For those of us who were hoping that Jerome Powell would represent a new type of Fed Chair, or might be able to at least begin the process of weaning us and the rest of the world off the dependency of easy credit and ultra-low interest rates, the recent words and actions of Mr. Powell and his comrades on the Board of Governors can only be seen for what it is – full capitulation and a massive disappointment. Capitulation to the market? Capitulation to the president? Take your pick.
In this letter I am going to review the year just finished in light of the extraordinary changes we have seen in the past few months from the new Fed Chairman, place the implications of this pivot against the backdrop of economic and fiscal reality, and draw some conclusions with respect to an appropriate investment strategy.
When one looks more carefully at what happened in the financial markets since the beginning of last year, you see that it really unfolded in 4 distinct phases:
- The market continued its momentum from 2017 and started off the year virtually on fire, with the S&P 500 rising approximately 200 points or 7.5% by January 26th. International stocks, including emerging markets, were along for the ride, as were commodities. The Bitcoin Bubble had already burst and was changing hands around $11,000 (down from $19,000 the month prior). Interest rates were rising rapidly, which may well have been the trigger to catalyze a transition to the next phase.
- Late January turned out to be the high for virtually every international market, and the major international stock indices (MSCI EAFE and MSCI Emerging Markets) remain well below those highs to this day. US stocks, on the other hand, managed to recover from their sudden decline in late January and early February and worked their way to an all-time high on October 3rd, with the S&P up more than 11% YTD at that point. The divergence between US stocks and their international counterparts was noteworthy to say the least. While the S&P sat around 3% higher from it’s January high, the EAFE index (developed international stocks) was down about 8% and emerging markets were down more than 14% over the same period. Many people wondered, myself included, how is this performance gap going to close? Are international stocks going to catch a bid and catch up to US stocks, or are US stocks going to succumb to the weakness that had been reflected in the overseas markets for most of the year?
- We got our answer in October - that was it for upside on the S&P 500 for 2018. What happened on October 3rd? That’s where Mr. Powell comes back into the picture.
“The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore……interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” – Jerome Powell, interview with Judy Woodruff, PBS, 10/3/18
Hello, bear market:
- Christmas Day, as it turned out, offered a welcome and much-needed one day reprieve from the carnage. Meanwhile, Kevin Hassett, Chairman of the Council of Economic Advisors, was preparing for media appearances the next morning with the Wall Street Journal and Fox Business Network. It appears this was deemed necessary in light of President Trump’s repeated and relentless criticism of the Fed and Jay Powell himself.
“The president has voiced policy differences with Jay Powell, but Jay Powell’s job is 100 percent safe. The president has no intention of firing Jay Powell.” – Kevin Hassett, 12/26/18
Here is what has happened with the S&P 500, EAFE, and emerging markets since then:
I think the market from early October to the present can best be understood within the context of the words that were spoken by four key players. In addition to Jay Powell, Kevin Hassett, and Donald Trump, I will include John Williams, President of the Federal Reserve Bank of New York. Of the twelve regional Federal Reserve Banks, the New York Fed is widely regarded as the most important and influential of them all.
Starting with President Trump’s tweets and remarks to the media following Jay Powell’s “long way from neutral” comment on interest rates:
October 10 - The Fed is “so tight. I think the Fed has gone crazy.” The Fed is “going loco” by raising rates.
October 16 – The Fed is his “biggest threat.”
October 23 – Tells the Wall Street Journal he “maybe” regrets appointing Powell to head the Fed.
November 20 – Tells reporters the Fed is a “problem” and he would “like to see the Fed with a lower interest rate.”
November 26 – “I think the Fed right now is a much bigger problem than China. I think it’s incorrect what they’re doing. I don’t like what they’re doing. I don’t like the $50B. I don’t like what they’re doing in terms of interest rates. And they’re not being accommodative at all. And I’m doing trade deals, and they’re great trade deals, but the Fed is not helping.” – Donald Trump, interview with The Wall Street Journal, 11/26/18
The “$50B” he refers to here is the Fed’s stated plan to allow up to $50 billion worth of Treasury and mortgage-backed securities to mature each month and not be reinvested, effectively allowing that money to disappear from the system, which is the exact opposite of the “quantitative easing” which was implemented by all of the major central banks following the last financial crisis of 2008-09. He believes that this “quantitative tightening” will obviously have the opposite effect that quantitative easing did (which was to artificially suppress interest rates and provide a major pillar of support for risk markets worldwide), and he is almost certainly right about that.
