Making the Case for Lowering the Fed Rate: A Strategic Shift

Good morning. In April, the US trade deficit decreased by 55%, according to the commerce department. Exports saw a significant increase, but the primary reason for the overall drop was a reduction in imports, particularly pharmaceuticals and gold bullion. This aligns with the idea that the previous quarter’s negative GDP might balance out later this year as tariffs lose their impact. Feel free to email us at unhedged@ft.com.

Interest Rate Cuts

Last December, the Federal Reserve indicated that it would pause its rate-cutting cycle until there was more clarity on inflation and employment conditions. Six months later, a strong argument is being made that the Fed should begin cutting rates again — not necessarily at its upcoming meeting in June, but in the near future. Today’s jobs report, which is expected to be weak, might further support this argument.

Until now, the Fed had good reasons to remain steady. Inflation data has been slowly decreasing, and the job market has remained resilient, sometimes surpassing expectations. Despite numerous negative sentiment readings, there’s little hard evidence showing inflationary effects from Donald Trump’s tariffs.

However, the situation could change. According to Guneet Dhingra, chief US rates strategist at BNP Paribas, while soft data is less predictive than it once was, it has been weakening and suggests a potential central bank nightmare — stagflation. Recently, the ISM services index fell into contraction, with declining new orders and rising prices. The ISM manufacturing data mirrored this trend: new orders fell while prices increased.

Nonetheless, more voices are advocating for the Fed to disregard any inflationary effects stemming from Trump’s policies. During a conference this week, Federal Open Market Committee member Christopher Waller presented his views on temporary tariff-induced inflation:

In my opinion, any inflation caused by tariffs is unlikely to be persistent, and since inflation expectations remain stable, I believe we should overlook these tariff impacts when determining the policy rate.

Waller also stressed that market inflation expectations should carry more weight than survey data, and the inflation swap market indicates that these expectations are cooling:

If prolonged inflation or unanchored expectations are not on the horizon, it could give the Fed the flexibility to lower rates at the first hint of trouble in the job market. That hint might come from today’s report. Earlier this week, the ADP employment data was disappointing, showing the private sector added only 37,000 jobs in May, significantly below what was anticipated. Although it’s a volatile series, there are also signs of weakness in other areas. An increasing number of people are either transitioning from unemployment without job searching to actively looking but failing to find work, or from being employed to unemployed. This trend was also observed prior to past economic slowdowns. Here’s a chart from Troy Ludtka at SMBC Nikko Securities America:

If today’s employment data falls short, and if inflation continues to decrease despite tariffs, a rate cut in July could be justified.

(Reiter)

Alternative Investments

Richard Ennis argues that having alternative investments in your portfolio is a significant mistake. This “you” extends beyond individual investors, applying even to sophisticated pension and endowment fund managers who, he believes, are undermining their returns by investing in hedge funds, private capital, real estate, venture capital, and similar options.

Ennis, who has a background that includes founding and selling his own institutional investment advisory firm and editing the Financial Analysts Journal, presents his viewpoint in a recent paper titled “The Demise of Alternative Investments.” He claims that while 35% of public pension funds and 65% of endowment funds are allocated to alternatives, this is largely due to conflicts of interest and poor incentives among fund managers and consultants, rather than genuine investment performance adjusted for risk. Over the past 15 years, the performance of alternatives has been disappointing.

His argument has two main points: assessing the high costs of alternatives, primarily by compiling existing research, and employing new statistical methods to establish a strong link between greater exposure to alternatives and worse investment outcomes.

To evaluate private asset costs, Ennis references research by Wayne Lim, which is based on a vast fee data database from an investment advisor. This work highlights discrepancies between gross and net internal rates of return for various alternative strategies. Here’s a table of Lim’s concerning findings:

The news for hedge funds is equally grim: research that Ennis cites indicates annual costs reaching more than 3% of assets.

The challenge lies in demonstrating whether the returns from alternatives justify the high costs. According to Ennis, reliable asset-class return data for institutional investors is scarce due to inconsistent and low-quality disclosure. The indices created to track alternative investment performance are often uninvestable, “hypothetical, and nebulous.” Ennis expressed surprise about the absence of standardized reporting protocols for both funds and managers, noting, “This is a major issue. No one is establishing standards. The CFA Institute has been quite disappointing in this area. There is simply no incentive to create the resource you’re describing.”

However, there are databases available that provide insight into overall pension performance and their exposure to various categories of alternatives. Ennis conducted a regression analysis on the returns associated with alternative exposure using two large databases, one for pension funds and one for endowment funds, from 2016 to mid-2024. He compared the cumulative results of the funds in these databases against a “market portfolio” of public indices with similar equity and bond compositions and volatility. The analysis found that pension funds underperform the market portfolio by nearly 1% annually, while endowments lag by over 2%.

This underperformance appears largely attributable to exposure to alternatives. Regression analysis indicated a statistically significant relationship where each additional percentage point of exposure to alternatives reduces annual performance by more than 7 basis points. Below is Ennis’ scatter plot, with each blue dot representing a pension fund and each green diamond, labeled one to five, indicating cohorts of endowments arranged by ascending size:

Ennis further analyzes the performance of funds based on their involvement with various types of alternative investments. Unfortunately, real estate is among the worst performers; he mentioned to me that funds often stick with it because “people are drawn to real estate investments. Consider Canary Wharf, Cadillac Fairview, etc. Real estate is something you can see and touch, and it can be quite appealing.”

So why do fund trustees and managers continue to trust alternative investment managers despite their poor recent performance? Chief investment officers and consultants often prefer to endorse intricate strategies to enhance their pay and appear savvy. They tend to choose their own benchmarks, leaning toward inadequate ones that make the unsatisfactory performance of alternatives seem more acceptable, Ennis contends.

Another possible reason might be that fund trustees and managers simply seek convenience. They often opt for money managers who can easily manage large investments, handle reporting and tax issues smoothly, don’t make major mistakes, and have a solid reputation and strong name recognition. Consequently, larger managers with advanced back-office systems and marketing teams tend to win the mandates. Since these prominent managers are savvy, they consistently push for high-fee products. In essence, the pension and endowment industry (like many others) can be quite lazy and resistant to change, defaulting to whatever large asset managers are eager to offer. However, this is mostly speculation on my part.

The most significant counterargument to Ennis’s view is that the past 15 years have been unusual in the markets. Riskier assets, especially large US shares, have seen massive increases. In this context, alternative investments, aimed at hedging, have been a drag on returns. If the market shifts back to a harsher environment, alts might demonstrate their worth once more.

I’m not entirely convinced. If Ennis’s data is at least mostly accurate, the recent negative impact of alts has been so significant that it would require exceptionally strong performance in the next market cycle to compensate for it. The proof now lies with alternative investment managers and their supporters within the pension and endowment sectors.

(Armstrong)

One good read

The boss.

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