What Powell's Jackson Hole Speech Meant for Markets

Markets rallied hard today after Jerome Powell's speech, in which he noted some small shifts in the Fed's policy-making framework. Investors interpreted these as "dovish," aka good for stocks.

It seems to me that the biggest of the shifts is toward a more flexible approach to setting policy. A lot of their decision making is data-driven, but the problem with data-driven policy is that the data is usually 3+ months old, while changes to policy rates take another 3-12 months to take effect. Whereas they've been somewhat more rigid and rules-based in the past, it seems like they might be taking a more proactive, even intuitive stance to managing the economy. This means they might cut rates even before data start to suggest a recession is imminent. Hence, markets acting like a rate cut is more likely.

The other change, which also leans in favor of a rate cut, is that the Fed shifted its goals for employment. They previously tolerated a higher baseline rate of unemployment. This was for the sake of managing their inflation goals as higher unemployment helps ease pressure on inflation. However, now it seems they're more interested in maximum employment, which means letting inflation (and growth) run a little hotter. Previously, their biggest goal was to contain inflation, and they were willing to inflict economic pain in order to do it.

Both these developments point toward rate cuts, or at least not rate increases.

These were positive for stocks, real estate, bonds, and other interest-rate sensitive investments, because they appear in line with expectations of a rate cut in September. Many investors had hoped for a rate cut, as this tends to make their holdings go up in value. Stocks aren't having a bad year though. Despite the sell-off in February, the S&P 500 is up over 10% year to date.

What's next for stocks? I don't really know. I'm picking up on a lot of nervousness and discomfort among fellow professionals as well as clients. Usually, that means stocks will keep going up, baffling though that may seem to some. Now, stocks will probably crash 10% or more sometime in the next 12 months, but that's nothing new. Stocks always do that, and it just isn't profitable to try to avoid those minor declines. The more sane approach is to hold on tight, and remember that stocks are a 5 year investment at minimum. The volatility along the way is just the nature of the beast. "The price of admission," as Morgan Housel calls it, to earning 10% returns in the long run.

Real estate and small cap stocks are the biggest beneficiaries of rate cuts though. Small caps are far less profitable, and more indebted than their large-cap peers. And worse, they have higher borrowing costs, making economic success a challenge for this group. Lower rates mean lower interest payments, however, and that translates into higher profits and cash flow. Hence, these companies become more viable with lower rates. Real estate has had a rough time for the last 3 years for similar reasons. Projections by investors failed to account for a 5% surge in interest rates, as happened in 2022, leading many once-profitable endeavors to either lose money or tread water. Many investors in real estate development have faced capital calls, in which they were asked to help keep their investments afloat by contributing more funds beyond their initial investment. Such are the risks that come with illiquid, private investments. Publicly traded REITs have been roughly flat over this period, but volatile. So pick your poison.

One final note, especially for real estate investors. Powell's third update was clarifying that this current interest rate environment is officially normal. Interest rates are not high, they are normal. Barring a recession, we will likely not see a return to the Covid days of 3% mortgages. Investors, whether in current real estate projects or proposed projects, should not expect to be rescued by a return to low rates. Therefore, I would recommend updating your projections for any real estate investments you might have, particularly those that need to refinance in the next few years. If your interest rates are not locked for 30 years, I recommend that you go through your capital stack and update your assumptions to reflect this reality. See if you'll be cash flow positive at these higher rates, and make whatever business or lifestyle changes you need to make. Many investments will take a few more years of rent increases to become profitable, though growth in rental income may be slower than it has been in the past.