So now the president has taken aim at both of the Fed’s major policy tools – direct manipulation of short-term interest rates through their policy rate (the “Federal Funds Rate”), and the size of the Fed’s balance sheet, which through the money creation process, clearly can and has kept longer term interest rates down by lending that newly created money directly to the government and homebuyers through the purchase of Treasuries and mortgage-backed securities. The other major central banks have also ventured into using this free money to buy up corporate debt (Europe) and even stocks (Japan and Switzerland), but that is a topic for another day. Trump is rightly concerned that by both raising short-term interest rates every quarter, and effectively shoveling up to $50 billion per month into the proverbial furnace, the Fed is risking creating the conditions to kill off the economic recovery he likes to take credit for, and the price action in financial markets in the last quarter of 2018 certainly reflected those concerns as well.
That doesn’t mean that he should be openly criticizing the Chairman of the Fed, however. This monetary system of ours is most certainly doomed if the free money gravy train is turned over to the politicians. If that perception ever really took hold, then the jig would truly be up. In my mind, that is the biggest concern that the market was screaming about throughout this period.
The very next day after the interview with The Wall Street Journal, he continued:
“I’m not even a little bit happy with my selection of Jay…..I think the Fed is a much bigger problem than China.” – Donald Trump, interview with The Washington Post, 11/27/18
This is all leading up to Jay Powell’s appearance at the Economic Club of New York where he gave a speech indicating his views on the appropriate Fed policy rate had evolved somewhat:
“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.” – Jay Powell, 11/28/18
Just below the neutral range? What happened to being a long way from neutral / may go past neutral? The Fed’s policy rate hadn’t changed. The economy was supposedly still going full bore, so what had changed since October 3rd? Good question!
Amazingly, the S&P 500 rallied from the mid-2600s at the time of this speech to roughly 2800 a week later by early December. Clearly, the Fed Chair, whoever that may be, hadn’t lost their ability to jawbone markets higher when needed. Now we bring John Williams, head of the New York Fed, into the picture, Remember, he is arguably the second most important voice at the Fed, right behind Jay Powell:
“Given this outlook I describe of strong growth, strong labor market and inflation near our goal – and taking into account all of the various risks around the outlook – I do continue to expect that further gradual increases in interest rates will best foster a sustained economic expansion and a sustained achievement of our dual mandate.” – John Williams, 12/4/18
Confused? I was too! Are we near the lower end of the range of neutral on interest rates, or do we need to keep raising them because the economy is so awesome? Needless to say, we all remember what happened next:
Leading up to the Fed’s Open Market Committee Meeting on December 18-19, where they were expected to raise short-term rates for the 9th time in this cycle to 2.25 – 2.5%, the president did not hold back on expressing his opinions, and certainly didn’t seem too concerned about the perceptions building that he was trying to exert undue influence on the central bank:
“I think it would be foolish for the Fed to raise interest rates.”- Donald Trump, talking to Reuters, 12/11/18
“It is incredible that with a very strong dollar and virtually no inflation, the outside world is blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!” – Donald Trump, via Twitter, 12/17/18
“I hope the people over at the Fed will read today’s Wall Street Journal editorial before they make yet another mistake. Also, don’t let the market become any more illiquid than it already is. Stop with the 50Bs. Feel the market, don’t just go by meaningless numbers. Good luck!” – Donald Trump, via Twitter, 12/18/18
Did Jay Powell really have a choice as to what they were going to do? In the face of such full-throated and open criticism of the Fed, and clearly stating his preferences regarding their choices regarding both interest rates and management of their balance sheet, was it even remotely conceivable that they could cave to the president and materially change direction? Probably not, because as I said, everyone would then plainly see that the central bank had been co-opted by politicians, and the jig would really be up.
