 80-20 existing versus new rents, right?

8:34And so you have most of that is existing rents as to catch up. So we are able to take that assumption, and then we're able to take any new rent index that you want. And in this case, let's take new tenant renewed rent index. And then we're able to take CPI rent with that assumption that 80 % of it is existing. And we can back out what is implied for existing rents and new rents. And if you just take that new tenant renewed rent index, it's implying things that are totally illogical about the state of the rental market. We've gone through that in more detail for our clients. And so the bottom line is that it implies that the existing rental market is actually higher on a level basis than the new rental market going back to 2020.

9:19So it would be the equivalent of you own an apartment building and you're boosting your current tenants up higher than the ones that come off the street and rent a vacant unit. That's on a microeconomic scale. That's illogical. It's not how the world works. So I'm having a very difficult time, honestly, reconciling all the data in the shelter inflation puzzle. But here's the thing I realized. We don't have access to the micro data. I'm not going to argue with this data. You've got to shoot first and ask questions later in this business. And you can't let that one thing stop you from getting invested if that's the direction the data is going.

10:01But I'm just flagging it for everybody. we've done a lot of work on it and I'm just going to say the data doesn't make sense to me. Hey everyone, we're going to take a quick pause and hear a word from our partners. We'll be right back. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? you can move to real money with as little as$100 once your account is approved.

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11:16No, it doesn't make sense to me either, Warren. Thanks for flagging that risk to the data released from last week from the Bureau of Labor Statistics or in the US CPI report. So, Warren, we got this soft CPI report last week, and all of a sudden, the Goldman research team made the rounds yesterday by suggesting that the July meeting is suddenly live in terms of rate cuts. I've had plenty of discussions through the day with my clients on whether that's actually a feasible risk scenario that they could decide to move ahead already in July. Paul obviously made a public appearance yesterday And I mean, to me, it wasn't clear that he really took it off the table.

12:01So what do you make of the timing of the first cut right now? Yeah, I think that's a little bit of like an attempt to grab headlines. It's unlikely that we get a July cut in my view. And so there's just not enough data between here and there, you know, a couple of weeks away to really, I think, shift the calculus. What I think is more if you're looking for extreme and this is not my base case, but if you're looking for extreme movements from the Fed, what what I've been playing with is this possibility of a 50 basis point cut in September. And so I wouldn't be surprised if we get another tick higher in the unemployment rate between now and the September meeting if we don't, that we wouldn't start hearing about a 50 basis point move.

12:54So that's kind of the outsized outlier Fed cut prediction in my mind that's more likely than for them to move in July. I think it's more like if we get any more deterioration in the employment statistics, then the Fed could start considering. There'll be people that are around the Fed at the very least discussing a 50 basis point move. And they could do 50 basis points in September and then go again in December. And again, that's not my base case necessarily. They could easily just go September, November, December, or something like that. But with the right mix of data, and we have enough time between here and there, you could start hearing about it.

13:33But no, I don't think July seems highly unlikely to me. I wouldn't make that bet. Warren, what do you make of the equity markets after the CPI released last week? It was kind of a head-scratcher to me that we saw a major rotation from NASDAQ into Russell, basically from the very concentrated large caps into smaller caps after the inflation release. And we've basically seen a continuation of that trend into small caps over the past week here. Are we amidst a great rotation into this cutting cycle?

14:06With a few caveats, I believe yes, we are. I think that's what we're in the early innings of what I think will be a pretty powerful rotation. I would call it more, it has been more rotational than I expected. I think it was going to my expectation was it'd be more of an expansion, like you hold some of these mega caps more or less in a holding pattern and the rest of the market catches up somewhat and you expand the rally. One of the things that we've been looking for, we made a new high on the S &P 500 on May 15th. And our view is that we would get an expansion in the market and we needed to see the S &P equal weight confirm that new high by August 15th.

14:48And as of right now, today, we will have a new all-time high. This is July 16th, if we're watching this next week or something. But as of today, we'll have a new high on the S &P Equal Waste. So that broadening that we expected that you need to happen to keep that bull market churning higher is in place now. We took time in our second half outlook to really lay out a case for what could fundamentally happen and cause this broadening. And in this, the case in our view is that when the Fed starts cutting rates, there has been this narrative that the Fed is is has become toothless in the in the face of this fiscal dominance, high massive deficits.

