Credibility Crisis
The Fed decided to leave rates unchanged last week. The
market seemingly received what was expected and longed for but sold off anyway.
Our opinion in last week’s post was that the Fed risked losing credibility by
not raising rates as the appearance that they were beholden to the stock market momentum. Indeed the news flow after the announcement focused on such
consequences.
Hawks, Doves and Chickens – Acting Man: “They are dead scared of being seen as
setting off a market crash, and they know of course that more than six years of
humungous money printing have achieved little besides blowing another bubble.
In fact, the real economy, though not yet in recession, looks decidedly lame.”
Why
the Fed couldn't raise rates – CNBC: “The
one factor that held that power was the recent volatility (read:
"selloff") in the stock prices. Simply put, the Fed still places far
too much importance on the stock market as a tool for priming the economic
pump.
The 10-percent selloff
in U.S. stocks, and the much greater selloffs in China and other emerging
markets, was THE factor that provided cover for the Fed's decision today. To
me, though, the capital-markets volatility we have seen in recent months
represents the downside to an ill-conceived policy of targeting stock prices as
a way to spur economic growth. The Fed's explicit strategy all along has been
to boost household wealth through stock and housing gains, hopefully causing a
trickle-down effect. Now, heavily committed to that strategy, the Fed believes
that if it moves to soon to tighten, it will risk reversing some of those
(perceived) hard-fought asset-price gains.”
What was really at
stake was repairing the Fed’s credibility in terms of successfully shaping US
monetary policy and sending a powerful signal that the US economy is in strong
shape.
The
Federal Reserve is losing credibility by not raising rates now - The Conversation: “Hoping to avoid previous bungled attempts to adjust monetary policy
in recent years that led to significant market volatility, this time the Fed
spent at least half of the year updating the language in its statements and
gradually preparing the world for a hike. And since it did not deliver, this
tells the world that the Fed is unable or unwilling to go against market
expectations. As a result, the central bank will have to either delay the
liftoff until the next meeting, slowly reshaping market expectations to be
consistent with a hike at that point, or risk a financial panic if it decides
on an unexpected policy shift sooner. Delaying the timing further would mean
losing precious time in normalizing monetary policy, necessary so that the Fed
again has the tools it needs to fight future economic downturns. There’s also
the increased risk that the economy will overheat and cause inflation to spiral
out of control. There is never a perfect time to start down this path; it is
always possible to find reasons to delay. But each postponement requires even
stronger data to justify an eventual liftoff the next time. The problem is that
with the hesitant Fed sending mixed signals to the economy, that imaginary
perfect day might not ever come.”
How
The Fed Lost Its Cred - Forbes: “The Federal Reserve bottled out Thursday
when it decided not to raise the short term cost of borrowing money. It’s
unfortunate, because the lack of action now removes any semblance of a fig leaf
it could hide behind and still claim credibility. “Clearly, the FED does not
even think it knows what it is doing,” writes Woody Dorsey of Market Semiotics.
That seems to sum it up in a nutshell.”
Why
Wall Street’s Stimulus Junkies Weren’t Thrilled by the Fed’s Rate Decision - The Fiscal Times: “Cutting to the quick: Investors, it seems, are losing confidence in
the Fed. While the Wall Street stimulus junkies should've been happy with the
continuation of the status quo, there is now a nagging fear that credibility in
central bankers is being lost — something that RBS' Head of Macro Credit
Research Alberto
Gallo took to Twitter this afternoon to reiterate. Moreover, the Summary of
Economic Projections by Fed officials revealed that, at the median,
policymakers now only expect a single rate hike by the end of 2015. The futures
market is now pricing in a 49 percent chance of a hike at the December meeting
(although Yellen noted that the October meeting was "live" and could
result in a hike should markets and economic data improve).
But the kicker — the
one that pushed large-cap stocks lower into the closing bell — was the
appearance of a negative interest rate projection by a Fed policymaker on the
newly released “dot plot.” Someone, it seems, expects federal funds policy rate
to be in negative territory at the end of 2016. Four officials don't expect any
hikes this year at all. Not only does this undermine confidence in the state of
the economy, but it calls into question the efficacy of the Fed's ultra-easy
monetary policy stance that has been in place, to varying degrees, since 2008.”
The
Truly Stupid Case For More ZIRP - David
Stockman’s Contra Corner: “There you
have it. The case for ease is that Wall Street prefers ease. Stated
differently, the Fed and other central banks have generated such an humungous
and incendiary bubble that they dare not risk puncturing it——even if it means
indefinitely perpetuating the absolute lunacy of ZIRP.”
