Investors’ Interest Rate Expectations Unrealistic, per NEPC

To many investors, it is back to normal for interest rates, meaning they expect the sunny days of low single digits will return soon. Consulting firm NEPC begs to differ.

You cannot blame folks for expecting a reversion to what they consider the norm. Low interest rates, along with tame inflation, have been the rule for many years. Although the post-pandemic spike in the Consumer Price Index was a jolt, the CPI has come back down and stood at 3.4% annually as of December 2023, and the Federal Reserve wants inflation lower, around 2%.

The Fed, which had jacked up interest rates to combat the inflationary surge, thinks the mission is accomplished and is talking about lowering its benchmark federal funds rate from its current band of 5.25% to 5.50%. Many investors are applauding, expecting lower rates to further juice the stock market.

That buoyant scenario is simply not likely, according to an NEPC webinar on Thursday. A lot of people “are anchored to low inflation,” said Phillip Nelson, the consulting firm’s head of asset allocation. As a result, “the market is biased toward low rates.”

Indeed, the futures market projects up to six quarter-point reductions in the fed funds rate, bringing it to a band of 3.75% to 4.0%, or lower, by year-end. Various Wall Street sages forecast the rate dropping to anywhere between 2.1% and 2.5% in 2024. U.S. inflation should fall to 2.3% this year and stay around 2% through 2028, according to the International Monetary Fund’s economists.

While the widespread “behavioral bias” toward low rates has fueled expectations for a low cost of capital in the future, economic reality will intrude, Nelson warned. He pointed to mounting federal debt that eventually will “require higher interest rates” to attract buyers.

Meanwhile, in a related delusion, NEPC’s strategists contended that investors remain besotted by the stock market’s bullish performance and believe more is on the way.

Trouble is, noted Tim McCusker, NEPC’s CIO, the S&P 500’s recent rise has merely recovered ground lost in the 2022 slump. The index’s new peak level set on Thursday, of 4,894.16, was just slightly more than the January 3, 2022, apex of 4,796.56. Thus, he said, “This has been a round trip.”

In addition, the Magnificent Seven, the mega-cap tech names that have propelled the entire market higher, are living on borrowed time, in his view. “It is priced for perfection,” Nelson declared, noting that Mag Seven member Tesla Inc. has seen its stock performance flag amid management guidance that sales growth of its electric vehicles might slow.

The group “will need sky-high earnings growth” to stay in their lofty perches, Nelson continued. To starry-eyed investors, such talk is a bitter tonic.