Here We Go Again
“Whenever you find yourself on the side of the majority, it is time to pause and reflect.”
Stocks and bonds have once again succumbed to the uncertainty of Federal Reserve interest rate policy. On cue, the Fed watchers have come out in force to question and criticize the unknown outcome of the Fed September FOMC Meeting scheduled for next week. Prior to the meeting and the quiet period, which began on Tuesday 9/13, Fed FOMC members hit the road expressing their opinion on a potential 1/4 point rate increase. As has been the case before, the opinions vary and in the end only add confusion to the potential outcome. Enter the Traders. With the stock market near all-time highs and bond yields at the low-end of the 2016 range, any prospect of a September rate rise results in increased volatility and a short-term selloff. Last week the volatility index (VIX) was below 12 and has risen to over 18 in three trading sessions. Over this period stocks, measured by the S&P 500, have fallen 2.3% and the 10-Year Treasury yield has risen from 1.53% to 1.73%. Rising volatility is the preferred trading environment for hedge funds and algorithmic traders who comprise up to 80% of volume under these conditions.
Three Card Monte is a card scam found in cities where the dealer challenges any passerby (the Mark) to choose the red suit card from two black suit cards. The slight of hand of the dealer makes it virtually impossible to choose the red suit card. This is a generalized description of the street game, but for most Fed watchers, the prospect of determining Fed interest rate policy yields a similar wrong choice. This has been ongoing since the taper ended in October 2014. Drawn by Fedspeak the Mark (the economists and strategists) have almost universally been wrong on future Fed policy. But unlike the passerby in Three Card Monte, the Fed watcher refuses to walk away and with increasingly sophisticated models, double-down on their bets. In financial markets, despite serial miscalculations, they continue to reset and trade on erroneous conclusions.
Many Fed watchers believe that a benign 1/4 point increase is a policy mistake and highly risky, even at these near zero levels. From late-October 2014 it took until December 2015 to start the tightening cycle with the first and so-far last 1/4 point Fed Fund rise. Handicapping before and after the Fed meetings has become a full-time profession doomed to failure over this 18-month period. The market verdict is that it will be very difficult for the Fed to embark on a policy of steadily rising rates. Although the August employment number, at 151,000 was below the assumed Fed minimum number, it was strong enough to support a rate increase. The 1.0% increase in 1H2016 Real GDP was less than the targeted minimum, however, 3Q2016 growth is tracking slightly over 3.0%. Core inflation is rising slowly but still below the 2.0% level. Wages have begun to move up but based on “data dependent” criteria, September seems to be a no-go. But, there are no disruptions overseas, although implementation of Brexit is yet to happen, and both bond and currency markets remain stable. While the outlook for the economy remains slow growth, a 1/4 point move may not be a policy mistake and definitely not precipitate dire consequences forecast by traders. It might be time to tweak the data dependent criteria.
Longer term rates will increase, but as Ben Bernanke has stated, “The Fed cannot do it alone.” The regulatory response to the financial crisis has limited financial intermediation by reducing risk-taking and leverage at the same time restricting economic growth. Fiscal stimulus has been absent, the victim of partisan politics and now dependent on the outcome of the election. Though hard to digest, we are still in the aftermath of the financial crisis. Deleveraging of household debt (Compass 8/29/2016) is almost finished but credit demand and wage growth are below historical levels. Housing is recovering but nationally prices remain about 10% lower than the pre-crisis peak. Productivity, or output per hour, has been negative for four consecutive quarters (2Q2015-2Q2016). This is a result of increasing labor costs and the effects of lower capital expenditures. With the move to normalization will prove to be the tonic to rid the addiction to record-low interest rates. A slow-but-steady increase in rates will increase the value of the dollar and may marginally impact the earnings recovery anticipated in 2017. As employment costs rise and margins become squeezed, companies will shift away from stock buybacks and bring dividend increases in line with earnings, thereby freeing funds for investment in productive resources, i.e., increased capital spending.
Our investment policy remains optimistic and favors a strategy based on slow economic growth and improving 2017 quarterly earnings. As long-term investors the repetition of these current conditions can be unnerving and result in second guessing a portfolio’s structure. However, over the past year these selloffs, whether from Fed policy uncertainty, falling oil prices, China’s slowdown, a rising US dollar, and more recently Brexit, have all provided a buying opportunity. During the downturns, our investment policy was cautious and to sit back and wait, turning optimistic after Brexit. Many of the problems which surfaced in 2015 have lessened or are gone. The S&P 500 as of this writing is 17.7% above its February 2016 lows. Oil, which is drawing attention again, is still 70% above its bottom, also in February. China’s economy has improved, along with many developing market economies and the US dollar has stabilized. Only Brexit remains alive, as the withdrawal process from the EU has yet to be put in motion. Additionally, after four quarters of lower earnings, a bottom appears to have been reached.
The transition into a more consumer-oriented economy is on schedule, but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap consumer and technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends. We would avoid companies deriving substantial revenues from Europe until the currency translation become favorable.