15:35And there's some truth to that. But there are pockets of the economy that are just dormant at this point because of Fed hikes and because interest rate policy. I look for those areas to really pick up in credit creation to take the baton from deficit spending in this next leg of the bull market. So if you look at things like existing home sales or new car sales, their new car sales are below 2018 levels. Existing home sales are back to where they were in 2009. I mean, and there's so many durable goods that go along with the sale of new homes or existing homes in new household formation. I believe that as rates come down, it might not happen overnight, but you're going to have this slow bleed higher in these other areas of the economy that have been dormant.

16:23And that what I would call credit creation takes the baton from fiscal deficits. And we did a lot of work looking at what does loan growth look like through your normal bull markets. And this bull market, especially on a real basis, we've never seen a bull start like this, where we have basically flat credit creation on a real basis through this entirety of the bull market. Usually you need credit creation to fuel a bull move higher. And then to tie that back to the economic projections, we, again, think it's a soft landing. There's not a lot of soft landings to study historically. But when you look at them, you get credit creation ramping something like 8 % on average in the year following the first Fed cut in a soft landing.

17:11So when I put all that together, I think that's the economic macro fuel for broadening. How do you play it is the question. I'm with you. I've been advising clients to play it other ways than small caps. I've been basically negative on small caps all year. Technically, they're breaking out. You don't want to like, I don't know. Like I was also, I had some trades on where I'd be long, high quality, non-Mag7 and then short Russell 2000 as a trade. I don't really want that trade on anymore. I don't want to short the Russell here quite yet because of the way the chart looks. It looks like a genuine breakout, but it's still not my vehicle of choice for the broadening.

17:56Okay. So, Warren, when we look at the sector rotation seen over the past week or so, it seems like some of these pockets, for example, home builders, real estate, also industrials to a certain extent, they've sort of taken off due to hopes of a soft landing paired with rate cuts. But what about the Trump presidency? We've seen loads of stories around that over the past week, especially after the weekend, and thank God he's still alive. So is a Trump presidency also a positive for this rotation story? Yeah, I believe it is. I mean, so, yeah, it's a political kind of question. But look, Trump is intensely focused on the markets when he's president.

18:46And I think he's going to cut taxes. I know there's a big debate. And this always is like a reveal. This reveals somewhat where you stand politically, I think. And I try my best to be objective and down the middle on these things, because I just think politics is a it's just a poison to your rational thinking when you're trying to make money. And that's all I really care about. But when I break it down, we have these deficits, which I think is the risk of these markets is that somehow there's a political movement, whether it comes from bond market and moves and yields or something down the road to close that deficit.

19:21And that would be a nasty thing for the economy, in my view, under the wrong circumstances. But it's pretty obvious to me, and you can lay the blame at whatever political parties feed. It's not about taxes. It's about spending. If you look at outlays as a percentage of GDP, we're off the map historically, something like 25 % of GDP. And I think tax receipts are somewhere around 16%, 17%. We've really never gotten above like 19, 20 percent on tax receipts in the United States. So there's some moderate room you could move up taxes, I suppose. But the truth is the spending is out of control. Now, I don't think Trump has ever shown an appetite to really cut spending.

20:06Maybe that'll change in this administration. And he's but I think he is a he's going to extend his tax cuts. That's kind of his legacy. and without that tax cut extension i think be pretty bad for the markets i mean you can look at what happened to earnings after they cut corporate taxes whether you like that policy or not societally it was good for the markets um and so to me it makes sense broadly speaking this is another kind of uh tailwind to the markets and as we said if the deficit's not going to close and trump doesn't seem to really care about the deficit he wants to kind of grow out of it so to speak, instead of tax our way out of it.

20:44We'll see if that works, but it's going to be good for the economy. It might cause inflation, probably will, but it's good for the stock market, in my view. Hey, everyone. We're going to take another quick break and hear a word from our partners, and then we'll be right back.

21:03Warren, one of the questions that we've received, given the topic of the day, is about the construction cycle. And we've basically been sounding positive on the real estate sector and the rate cut prospects from the Federal Reserve. But we also get questions on the amount of completions arriving over the course of the next, say, two to four quarters. So how do you view the construction cycle and the sales cycle in the real estate sector? Is it something that we should worry about also given that we are at cycle highs in the construction employment? Yeah, I think that we should worry about that.

21:48We keep our eyes on it. And so the biggest change we've seen, like when I go back, we do a quarterly chart book for our clients. And so we update charts, like 75 charts in these chart books. And it's interesting to do this exercise because a lot of the same charts from one quarter to the next, you just update them. And the ones that stuck out to me from the beginning of Q2 to the beginning of Q3 were all these construction employment charts. And especially in the multifamily area, we've seen starts collapse in multifamily. We've seen time to complete collapse. So time to complete a unit went from like 21 months pre-pandemic up to almost 30 months, I believe.