As expected, the Fed raised interest rates by another quarter point on December 19th. Up to this point, they had avoided elaborating too much on their plans to continue to shrink their balance sheet (“quantitative tightening”) – but there is little doubt that investors were beginning to get concerned that this “50Bs” policy was starting to have a real effect on credit conditions and asset prices. And it wasn’t just stocks, as can be seen in the previous chart. Look at what was happening to the prices of two popular ETFs which invest in corporate debt (HYG – high yield or “junk” bonds, and SRLN – senior or “floating rate” loans):
You can see the ultimate wave of selling pressure hit the markets after Jay Powell decided to wade into the topic of the balance sheet and their stated plan to continue to shrink it by up to $50B per month in his press conference following their decision on interest rates:
“I think that the runoff of the balance sheet has been smooth and served it’s purpose. I don’t see us changing that……we don’t see the balance sheet runoffs as creating significant problems.” – Jay Powell, 12/19/18
Obviously, investors saw this quite differently, and the bottom fell out. Maybe on account of this, and wondering where all this money was going to come from if not the Fed:
And let’s not forget the borrowing binge corporations have been on (this is a global phenomenon, not just limited to the USA):
This includes impressive growth in riskier high yield bonds and leveraged loans:
Meanwhile, the quality of so-called “investment grade bonds” has never looked worse:
Put it all together and take a longer-term view, and this is what you have:
The two clearest messages from that chart are this:
- Dating back to the Greenspan era, the Federal Reserve has enabled a series of financial bubbles which have burst and led to recessions every 7-10 years.
- With US corporate debt back over 45% of GDP, we are in a zone which has always led to immediate, major problems in the past.
Many investors have come to realize (correctly in my view) that this debt binge we have been on, which has led to more than $250 trillion in debt worldwide (up from “only” $170T in 2009), made possible by quantitative easing and all of the other highly experimental policies from the major central banks of the world, has left us with no good options. Either we allow interest rates to find their own natural level, which would risk driving the whole world into bankruptcy, or we continue to artificially suppress them by any means possible, and hope for the best.
Jay Powell’s statement on the Fed’s balance sheet, “I don’t see us changing that……we don’t see the balance sheet runoffs as creating significant problems,” allowed people to think, momentarily, that they may actually give the first option a try. For a few days at least.
The markets continued to tank. Oops! Better send John Williams, Head of the NY Fed, (who arguably started the December bloodletting with his statement about continuing to raise interest rates on December 4th) over to CNBC for an interview!
“What we’re going to be doing going into next year is reassessing our views on the economy, listening to not only markets but everybody that we talk to, looking at all the data and being ready to reassess and reevaluate our views.” – John Williams, interview with Steve Liesman, CNBC, 12/21/18
Listening to markets and reassessing our views – that sounds a little better, right? And quite a turnaround in only 17 days too! But the real damage would not stop until the day after Christmas, when Kevin Hassett was talking to reporters and fielded a question about the president’s ongoing criticism of Jay Powell and the Fed:
“The president has voiced policy differences with Jay Powell, but Jay Powell’s job is 100% safe. The president has no intention of firing Jay Powell” – Kevin Hassett, 12/26/18
So, there you have it. The Fed is truly independent from political influence. They said so themselves! Let’s not bicker and argue about the role they have played in enabling this massive buildup of liabilities! For those of you who might be worried that they have played a starring role in all of this, and a primary reason we are in this mess, including $22T of US Government Debt outstanding, is on account of their “accommodation” – don’t worry! Buy stocks! Don’t you know the floor is in because now Mr. Powell is free to “turn dovish” and he is not being influenced by politicians when he does that! And if stocks ever sell off again like they did in December, he’s got your back! Just like Janet Yellen and Ben Bernanke did! And Alan Greenspan before that!
Party on, Garth.
