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The Fed’s Silver Linings Playbook

| July 17, 2019
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As the first half of 2019 concluded on June 30, the economic expansion officially became the longest in US history.  And still, over 10 years in, we see limited near-term risk of the usual catalysts that bring economic expansions to an end – financial vulnerabilities leading to a deleveraging or overheating that prompts central banks to overtighten policy.  Global stocks and bonds have rallied in tandem thus far in 2019, primarily driven by a synchronized dovish stance from major central banks, a weaker US dollar, and a temporary trade truce between the US and China.  The macroeconomic backdrop is still supportive for stocks, and we will be closely monitoring the Fed’s level of commitment to further promoting growth near term.

An important development in the second quarter was the global re-rating of monetary policy expectations, with the market now seemingly pricing in that the Federal Reserve will ease by 1.00% over the next 18 months and the European Central Bank will remain on hold through 2020.  This 180-degree turn contrasts to prior intent of raising rates once or twice in 2019.  Essentially, tightening to get policy to “neutral” or combat inflation pressures is out, and supporting growth while inflation remains low is in.  At the most recent June meeting, the Fed kept rates unchanged but removed a reference to “patience” in its statement, indicating it stands ready to cut rates if conditions warrant.

Economic indicators, while mixed, favor a continuation of slow but positive growth.  In the US, low unemployment, strong consumer sentiment, higher productivity, and low inflation all promote encouraging outlooks.  Some evidence of deteriorating growth exists as well, though.  Both global manufacturing and services sector businesses report weaker conditions today than at any time in the past three years.  The Institute for Supply Management (ISM) Purchasing Managers’ Index (PMI) declined to 52 from summer 2018 highs of 58.  Likewise, corporate profits decelerated from 20%+ y/y growth toward low single digits.

Markets currently expect the Federal Reserve to keep recession at bay by proactively cutting short-term interest rates.  Lower rates – which tend to spur borrowing and business investment – could help balance out the negative effects of slowing global growth and an ongoing US -China trade war.  According to Charles Schwab’s Liz Ann Sonders, “Initial rate cuts when no recession was underway or imminent were historically accompanied by stronger stock market performance over the subsequent year relative to recession periods.  If the economy holds up and the rate cuts are simply ‘insurance,’ stock markets could rally strongly.”

In the very near term, we believe that the market has overpriced the extent of Fed easing and anticipate some retracement to higher yields as well as increased stock market volatility.  Payroll growth from the June report exceeded expectations with 224,000 new jobs, reiterating strength in the economy and the opportunity for patience above action.  Another reason why the Fed may decide to delay accommodative policy is the persistence of low inflation, which buys them time to act.  The University of Michigan Expected Change in Prices Survey, a measure of 5- to 10-year inflation that dates back to 1979, fell to its lowest level ever.  Furthermore, the Personal Consumption Expenditure (PCR) price index, a primary Federal Reserve inflation gauge, shows year-over-year inflation of 1.5%, and annual core inflation of 1.6%, well below the inflation target of 2%.  The third quarter of 2019 will bring several consequential European developments: In the UK, the race for the Conservative Party leadership will have direct implications on possible Brexit outcomes; After recent divisive European Union elections, key leadership nominations will shape future economic and fiscal policy, including the succession of ECB President Mario Draghi with current head of the International Monetary Fund, Christine Lagarde.  Other issues such as US-Iran tensions and growing political and social discord with the US have also been causes for concern.  The silver lining is that the Fed has signaled a willingness to cut interest rates if economic or financial conditions deteriorate.

Tariffs and trade remain the wild card, creating the most uncertainty looking forward. The ongoing trade war between the US and China remains a headwind for growth as Americans pay the tariffs as a de facto tax on consumption, and in some cases, producers absorb the tariffs at the expense of their profit margins.  Cornerstone Macro estimates a drag on US GDP of -0.30% based on already-imposed tariffs, with significant 0.4% additional hit expected if the remaining proposed, but currently postponed, tariffs on $325B of Chinese imports are imposed.  Even beyond China, new trade uncertainties can flare up at a moment’s notice; including with Mexico, Canada, India, and the Eurozone.  An economy with 3.7% unemployment would typically not seem to be in need of easier monetary policy, but the loss of confidence among businesses since the start of the trade war last year has already led to lower growth in private investment and could eventually cause a slowdown in hiring.  The June 2019 survey of Chief Financial Officers (CFOs) confirms that companies are pulling back on business investment plans for the coming 12 months.  Perhaps optimistically, we would not be surprised to see some progress in the trade talks given the fact that 2020 is a general election year.

In periods of growth slowdown, the Fed has historically walked a thin line, balancing the desire for proof of actual deterioration with the need for pre-emptive action.  Given underlying growth dynamics, the required amount of Fed easing is relatively low and any adjustments can be done quickly.  The easing cycle of 1998 – three eases totaling 75 bps – may be the best analogy, and provides foresight to some expected changes, including the structural move to a steeper yield curve and a weaker dollar.  Unsurprisingly, a slowing growth environment also produces volatile markets rife with fears of hard landing, recessions and market crashes, most of which are simply overdramatic and temporary.  We are committed to unlocking the real investing opportunities associated with recognition of short-term dislocations between the facts and over- or undervalued market prices.

In the second half of 2019, we will continue to be selective with which securities we hold using diligent research, risk management, and portfolio allocation.  As the broad market approaches more true-valued levels, our focus remains on reasonably priced, quality growth companies that can dominate their markets and establish pricing advantages built for the long term.  We will continue to tilt our securities toward investor friendly companies with sizable cash flow that are making record stock buybacks to enhance earnings-per-share numbers.  Income will become a larger percentage of total returns while navigating through the economic late cycle.  As such, we will actively generate this income from interest, dividends, and defensive option strategies.  Our active management approach gives accounts the opportunity to outperform with respect to overall objectives for return and risk.

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