22:33And just in the last quarter has collapsed down to 25, 24 months. So that's coming down rapidly. It's normalizing rapidly. It's also normalizing the single family side. And the consequence of that is that your multifamily units under construction is off a cliff. So there is this backlog that was keeping everyone employed. And we had like a million multifamily units under construction just like a year ago. And now we're sub 900 ,000. Man, it's a huge drop. It's like a 10 % drop in units under construction in less than a year. And so that's how that flows through to us is it flows into our housing employment model.

23:13And our housing employment model is for the first time really this cycle showing slack in the residential construction labor side of the economy. And this is an important leading indicator for the economy. We've made this case probably on Real Vision before in plenty of media appearances. when you look historically, residential construction payrolls lead overall payrolls. You get like an 8 % drawdown in residential construction payrolls. And that happens before, but on average, you get your recession start. And so we haven't seen these payrolls actually decline yet. But our model says that there's slack emerging.

23:54And it's really about going back to this, the completions in the lack of activity going on in multifamily. And as you said, we get more deliveries coming through the end of this year, that multifamily, the multifamily segments in recession, basically at this point in time. So, but the one other point I'd say about that is multifamily employs a small fraction of the workers compared to single family and renovations in the residential construction market. We account for this in our model. So it's not a, this is not a place where I'm ringing the recession alarm because of this, but we did, because of this, take up our bond exposure for the first time, our overweight bonds for the first time since this entire year we've been underweight all year until a year few weeks that we went overweight bonds.

24:46And I think that in this environment, bonds are actually hedging your equity risk. And that's the risk of a slowdown versus a re-acceleration inflation through year-end. So Warren, you and I have had a discussion on the quote-unquote golden handcuffs in the US real estate market before. So let's assume that we'll get a few rate cuts through the second half of the year, also bringing mortgage rates lower. Households stuck with golden handcuffs, Will it be more appropriate for them to put their home on the market, if you know what I mean? Is that a true risk to the price development in the real estate market?

25:29Could we actually get, I'm laying forward a thesis here, could we get a slide in prices because of rate cuts due to this golden handcuffs syndrome? I think that's, I've heard that. And I think it's, we're running this experiment real time. Obviously, I don't know for sure. and nobody's seen a market like this. So we don't really know. I think some of that's going to come down to the pace of rate cuts. You know, if we were, if the Fed were to like go through a normal recession slowdown where they do emergency rate cuts in there, you know, they chop 200 basis points off the Fed funds rate. And, you know, on the other side of that, whatever that would cause that, on the other side of that, I think you could see a big wave of supply coming onto the market and it would be a sloppy market for these builders.

26:17It would be a bad market for the builders, for instance. But in this soft landing scenario where the rate cuts come in kind of drips and drabs, you have maybe two, maybe three this year, maybe two, maybe three next year. And it's just constantly feeding this beast a little bit. I think that the return of supply should be somewhat controlled as houses come back on the market. And I've liked, I've been encouraged by the way home building stocks have responded to these inflation prints and basically the market recognizing that we're going to cut rates now. It's kind of a certainty. And they, instead of selling off, which is they've had that reaction before to your point, instead of selling off, they've really rallied.

27:05I think that the home builders have led the market over this broadening rally. They've actually gone up more than small caps. And so to me, that's encouraging. It tells me that the market's saying, okay, these guys, they might have some margin contraction here in the near term, but the secular thesis that we're short housing is intact. You have a huge, huge number of millennials who are hitting that like 35 to 45 year old region of their life in the next few years. And they've all delayed household formation. And I think there's just a big need for housing supply. And so the fact that some existing home sales are going to come on the market is probably a net positive for society.

27:50And I don't think it's going to, under the scenario I'm laying out for soft landing, I don't see it crashing prices. If anything, just keep a lid on prices, allow the market to just cool off and hopefully make housing in general gets more affordable. Yeah, fingers crossed, Warren. I also want to touch upon commodities in this rate-cutting scenario. We've seen gold through the roof today, basically making a new high, while the oil price is slowing down a little bit. So what do you make of that divergence between gold and oil here amidst the rate-cut rumors? Well, one of the main overarching just principles that we have that we've built into all of our stuff here at 314 is that we don't believe so much in this commodity super cycle thesis and the commodity super cycle kind of put forth by the Jeff Curry's of the world before he left Goldman.