What to expect as the Fed gets ready to raise interest rates
Cumberland Advisors CIO David Kotok joins Yahoo Finance Live to discuss the Fed's next moves, what rate hikes will do for the U.S. economy, and the outlook for the market.
Video Transcript
BRIAN SOZZI: All right, two things we are sure of. First, the Rock's arms looked really enormous at the start of last night's Super Bowl. And two, the Fed is getting ready to raise interest rates likely in March. Let's stay on rates, rather than the Rock's biceps. David Kotok is the co-founder and CIO of Cumberland Advisors and joins us now. David, always so nice to see you. How concerned are you that the Fed frontloads these interest rate hikes? And what impact do you think that will have on the economy this year?
DAVID KOTOK: I hope they don't frontload. The Jim Bullard warning, which created a lot of turmoil in the market is less likely, in my opinion, to happen. I believe the majority of the members of the Federal Open Market Committee know that moving policy should be like moving a battleship, not a speedboat. And so I don't expect frontloading.
My biggest concern, Brian, is the balance sheet shrinkage because the Fed has only done that once, and their record about it is poor. So I'm OK with four or five rate hikes, get the short-term interest rate up to 1%, let money markets start to clear, let people get away from the zero bound, let them earn something on savings. I think that would stabilize a lot of issues. It's the balance sheet shrinkage that is the unknown. And it's way out in the future, but it may come out as fast. I hope it doesn't.
JULIE HYMAN: Well, what's the risk that you're concerned about? Is it the speed of the shrinkage, how soon it's going to happen and what-- what are the sort of potential mistakes they could make when it comes to that shrinkage?
DAVID KOTOK: Well, there's the real cutting edge question, Julie, because nobody knows the shift in bond market duration as the Fed moves from taking balance sheet to neutral and then shrinking it. And this is interactive with the Treasury since the Treasury is still issuing Treasury debt, which I believe Janet Yellen, as treasurer of the United States or secretary of the Treasury, and Jay Powell, who worked together, are going to balance this so there's no instability in the financial system.
The Treasury may raise the amount of bills versus notes and bonds as the Fed changes its holdings. So this is an integrated task. There's only been one case study of trying to do that and raise an interest rate at the same time, and it failed. Was enough learned from it? We're going to find that out. Remember this, though. If the Federal Reserve throws the balance sheet today, there would be paydowns on the mortgage portfolio.
And there would be a basic shrinkage of need for balance sheet size at the rate of $15 or $20 billion every single month, just by virtue of the growth of the economy. So I believe the Fed knows not to shock the markets. Markets, by the way, want to talk about the shock. But I don't believe the Federal Reserve wants to put the US economy in a recession, and I don't believe it will shock the markets.
JULIE HYMAN: Well, the markets want to talk about the shock, potential shock, so to speak, and they want to price it in, right, which is the process that we have been seeing play out in the markets, as people try to price in all those potential scenarios that you're talking about. So what do you think should be priced in at these levels? Do you think that stocks are where they should be right now, given those risks that you're talking about?
DAVID KOTOK: Well, the word "should" is always a dangerous one to use. You and I over the years have talked about that many times. So let me just put it this way. I believe when the books are closed on the earnings sequence we see now, the stock market is going to look and say, gee, the S&P 500 index for the fourth quarter earned over $55, for the third quarter, almost $54. All the forecasts for those quarterly earnings aggregates were $2 or $3 lower each and every time, and that has been the case for the last six quarters since the pandemic shock bottom.
What changes to keep that trajectory from continuing to rise? Well, war-- Ukraine, China-- a massive Fed shock that we don't see that coming. So the alternative is 55 quarterly earnings will be 56 and 57. My number for the S&P at the end of 2022 is about 4,800, 4,900, 5,000, earnings trajectory getting to about $60 for the quarterly run rate. That's pretty reasonable. So stock prices at 4,300-- 4,400 on the S&P right now are attractive or reasonably priced.
BRIAN SOZZI: Within that S&P 500 target, how much are you concerned about inflation sticking around for the balance of the year, or in other words, not decelerating?
DAVID KOTOK: Well, Brian, I know it's a dirty word to say transitory. But I think that in pandemic shock history, transitory happens. It's just a long stretched out process. And for me, our best guess is the inflation rate comparisons are peaking right now, this quarter, this month, next month. And as we move through the year, they're going to roll over.
When they roll over, maybe this market, or at least some of the people who are talking about it, will calm down a little bit. So if I had to have one message for investors-- and in our firm, we're trying to practice it-- it's calm down. Don't get so excited. Because we are recovering from a massive pandemic shock, and the recovery trajectory has years to go.
BRIAN SOZZI: You know what? That's actually some good advice for me. I'm going to calm down on this. You know, I'll just take these earnings in stride, David. Very good words of wisdom from you, as always. David Kotok, co-founder and CIO of Cumberland Advisors, we'll talk to you soon.