“The Fed is sitting on
a powder keg. As my colleague, Lee Adler, noted the other day, the eruption of
Federal Reserve credit since the early 1990s, but especially since the
financial crisis, has inundated the banking system with excess reserves. To
wit, so called “required” reserves are in the range of $95 billion, but excess
reserves parked at the New York Fed amount to upwards of $2.6 trillion. So, as
shown below, the Fed’s massive credit emissions never left the canyons of Wall
Street.”
“Needless to say, this
enormous reservoir of money caused a rip roaring inflation, but it was in the
goods that Wall Street makes—-stocks and bonds—not the products and services
generated by the factories, shops and offices located on main street.”
Developments Abroad
It appears much of the market dismay was rooted in a
specific passage within the Fed’s policy
press release. They go on to say (Emphasis added), “Recent global economic and financial developments may restrain economic
activity somewhat and are likely to put further downward pressure on
inflation in the near term. Nonetheless, the Committee expects that, with
appropriate policy accommodation, economic activity will expand at a moderate
pace, with labor market indicators continuing to move toward levels the
Committee judges consistent with its dual mandate. The Committee continues to
see the risks to the outlook for economic activity and the labor market as
nearly balanced but is monitoring developments
abroad.”
Many market participants read this to mean the Fed is
watching what is unfolding in the Chinese economy as a determinant for raising
rates. So the question begs, if the Fed has pushed “liftoff” out into October
or December, what is going to happen in China over the next several weeks to
appease their concerns.
I am not an expert in the Chinese economy. I have never been
there nor invest directly (I’ve bought a China ETF in the past). What I can say
from my readings on the topic is that it appears the Chinese economy is going
through a significant metamorphosis as it transforms itself from a manufacturing
based economy to a service based one. John Mauldin from Mauldin
Economics has views on China that I continually reference. He writes, “The China of today is not your father’s
China. Fifty percent of the economy is now services. That part of the economy
is growing – and evidently growing enough to offset the contraction in the
manufacturing sector. And we must remember that China actually added twice as
much to its GDP in either dollar or yuan terms in the past year than it did in
2003 when its growth was a “miracle.” That helps to put their reduced growth in
context. As I have pointed out, the law of large numbers requires that their
growth will be slower in percentage terms in future years.”
“The transition from
an investment-driven export economy to a consumption-driven service economy
will take years. Further, it won’t be easy for those on the industrial side of
the house. While it may be hard to believe, over the years China has lost more
steelworkers than the US and Europe have. They overbuilt steel mills. It seemed
that every province wanted its own mills, and their production capacity just
grew too large. It likely still is too large.”
“As Worth Wray and I
wrote in A Great Leap Forward?, China is engaged in a transition from which it
cannot turn back. Well over a billion Chinese are in various stages of joining
the modern world. Our planet has never seen anything like this, so it’s no
surprise that the process is rocky. The transition will continue regardless,
because China has no other option.”
So China is going
through a massive economic transition and it needs to resolve itself before the
next Fed committee meeting. Yes that is a ridiculous statement but it puts
into perspective the economic challenges that are likely to get worse before
they get better.
So when the Fed says its monitoring developments abroad over
the next few weeks to assist in the monetary policy decision making process
they appear to be talking about the stock market. Once again this is a
credibility issue. John Mauldin also writes, “It’s easy to assume that a country’s stock market reflects the
condition of its economy, but that is not always the case. Further, what the
stock market really does reflect is the consensus estimate of an economy’s
future condition. More specifically, stock prices reveal future expectations
for corporate profits.
This generally applies
to both the United States and China. One key difference, though, is that most
American stocks represent companies that seek to make profits. In China, that
isn’t necessarily the case. The Chinese stock market includes many state-owned
enterprises (SOEs), whose executives answer to bureaucrats in Beijing. The
government views them as public policy tools. Everyone is happy if the SOEs
make a profit, but profit is not the first priority. If US stock prices
generally tell us more about the future than the present, except in times of
serious over- or undervaluation, then Chinese stock prices tell us even less
about either. Just as last year’s incredible run-up in Chinese stocks did not
signal an economic boom, the ongoing decline does not signal an economic bust.
The correlations aren’t just weak, they are nonexistent.”
Yellen Resistance
The global economy appears to be struggling. Corporate
revenues and profits in the U.S. are shrinking year-over-year. Stock volatility
is the highest it has been in years and the long-term market technicals are on
the verge of breaking. Fiscal policy is a mess as always with another threat of
a government shutdown on the horizon. And now the Fed has come out and told us
that as soon as the stock market gains some traction, they’re going to smack it
down by raising interest rates. How can anyone be excited about owning
equities at this point?
