The Fed’s "Financial Conditions" Conundrum

 

April 3, 2019 [Bond Funds, ECONOMIC GROWTH, Equity Funds, Federal Reserve, Global Economy]
Jason Brady, CFA


Just because the market is celebrating the Fed’s policy u-turn doesn’t mean volatility is a thing of the past. Disconnects between fundamentals and assets prices don’t make for market stability.

 

Spectacular first-quarter market returns are quite a bounce back from the December 26 lows, when all anyone could think of was fleeing risk exposures. Many markets saw their best quarter in a decade. We’re back!

Not so fast. Both markets and the U.S. Federal Reserve face a multifaceted conundrum: Where exactly are we in the economic cycle? How can we be late cycle but also still have room to grow? Ex-energy, have we reached inflation targets, or is deflation still the concern? Is the labor market tight, as former Fed Chairwoman Janet Yellen recently said, or is there still significant slack, as a number of current Fed officials have also asserted. Significant excesses have built up, including corporate leverage and re-compressed yields amid renewed investor risk appetite. After the fourth-quarter selloff and first-quarter rebound, should investors now expect less market volatility, or more?

Feast or Famine

Toward the end of her tenure, Yellen called out the market excesses, but they haven’t become less spicy since current Fed Chairman Jerome Powell took the monetary helm 14 months ago. To be sure, risk markets suffered plenty of indigestion after the Fed hiked its target rate four times in 2018 and gradually shrank its still-bloated balance sheet. But since Powell’s end-2018 policy u-turn, the Fed’s focus now appears trained more on ebbing, albeit still decent, global growth and especially “financial conditions,” which nowadays is to say equity markets.

Investors would do well to examine the fundamentals of each security and place them in the context of the value offered. Aim to buy when prices are lower, not when they are higher. Prices are now higher not because earnings are better or because growth is terrific, but because monetary policymakers seem like they are done hiking. So, while U.S. blue-chip earnings rose last year, and price/earnings ratios declined, that dynamic has flipped so far this year. Too often the market takes the latest Fed signal and extrapolates that out to the long run. That’s why we’re skeptical about the Fed’s abrupt about-face, which engendered a great hope the still-accommodative stance will continue in the face of above-trend growth.

No Imminent Doom, But Minsky Moment Looms

The Fed’s liquidity injections—not to mention those of the European Central Bank, the Bank of Japan and the People’s Bank of China (PBOC)—have fended off some problems. But they are not going to lead to higher growth in the long run if we cannot push credit creation further, a challenge when debt levels are generally running higher and higher globally. Monetary stimulus has become less and less effective. Global growth is slowing because credit creation has driven it about as far as it can in the context of the cycle. Typically, when the Fed is finished hiking, there is a relief rally. But because its hiking generally indicates the close of an economic cycle, it’s not good news.

So what now? We cleared the decks a bit in 2015-16 and were able to extend the cycle as commodity-centric investment faltered. And indeed, the 2008 and 2015-16 challenges were both met by central bank accommodation, principally the Fed and PBOC. But we have run that play too many times, and valuations are not likely to provide a cushion, either in equities or fixed income. When rates rose in 2018, it caused risk assets to falter because we are dependent on ever-lower interest costs with debt burdens of corporations and governments now quite high. Certainly moving the U.S. 10-year Treasury yield down 80 basis points helps, but most of the world is at the zero lower bound. Curves are flat or inverted not because there is imminent doom, but because markets effectively expect the trajectory of medium-term rates to be lower to deal with a downturn. Ultimately this cycle will not die of old age. It will die because we have borrowed and pulled forward growth, and inevitably that creates conditions for “Minsky Moment” instability.

Markets adjusting to better reflect current fundamentals and future prospects shouldn’t be cause for Fed capitulation amid above-trend growth. Nor should investors want rising valuations from easy money, absent improving fundamentals. Spotting the difference is crucial for successful investing.

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