On the first Friday of the new year, Jay Powell found himself on a stage in Atlanta with his two predecessors, Janet Yellen and Ben Bernanke, for a roundtable discussion and took the opportunity to find his new voice now that he was apparently free of political influence:
“With the muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves….We’re always prepared to shift the stance of policy and to shift it significantly if necessary.” – Jay Powell, speaking at the American Economic Association annual meeting, 1/4/19
The following week, when it was time to release the minutes from the Fed meeting in December, somehow, the message had seemingly been managed in light of the intervening events. If you recall, at that meeting, they decided to raise interest rates, and effectively stated that the plan to burn up to $50B per month and send it back to from where it came, was on “autopilot.”
The minutes from that meeting of December 18-19, released on January 9th, read in part:
“Many participants expressed the view that, especially in an environment of muted inflation pressures, the committee could afford to be patient about further policy firming.”
What. The. Hell? Was there any mention of “patience” at the press conference in December, when the markets were getting crushed? I can assure you there was not.
Just in case the message was not crystal clear, Mr. Powell took the opportunity to amplify and clarify his new perspective for those who hadn’t heard the massaged message from the minutes clearly enough the very next day. Finding himself on another stage, this time at the Economic Club of Washington, he was being interviewed by David Rubenstein, co-founder of The Carlyle Group:
“Especially with inflation low and under control we have the ability to be patient and watch patiently and carefully as we figure out which of these two narratives is going to be the story of 2019” – Jay Powell, 1/10/19
Maybe next time he finds himself on a stage he should just grab the nearest microphone and channel his inner Axl Rose and go full karaoke:
Said woman take it slow, and it'll work itself out fine
All we need is just a little patience
Said sugar make it slow and we'll come together fine
All we need is just a little patience
The messages are equally clear, and the reposts of the video clip to social media will get the attention of a lot more people to boot!
Following their next meeting on January 29-30, where they were not expected to change their policy rate (they did not), he used the opportunity of the post-meeting press conference to re-open the possibility of not only stopping the roll off of $50B per month from the balance sheet, but to actually crank up the printing presses (or their digital equivalents) yet again in the near future should they deem that necessary:
“The committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative policy than can be achieved solely by reducing the federal funds rate.” – Jay Powell, 1/30/19
Let there be no doubt. In the space less than four months, we have witnessed a complete reversal in policy out of the Federal Reserve. The punchbowl has been refilled, for now. The biggest lesson in this is that, unfortunately, markets are far more immediately influenced by the thoughts and words of a few important people in a few important cities than economic fundamentals. And there is little doubt that we will continue to live in a world of massive distortions for the foreseeable future. Look at the yields on 10-year government bonds around the world (Japan – negative 0.01%, Germany - 0.15%, Italy - 2.59%) and ask yourself if that prospective return in any way compensates you for the risks you are taking by lending to those governments until 2029. While we’re at it, what does it say that against this backdrop of free money and trillion-dollar annual deficits as far as the eye can see, the 30-year US Treasury still only pays you 3%? Are you kidding me?
So where does all of this leave us? The bearish case can best be summed up by the chart of US corporate debt, which is just one relatively small piece of the global debt picture, but an important one, especially for US investors. And remember, all of the shares of stock held by investors stand in line behind that debt in the capital structure. This is critical to remember for at some point, we will run into real economic trouble. If future economic weakness leads to a series of credit downgrades and defaults, the stockholders of those companies will likely be wiped out. And clearly, every time US corporate debt has exceeded 45% of GDP, a crisis followed. Why would it be different this time?
On the other hand, if one were inclined to see this pivot from the Fed for what it is – an attempt to reassure investors that they stand ready to accommodate with all of the tools available to them – that’s a pretty powerful argument against getting too bearish on risk assets. The trick will be to find the appropriate balance between these two conflicting arguments and invest accordingly. And if one were inclined to take on more risk this late in the credit and economic cycle, then the investment implications of this Fed pivot seem pretty clear, so here is where I will be looking to add exposure to client portfolios in the near future, where appropriate:
- Weaker dollar, which should help:
- Gold, silver and oil
- High-quality US multinationals with a lot of overseas revenue
- International stocks, including and especially:
- Emerging markets, since they tend to have a lot of dollar-denominated debt
Meet the new boss
Same as the old boss
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