As Chairman Bernanke provided support for equity markets in
the past, it seems Chairman Yellen has just supplied Fed resistance for the market. After digesting the information for
a day or two, it finally is clear to me why the market sold off the way it did
when seemingly getting exactly what was wanted and expected. I could be wrong,
certainly much of the macroeconomic complexity is above my pay grade but one
can’t deny such curious action.
Something Is Wrong
Here
As per the Fed’s dual mandate they are acting now to govern
full employment that is expected during times of swelling economic growth and
contain inflation from wage pressures from a robust labor market that is sure
to follow. We’re told this is right around the corner. The only issue is that
economic growth is anemic (especially as the global economy slows) and
excessive inflation seems non-existent (especially as the global economy slows).
Take a look at these graphics from Bloomberg
and make note of the trend over the past several years.
We face a problem of slowing global economics. Declining
demand for goods has impacted the commodity space and emerging markets
significantly thus the spiral continues. This along with the stronger U.S.
dollar has created an inflation dynamic that appears to be truly hindering the
task at hand for the Fed. I read this article in The Economist
that summarized the situation fairly thoroughly. “The challenge for the Fed is as follows. Many have interpreted Ms
Yellen’s focus on the labour market as a signal that once slack is gone, rates
will rise. This follows from a conventional model of the economy that says a
tight labour market leads to inflation later on, as firms bid up wages and then
raise prices to offset the cost. So strong has Ms Yellen’s emphasis on the
labour market been that some analysts thought August’s jobs numbers were all
that mattered for today’s decision. But the world economy is throwing a spanner
in the works of this model. In the committee’s median forecast, inflation does
not return to target until the end of 2018, despite three years of
near-equilibrium unemployment.
If the world economy
continues to weaken, the Fed will need an ever-tighter domestic labour market
to meet its 2% inflation goal. Ms Yellen
would then find herself demanding “further improvement” in the labour market
every month, even in the face of repeatedly strong labour market data. That
would be a confusing message for markets, especially if unemployment falls
beneath the Fed’s own estimate of its long-run sustainable rate and broad
measures of underemployment fall further.
Ms Yellen’s focus on
the labour market, then, does not mean that the Fed is ignoring the world
economy. Quite the opposite; the gloomier the world outlook, the stronger the
labour market must perform to justify a rate rise. In the coming months,
markets should look to the world, as well as the jobs data, to predict when
interest rates will, at last, take off.”
If deflation becomes a key import for the U.S. then the Fed’s
job will get even more difficult. In this piece by Ozy,
““We are only one misstep from outright
deflation in the West,” says Edwards, noting that the core level of inflation,
which excludes food and energy, is around 1 percent in the U.S. and the
eurozone, which is considered very low. He foresees more devaluations sending
“waves of deflation to the West to overwhelm already struggling corporate
profitability.” Edwards’ colleague, Robbert van Batenburg, a market strategist
at SocGen, says, “There are many who believe this is just the beginning of the
devaluation [by China.]” Or put another way, more devaluations will send more
waves of cheaper goods raising the risks of deflation.
Why is this such a
concern? After all, falling prices mean cheaper goods, right? (Also, put aside
whether the government inflation statistics are a precise measure of this
phenomenon.) Cheaper goods are great for consumers, but not for corporations
that might have borrowed. Falling prices result in lower revenue, yet the debt
companies owe stays the same. Likewise, the mortgage on your home doesn’t get
reduced just because your salary dropped. In fact, it’s probably fair to say
that many workers may already feel that their pay hasn’t kept up with the cost
of living since the financial crisis — a form of relative wage deflation.”
What The Markets Will
Tell Us
The market as a whole are at times more intelligence than
its participants. All I can do is humbly attempt to interpret the battery of
information that is provided. As earnings season wraps up and we now enter the
pre-announcement season, we are seeing cracks in the corporate earnings picture
as it relates to economically sensitive companies. Consider FedEx, certainly a gauge for sensitivity
changes in the global economic outlook. They reported lower than expected
earnings and lowered annual guidance citing slower demand for global freight services
as one of the reasons. Caterpillar, another economically sensitive company met
earnings expectations but missed revenue projections and guided lower going
forward, also citing slower global economic growth and the deteriorating
commodities sector. Pepsi, John Deere and Microsoft have all expressed concerns
about the slowing global economic picture. The nuggets of information from
these earnings reports are priceless but glum and should be ignored at one’s
portfolio peril.
It shows that leading into the Fed announcement the best
performing sectors included Utilities, Consumer Staples and Health Care. The
worst performing sectors included Materials, Financials and Industrials. This
is discouraging for me because I would expect the exact opposite heading into a
perceived Fed rate hike. A Fed hike should indicate strong economic growth,
wage pressures, potential inflation and accelerating corporate fundamentals. To
have utilities outperforming and financials underperforming heading into the
Fed hike is just unusual for me. The market is telling us something is not
right.
