The case for a Fed rate cut

Good morning. The US trade deficit fell 55 per cent in April, according to the commerce department. There was a noticeable uptick in exports, but the overall decline was mostly due to a drop in imports — pharmaceutical and gold bullion imports, in particular. Remember the argument that last quarter’s negative GDP reading would net out later this year, as tariff front-running recedes? That seems to be happening. Email us: unhedged@ft.com.  

Rate cuts

In December, the Federal Reserve made it clear that its rate-cutting cycle was on hold until the inflation and employment outlooks became clearer. Six months since that declaration, a strong case is emerging that the Fed should start cutting again — not necessarily at its June meeting, but soon. Today’s jobs report, which many are speculating will be weak, could strengthen that case.

So far, the Fed has had every reason to stay put. The inflation data has been on a slow downward trend. The labour market has held up well and even surprised to the upside on occasion. And despite reams of bad sentiment readings, there is still very little evidence of inflationary impacts in the hard data due to Donald Trump’s tariffs.

That could just be a matter of time, however. While soft data is not as predictive as it once was, according to Guneet Dhingra, chief US rates strategist at BNP Paribas, the soft data has continued to weaken. And it is suggestive of the outcome the central bank fears the most — stagflation. Just this past week, ISM services slipped into contraction, with falling new orders and prices way up, building on a multi-month ascent. The ISM manufacturing picture was similar: new orders dropped, and prices continued rising.

All the same, a growing chorus says that the Fed should look through any inflationary impact of Trump’s policies. At a conference this week, Federal Open Market Committee member Christopher Waller laid out his case for transitory tariff inflation:

Given my belief that any tariff-induced inflation will not be persistent and that inflation expectations are anchored, I support looking through any tariff effects on near-term inflation when setting the policy rate.

Waller also emphasised that the market’s expectations of inflation should be given more weight than survey data. And the inflation swap market shows that inflation expectations are cooling:

If persistent inflation or unanchored expectations are not in the offing, that gives the Fed more room to cut at the first whiff of trouble in the job market. That whiff could come in today’s report. The ADP employment report from earlier in the week was cold: the private sector added only 37,000 jobs in May, well below expectations. It’s a temperamental series, but there are signs of weakness elsewhere, too. A rising number of people are either shifting from being jobless but not looking, to looking but not finding, or shifting from employed to unemployed. This was also the trend ahead of previous slowdowns. Chart from Troy Ludtka at SMBC Nikko Securities America:

If today’s jobs numbers come in on the weak side, and if inflation continues to trend down in the face of tariffs, a cut in July makes sense.

(Reiter)

‘Alts’

Richard Ennis thinks that having alternative investments in your portfolio is a big mistake. And that “your” doesn’t just cover individual investors, the usual targets of the standard “allocate, index, rebalance and relax” advice. He thinks even the most sophisticated pension and endowment fund investors are hurting their returns badly by owning hedge funds, private capital, real estate, venture capital, and so on. 

Ennis — whose credentials include founding and selling his own institutional investment fund advisory, and serving as editor of the Financial Analysts Journal — lays out his case in a new paper called, categorically, “The Demise of Alternative Investments”. He argues that while 35 per cent of public pension money and 65 per cent of endowment money is invested in alternatives (“alts”), this is mostly down to conflicts of interest and poor incentive structures among fund managers and consultants, not risk-adjusted investment performance. For the past 15 years or so, that performance has been terrible for alts of all flavours.

There are two legs to his argument: quantifying the high costs of alts, mostly by marshalling previously published research; and then using a new statistical analysis to show a strong correlation between higher exposure to alts and weaker investment performance.

For private asset costs, Ennis turns to a paper from Wayne Lim, based on a large database of fee data from an investment adviser, which lays out the difference between gross- and net-of-fee internal rates of return for various alt strategies. Here is a table of Lim’s appalling findings:

For hedge funds, the news is bad, too: the academic research Ennis cites finds annual costs averaging more than 3 per cent of assets.

The challenge comes in showing that the returns from alts do or do not justify the very high costs. “There is no reliable source for asset-class-level return data for institutional investors” because disclosure is sporadic and of poor quality, said Ennis. The indices meant to track alt investment results are uninvestable, “hypothetical and nebulous”. As an aside — I’m amazed by the lack of an industry standard reporting protocol for both funds and money managers. I asked Ennis why there isn’t one. “This is a huge problem,” he said. “No one is setting standards. The CFA Institute has been a big disappointment in this regard. There simply is no incentive to create the type of resource you describe.”

What we do have, however, are databases that include pensions’ overall performance and their exposure to various categories of alts. Ennis ran a regression on the returns on alt exposure using two large databases, one for pension funds and one for endowment funds, covering 2016 to mid-2024. He then compared the aggregate results of the funds in the databases to a “market portfolio” of public indices with the same equity and bond mix and same volatility of returns as the funds. The pension funds underperform the market portfolio by almost 1 per cent a year, and the endowments by more than 2 per cent.

Much or all of the reason for the underperformance appears to be exposure to alts. Regressing performance and alt exposure renders a statistically significant slope coefficient of -0.071; for every extra percentage point of exposure to alts, annual performance falls by a bit more than 7 basis points. Here’s Ennis’ scatter plot, with each blue dot representing a pension fund and each green diamond, labelled one to five, representing cohorts of endowments of ascending size:

Ennis also breaks the performance down by exposure to various types of alts. Real estate fares particularly badly; he suggested to me that funds stick with it simply because “people are suckers for real estate investments. Think Canary Wharf, Cadillac Fairview, etc. Real estate is tangible and can have tremendous sex appeal.”

Why, given the wretched recent record, do fund trustees and managers keep trusting alt managers with their money? Chief investment officers and consultants can earn higher pay and look clever by backing complex strategies. They also pick their own benchmarks, gravitating towards bad benchmarks that allow the poor performance of alts to appear acceptable, Ennis argues.

I would propose another explanation: that fund trustees and managers just want an easy life. So they will go with the money managers that can handle multibillion-dollar cheques easily, deal smoothly with reporting and tax requirements, don’t screw up anything massive, and have good reputations and high name recognition. So the big managers, with the sophisticated back-office systems and marketing operations, win the mandates. And the big managers are no fools, so they always push the highest-fee products. The pensions and endowments industry (like most industries) is fundamentally lazy and inert, in other words. So it defaults to buying whatever the big asset managers feel like selling. But this is mostly just speculation on my part.

The strongest objection I can think of to Ennis’ argument is that the past 15 years in markets have been anomalous. Risk assets, and particularly big US stocks, have just gone up like crazy. In such an environment, the hedging strategies and uncorrelated returns of alts are a pure drag on performance. If we return to a more unforgiving market environment, alts will prove their value once again.

I don’t quite buy this. If Ennis’ numbers are even mostly right, the recent drag on performance from alts has been so large that it would take staggeringly good results in the next market cycle to make up for it. The burden of proof is squarely on the side of alternative investment managers and their fans in the pension and endowment world.

(Armstrong)

One good read

The boss.

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