Forecasting Fed activity is a national pastime only surpassed in popularity by Fantasy Football. Over the last 25 plus years, I have written many times about the Fed, their objectives, the factors which would likely influence their decisions and my forecast for their next move. Unfortunately, virtually none of this analysis has earned excess equity returns for my clients. It’s almost pointless. Like economists, professional Fed watchers only deserve fame and fortune if they have a mechanism which can directly impact the wealth of investors. Since they don’t, they shouldn’t. Investment managers, conversely, can directly impact the wealth of their customers on a daily basis by selecting potentially superior assets or securities and that’s where I spend the bulk of my energy. Fortunately that focus seems to have paid off for clients this year as our ability to pick stocks has dramatically helped more than our ability to articulate market color or prognosticate the next Fed hike.
With that said however…
I believe the Fed is behind the curve in its attempt to neutralize monetary policy. In July, my comments entitled “Traffic Lights and Stop Signs” summarized the last six years of QE, how it was successful up to that point and the rationale for moving to a new policy. Now “Monetary Neutralization” — which I advocate — should be clearly distinguished from “Monetary Tightening.” Tightening is the act of raising short term interest rates to a level which discourages borrowing and investment. It’s simple. If the borrowing rate exceeds your likely return on investment, you don’t borrow. Neutralization, on the other hand, moves rates from their extraordinary low levels — negative real interest rates — to a level which is neither accommodative nor restrictive AND reduces the size of the Fed’s bloated balance sheet. The most recent expansion of the Fed’s balance sheet to $4.2 trillion represents an increase in both assets such as Treasuries and mortgage backed securities AND in liabilities like $2.6 trillion in excess reserves. In a positively sloping interest rate environment, the U.S. Treasury has been the fortunate beneficiary of the arbitrage of high interest earned which is greater than the +0.25% paid on reserves. If inflation moves up rapidly or U.S. credit deteriorates, the arbitrage could reverse. While I don’t see rampant inflation in the near future, shouldn’t the Fed safely scale back its liabilities? The unwinding of junk bonds earlier this year and its progression to high grades currently should serve as a warning that leveraged buyers do not always control their refinance options. Now’s the time to “Rip Off the Band Aid!” — for risk management purposes, if for nothing else.
Just the Tail
Are we no longer the center of the economic universe? Post September’s Fed meeting, it certainly doesn’t feel that way. According to Janet Yellen, China’s economic deceleration is so pronounced that Fed neutralization as described above has been put on hold. It is now unclear if our monetary policy has a broader objective than just U.S. full employment and contained inflation or if the Fed perceives the China slowdown as a source of not-yet-seen collateral damage to our economy. Honestly, the U.S. is becoming just the tail of the dog in the global economy. BCA Research reports* that Emerging Market (EM) plus China imports are, in fact, greater than the combined imports of U.S. plus Europe. While the U.S. may not fall into recession from the slowdown in EM/China imports — as it has little exposure to these areas — the Fed is beginning to recognize a decline in the dog’s health and its material impact on global economic and earnings growth. Although U.S. and European consumption continues to support solid annual import growth, now between 4 to 5%, this is not enough to overcome EM/China weakness as U.S. export growth has declined 3.2% and global exports are on the verge of contracting year over year.
Equity markets hit a sharp skid this quarter on the back of slowing EM/Chinese economies, devaluation of the yuan, declining U.S. earnings and revenues and flip-flopping Fed policy. Declines corresponded to historical measures of risk — S&P 500 declined about 6.5%, large cap international foreign stocks fell about 10% and broad international indices and the Russell 2000 both declined 12%. Chinese stocks fell about 22% on slower economic expectations and an abrupt 2% yuan devaluation by the People’s Bank of China (PBOC) designed to aid their export driven economy. Despite strong GDP growth, overall U.S. sales and earnings both declined year over year in the second quarter. Recently, Goldman Sachs reduced its 2015 S&P 500 earnings per share estimate to $109 or down 3% from 2014. While the decline in energy prices has driven a substantial portion of the earnings shortfall, weak results and expectations have leaked over into the dollar-sensitive Materials and Industrial sectors as well. Old economic theory concluded that oil price declines helped U.S. economic growth, but in a now virtually energy import/export neutral economy, capital expenditure shortfalls may be overwhelming consumer gains. As Yogi Berra said, “In theory there is no difference between theory and practice. In practice there is.”
*Emerging Markets Strategy, BCA Research, September 30, 2015, “How Important Is EM/China To Global Trade.
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