Even though the market was expecting the Fed to remain on
hold, the market action last week exhibited perplexing price action. Treasuries
and Gold moved higher on the announcement (safe haven instruments). Global stocks
sold off but utilities and REITS held firm. Not the type of action one would
expect to see in an economically strong situation and certainly not the place
investors would be expected to move money in the face of rising interest rates.
One of the hardest hit sectors was the financials. Banks and insurers sold off
and isn’t exactly what an investor would expect in the face of rising interest
rates. Something is out of order. A continuation of this pattern could spell
serious problems on the horizon.
Yield spreads are also indicating fixed income investors may
be anticipating something equity investors are not. We pointed out in the past
that yield spreads and the stock market have been diverging since the start of
the year. That gap has closed somewhat given the recent market weakness but the
spreads are still tilting toward additional downside.
The lumber-to-gold ratio that we track has been trending
lower since the start of the year as is the copper-to-gold and steel-to-gold
ratio. By comparing these construction materials to a safe haven instrument can
provide economic insight and market directional indications.
These market signals are concerning in our view and are
worth watching. While we continue to believe that this is a moment of
correction for the stock market and not a bear market that opinion can change
with changes in the underlying analysis. In a blog
post a few weeks ago, we noted that we will need to see the yield curve for
the two and ten year flatten significantly (or invert) in order for us to be
swayed closer to the bear market camp.
So what’s Next?
We have been very fortunate thus far navigating the market.
We inserted portfolio protection and built short positions prior to the crash of
2015 (see Time
to Consider Portfolio Protection 8/9/15). We covered of short positions in anticipation
of a bounce in the market and took long positions for our more risk tolerant
investors (How
We Position Ourselves From Here 8/23/15). In the note we wrote we were
looking for a rebound in the S&P 500 to a level between our lower bound 2020
and upper bound 2070. We took off our long positions upon the Fed announcement
(SPX briefly hit 2020) and we now expect additional downside from here.
From StockCharts.com,
“The "rising wedge" pattern in
Chart 2 strongly suggests that the short-term rebound in the S&P 500 has
ended. A "rising wedge" is identified by two rising trendlines that
also converge. A break of the lower line would confirm that the bounce has
ended. The volume pattern (below chart) confirms that negative view. Volume was
light during the price rebound, before turning higher on Thursday and Friday as
prices fell. Although some of Friday's volume can be attributed to the
expiration of futures and options, it was still the third heaviest trading day
of the year. That suggests a lot of selling. It also suggests that a retest of
the August low is likely.”
“My September 2
message addressed the question about whether the market is in a normal
correction or something more serious. We'll find out soon enough. I've leaned
toward the correction view (a drop of 10-15%), but a lot of longer-term
indicators suggest a more serious decline (20% or more). The only way we'll know
for sure is whether or not previous support levels hold. The daily bars in
Chart 3 put the recent stock rebound in better perspective. Thursday's downside
reversal day in the S&P 500 took place just shy of the 62% retracement
line. (The Dow bounce ended closer to the 50% line). Those are normal spots for
a counter-trend bounce to end. The SPX also fell short of its 50-day average.
The 50-day also remains below the 200-day line which is a negative sign. The
normal expectation is for a retest of the August low which means a loss of -12%
from its May high. A drop to more important support at last October's low near
1820 would constitute a loss of -15% from its May high which is still
correction territory. But that low has to hold if this is just a correction.
The month of October is also very important. My August 26 message studied three
previous downturns in 1987, 1998, and 2011. All required a retest of the first
low before turning back up again. And all three bottoms took place during
October. All we can say with some degree of confidence at this point is that
prices are probably headed lower in the weeks ahead, most likely into October.
How much lower will depend on whether or not previous lows hold. In the
meantime, a very cautious stance is still warranted.”
Bottom Line: We have
stated in the past that we would use a near-term bounce to close specific long
investments. We have done that and will be using near-term overbought situations
to take advantage of what we believe is a downward bias in the stock market. We
believe this is a correction within the bull market currently and expect the
market to bottom sometime in early 4Q15 before resuming an uptrend. Should the
economic picture continue to deteriorate our view may shift to a more bear
market investment thesis. We will be watching for clues.
Joseph S. Kalinowski, CFA
Additional Reading
Lots of
Things Ray Dalio Knows he Knows – Pragmatic Capitalism
X-factor
Report – Street Talk with Lance Roberts
Dangers
Facing Stocks – Barron’s
Occam’s
razor says the stock market is in a downtrend – Market Watch
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