Investing against a hawkish Fed
Last week stock markets briefly celebrated the US midterm election results, rallying sharply on prospects for a better balance of power in Washington. But from an investment perspective, the most important political appointment had already occurred several months earlier: Trump's selection of Powell as Federal Reserve chairman — a decision he has come to regret.
As if to make a point, the Federal Reserve Open Market Committee minutes released last Thursday flipped the election-fuelled rally and stocks have been heading lower since. According to the minutes, the Fed still does not acknowledge mixed American economic data, volatile markets and an escalating trade war with China. Although it was more of a footnote, the committee did conclude that “business fixed income investment had moderated from its rapid pace earlier in the year”.
Trump last month called Jerome Powell, the Fed chairman, “crazy” for raising interest rates in October. Later, during an interview with the Wall Street Journal, the President escalated his attack, essentially saying he was sorry for nominating Powell. Such theatrics are not unusual for Trump, but in this case, he may not have been too far off the mark.
Throughout history, the Fed has consistently overshot monetary policy initiatives and in many cases created problematic outcomes running far afoul to the agency's implicit responsibility of stabilising the economy. Alan Greenspan, a former Fed chairman, made headlines with his “irrational exuberance” comment in 1999. He used the excuse of a single high-flying stock sector to raise rates in late 90s and into 2000, sending America into the 2001 recession.
Later, Greenspan sowed the seeds of the subsequent real estate bubble by lowering interest rates to almost nothing. He was a tough act to follow, but the next Fed chairman, Ben Bernanke, continued a string of 17 successive rate increases, effectively tipping the economy into the gruelling 2009 recession — close to the worst one ever.
At the moment, incoming economic data is decidedly mixed. US growth looks okay thanks to a massive tax cut, but the rest of world is slowing down. The International Monetary Fund lowered its global growth outlook in October for the first time in over two years. About 43 per cent of large US company revenues come from other countries.
Employment may appear on track using the unemployment rate as a benchmark, but the US labour force participation rate, a more comprehensive measure, remains stuck near a 20-year low. Wage growth of barely 3 per cent hardly implies a massive worker shortage. Consumer confidence is high, but housing starts have fallen about 10 per cent this year. ISM manufacturing surveys are strong, but the stock market has suffered two severe corrections this year and volatility is on the rise.
I find it curious how the Fed rarely comments on stock market performance — often a good predictor of future economic growth. Perhaps this is because government employees enjoy the unique privilege of having “defined benefit” retirement plans which do not depend on the markets? In sharp contrast, most US citizens rely on “defined contribution” or 401k-type plans benefits as is true for most Bermudian-based employees working in the private sector. These retirement benefits require market performance.
The Fed began raising the benchmark Federal Funds interest rate in late 2015 and has since hiked a total of eight times. From essentially zero, the Fed Funds rate now stands at 2.25 per cent, the highest since March 2008.
In addition to the rate hikes, the Fed has been reducing its balance sheet in a process known as quantitative tightening, or QT. This Fed began unwinding positions in mortgages and Treasury securities at a nominal rate of $10 billion per month, but has now ramped up to $50 billion per month. Less noted is that the M2 money supply growth has decreased from 7.1 per cent to 3.9 per cent since the beginning of the year. All these initiatives are considered “tightening” measures designed to slow growth.
The scary thing about this Fed is its apparent unwillingness to consider new data. For example, Trump's escalating trade war with China while simultaneously alienating America's other long-term partners seems to carry little weight in policy decisions. Janet Yellen, one of few level-headed chairpersons in recent decades, would almost certainly have taken a more nuanced approach. Currently, no other developed country is being as anywhere near as aggressive as the US. The UK, for example, has increased its base interest rate only once in the past two years and Europe not at all.
A recent issue of The Economist magazine featured a caricature of Trump on the cover sitting atop a wrecking ball ostensibly swinging across the global economic landscape wreaking havoc. Perhaps this picture should have included Mr Powell. Certainly, the latest stock market mini-crash could be attributed to him and his comments about rising interest rates which he said “..may go past neutral. But we're a long way from neutral at this point.”
In general, rising interest rates negatively impact bond prices, stock prices, economic growth and real estate values.
A well-kept secret is that a disproportionate number of arson fires are, if fact, caused by firefighters. According to a report by Homeland Security, up to 100 arsons are committed each year by firefighters. The study concluded the predominant motive was to be seen as heroes when they later extinguished the flames.
While it might be hard to imagine the Federal Reserve sliding down such a slippery slope, history clearly supports the notion. Veteran hedge fund manager Steve Einhorn, recently stated: “Bull markets do not die of old age, they are murdered by the Federal Reserve.”
The good news for investors is that cash and short-term bonds are paying a more reasonable rate of interest and provide a place to ride out the political storms. After a decade of yield starvation, investors can finally earn a positive return on safe assets. As I have said before in this column, having some cash during this time is a good strategy.
Equity investors can buy selectively but need to be more patient. Cyclical sectors such as autos, home builders and semiconductors are trading at prices which assume an imminent recession, or at least a slowdown.
For example, home building stocks are down about 25 per cent since January and semiconductor stocks are trading at seven-year lows on forward earnings. If the Fed can somehow come to its senses and engineer a soft landing, many stocks in these industries could ultimately be seen as bargains at today's prices. But patience is required.
Meanwhile, expect ongoing volatility in the months ahead. Political leaders may eventually get it right, but positive outcomes are not guaranteed.
• Bryan Dooley, CFA is the Senior Portfolio Manager and General Manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority