Suffering Liquidity Withdrawal Syndrome, Market Gets Its Fix


January 8, 2019 [Powell Put, Federal Reserve, Quantitative Tightening]
Charles Roth

It appears the “Powell Put” has been exercised as the Fed chief declares no “pre-set” course on rates and no “hesitation” to change its balance sheet runoff. But does the economy still need Fed accommodation, or do markets just want it?


U.S. stocks suffered intense withdrawal symptoms in the last quarter of 2018 as the U.S. Federal Reserve signaled slow, if steady, retraction of easy money highs. But it only took a few dovish words from Fed Chairman Jerome Powell on the heels of a stellar December unemployment report to resuscitate the stock market and reverse the swoon in 10-year Treasury yields.

It’s hard to wean markets off monetary injections, even when economic fundamentals indicate the economy no longer needs central bank elixirs to stand on its own. Indeed, the Fed sent shivers through markets when it lifted its key rate a quarter point on Dec. 19, but Powell then sent them into convulsions after implying in post-meeting remarks that the Fed’s balance sheet reduction program is on autopilot. The MSCI USA Index crumpled nearly 9% over the following week.

Was the equity market hysteria at the prospect of decreasing central bank liquidity reasonable? Perhaps not. As Thornburg President and portfolio manager Jason Brady pointed out, the Fed has effectively met its dual-mandate for sustainably low unemployment and inflation around 2%. While “Quantitative Tightening” and Federal funds rate hikes are happening concurrently, he added, “investors should keep in mind U.S. economic conditions remain quite strong.” Real GDP is growing in the U.S. and abroad at good clips, with inflation hovering not far from target.



Country/Region 2017 2018 2019 2020
  U.S. 2.2% 2.9% 2.6% 1.9%
  China 7.3% 6.6% 6.2% 6.0%
  European Union 2.5% 2.0% 1.8% 1.7%
  Emerging Markets 4.9% 5.0% 4.9% 5.0%

Source: Bloomberg; 2019 and 2020 are consensus forecasts


Country/Region 2017 2018 2019 2020
  U.S. 2.1% 2.4% 2.6% 2.2%
  China 1.6% 2.2% 2.3% 2.3%
  European Union 1.8% 1.9% 1.8% 1.8%
  Emerging Markets 3.4% 3.7% 3.7% 3.5%

Source: Bloomberg; 2019 and 2020 are consensus forecasts

Nonetheless, many pundits pounded the table, accusing the Fed of ignoring asset price signals that they say suggest a U.S. recession might be in the offing. On Christmas Eve, President Trump also chimed in via Twitter: “The only problem our economy has is the Fed. They don’t have a feel for the Market, they don’t understand necessary Trade Wars or Strong Dollars or even Democrat Shutdowns over Borders. The Fed is like a powerful golfer who can’t score because he has no touch – he can’t putt!”

But the Fed can exercise a put, or put option, as the market colloquially refers to Fed reopening the monetary spigot in reaction to market tantrums. Many observers had wondered whether, as with his immediate three predecessors, there would be a perceived “Powell Put.” It appears to have materialized on Jan. 4, the same day that December’s unemployment data were published. The labor market report could hardly have painted a better picture of economic health.

U.S. employers added 312,000 jobs in December, and the Labor Department revised up the previous two months by 58,000. Nearly 420,000 people returned to the labor force, lifting the unemployment rate to 3.9% from 3.7%, positively reflecting that sidelined workers are reentering the labor force. Wages might have been the brightest spot, though, as average hourly earnings rose 3.2% over the last year, the fastest pace in a decade.

Despite the excellent labor data, Powell clearly felt compelled to mollify stimulus-seeking markets. The Fed isn’t on a “pre-set” course to raise benchmark rates, he said, adding that it will be prepared to “adjust policy quickly and flexibly and use all our tools to support the economy.” On the Fed’s balance sheet reduction, he made clear the monetary authority won’t “hesitate to make a change” if it concludes the program is driving financial instability.

Equity markets have since perked up on the view that the Fed is likely to pause its rate tightening at least through mid-2019 and may not even bag the two hikes it had flagged in its December meeting, representing a cut from a projected three beforehand. Were the markets correct in signaling economic weakness ahead, or simply agitating for the Fed to support asset prices?

It’s hard to say. But as Jefferies chief market strategist David Zervos points out, short rates have risen 250 basis points over the last three years; the Fed’s balance sheet has already shrunk $500 billion; and before Powell’s Jan. 4 walk-back of the “autopilot” faux pas, the market had been pricing in another $600 billion this year. Throw in swelling corporate credit and Libor/OIS spreads, and total system monetary tightening runs anywhere from 300bps to 400bps, Zervos reckons. That could tip some apple carts.

On the other hand, the Chicago Fed’s National Financial Conditions Index ended 2018 at -0.70, well below the average value of zero, indicating that financial conditions are still looser than average. Moreover, as Berkshire Hathaway’s Charlie Munger noted at his firm’s 2018 shareholder meeting, the purpose for slashing rates to rock-bottom levels and keeping them there for nearly a decade was to fight the Great Recession. It was needed to help the economy at the time, but since then such low rates have hurt people with savings accounts but few financial assets. “It benefited the people in this room enormously, because it drove asset prices up,” he said. “We’re all a bunch of undeserving people.”

Like his partner, Warren Buffett, Munger is an acolyte of Ben Graham, the grand-daddy of value investing. One of Graham’s famous maxims is particularly germane today: “In the short run the market is a voting machine, but in the long run it is a weighing machine.” By “voting” Graham was alluding to the popularity of individual stocks among fickle and short-sighted market participants at any given time. In contrast, more astute longer-term investors who accurately “weigh” the current value of a company’s projected earnings growth and detect a stronger share price down the road should do better.

We agree, we don’t see U.S. and global economic growth falling off a cliff, or expected earnings growth tanking near term. To be sure, forward earnings-per-share levels have tapered off or moderated a bit lately, but in most cases, they remain higher versus a year ago. Couple still good forward earnings expectations with last year’s global selloff, and regional equity markets the world over have become quite a bit more attractive than they were a year ago.

NEXT 12 MONTHS' EPS, Indexed to 100 (based on consensus estimates)

Source: Bloomberg

Next 12-Months' Price-to-Earnings Ratio (based on consensus estimates)

Source: Bloomberg

“Index earnings are one thing, market sentiment another, and valuations the integral third,” we noted in our Outlook. “Portfolios populated with select securities offering attractive risk/reward propositions in both the credit and equity worlds have the most potential to limit their downside volatility and participate in market upturns, compounding off a higher base over market cycles.”

Investors in good businesses with strong earnings growth and trading at compelling valuations in a goldilocks economic environment really shouldn’t need the Fed to “drive asset prices up.”

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