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The Fed's Action
- Dec 18, 2018
- 13 min read
The market is currently expecting a Fed rate hike for December. The market is placing odds of an effective Fed Funds rate of 2.25% to 2.50% at 67.5%, down from 77.0% a few short weeks ago.
From Bloomberg, “Federal Reserve officials will pull the trigger on another interest-rate increase next week before slowing the pace of hikes in 2019 as risks to the U.S. economy mount, according to a new Bloomberg survey of economists.
They expect the Fed will raise rates by a quarter percentage point at its Dec. 18-19 meeting while dialing back the number of moves next year to two, in March and September, from the three hikes economists saw in September. Median responses in the Dec. 7-11 poll also anticipate one additional hike in mid-2020 when the rate would peak in this tightening cycle at a target range of 3 percent to 3.25 percent.
The somewhat more dovish expectations fit with a more cautious tone projected in recent weeks by Fed policy makers, including Chairman Jerome Powell, and with the anxiety exhibited in financial markets. Since the end of September, the S&P 500 Index of U.S. stocks has plunged more than 9 percent.”
“The waning impact of stimulative U.S. fiscal policies, the trade dispute with China, a potentially chaotic exit for the U.K. from the European Union, and the possibility the Fed might tighten too much.
Investors see a 77 percent chance the Fed will move next week and are betting on less than one full quarter-point increase in 2019, according to pricing in interest rate futures.
More than half the economists said risks, with respect to growth and inflation, were now tilted to the downside. In September just 16 percent of respondents had that view. Upside risks had dominated responses to this question in each survey of this quarterly series since December 2017.”
The latest buzz around the street is that the Fed will take a dovish tone towards further rate hikes given the softness in the global economic picture, weakness in our equity markets and political pressure. The criticism has merit given our benign inflationary environment. As it stands, the Fed seeks to normalize rates by getting them up to 3.25% to 3.5%. Given the market weakness and ultimate nervousness by market participants, it’s becoming increasingly obvious that the general view on Wall Street is that the market can’t bear the burden of 3.5% Fed Funds.
There are those that question the logic. From CNBC, “The pundits at the Federal Reserve indicate that the agency is striving to raise interest rates to a "neutral rate." Observers believe that this would be in the 3.25 percent to 3.50 percent range. The history of the Federal Funds rate in the last 18 years does not indicate that it ever stabilized at anywhere near this rate. The average Federal Funds rate since it was first published in July 1954 has been 4.80 percent.”
“It would appear that the Fed simply made up this concept of a "neutral rate" since there is little evidence that it has ever existed before. Interestingly, CNBC's Andrew Ross Sorkin recently interviewed ex Fed Chairman Paul Volcker. In the interview Mr. Volcker stated "a 2 percent [inflation] target, or limit, was not in my textbook years ago. I know of no theoretical justification."
Apparently, Mr. Volcker thinks that the Fed may have made up the 2 percent number as a convenience. Others may think that the "neutral rate" concept was conceived for similar reasons.”
I suppose that is apparent in the statements made by Chairman Powell when on October 3, 2018 he stated we were a long way from neutral at this point to just below the level that is considered neutral on November 28, 2018.
We like to watch the Yield differential between the 5-year TIPS and Effective Fed Funds rate.
A drop to negative 200bp would indicate the Fed is over-tightening and that a recession could be nearing. The yield differential of -147bp is getting close to alarming levels. This is in the face of inflation expectations that have been declining.
So, what has happened to sway the Fed’s thought process? It is probably a combination of pressures from the weakening US and global economic outlook, the wobbly stock market and pressure from the Executive branch (Trump Tweets).
Weakening US and Global Economic Outlook
From MarketWatch, “The Chicago Fed’s index of national economic activity registered at a positive 0.24 last month, up from positive 0.14 in September.
The volatile nature of the monthly reading puts added emphasis on following the index’s less-volatile, three-month moving average. It ticked up to positive 0.31 in October from positive 0.30 in September.
The Chicago Fed index is a weighted average of 85 economic indicators, designed so that zero represents trend growth and a three-month average above 0.70 suggests an increasing likelihood of a period of sustained increasing inflation. Fifty of the 85 individual indicators made positive contributions in October, while 35 made negative contributions. Fifty-one indicators improved from September to October, while 33 indicators deteriorated and one was unchanged.”
The manufacturing picture is starting to deteriorate. This could have negative implications for global economic growth.
Atlanta Fed GDPNow is forecasting 3.0% GDP growth in Q4.
New York Fed Nowcast is also calling for 2.4% 4Q GDP growth.
In a previous post we indicated how we use unemployment claims as a leading indicator of coming economic weakness. We wrote, “The four-week moving average for unemployment claims are near generational lows. We will be on high alert when the year-over-year change increases by 10% of the lows. The following charts depicts in yellow the instances when it has risen 10% YOY highlighted against the S&P 500. We are not getting warning signals just yet.” This could certainly change.
Surely the news out of GM this week will be worth watching and to see if layoffs are going to be a trend. From CNN Business, “General Motors on Monday announced a major restructuring of its global business, saying it will shut production at five facilities in North America and slash its staff. GM will reduce its salaried workforce by 15%, including a quarter of the company's executives.”
The latest Duke University/CFO Global Business Outlook survey noted that half of the CFO’s that they polled believe a recession on the US is likely by the end of 2019. More than 80% of those surveyed believe a recession is likely by the end of 2020. They noted recent trade policy concerns as a source of contention as companies put off capital investments and other business moves until a clearer path is known.
NFIB Small Business Optimism Survey is now negative year-over-year.
The Sabrient Insider Sentiment Index is an equal- dollar weighted index comprising publicly-traded companies that reflect positive sentiment among those 'insiders' closest to a company's financials & business prospects (top management, directors, analysts). That too is negative year-over-year.
From CNBC, “The latest CNBC|SurveyMonkey Small Business Survey, released Monday, reveals that small-business confidence is starting to cool.
After hitting a record high in Q3, the Small Business Confidence index declined from 62 to 59 in the fourth quarter, led by small moves lower in components across the board. This new data from CNBC and SurveyMonkey underscores the idea that while sentiment is at or near record highs, challenges still remain for Main Street.”
“For the first time in six quarters, sentiment around business conditions also has taken a slight dip, from 58 percent in Q3 to 55 percent in Q4, although that read is still up 11 percentage points year-over-year, according to the survey.”
“Just 34 percent of small-business owners now say that tax-policy changes will have a positive effect for them in the next 12 months, down from a high of 46 percent kicking off the year, indicating some of the positive sentiment surrounding the law may have waned.”
“More small-business owners are questioning the positives the administration's trade policies will have on their bottom lines. Sixteen percent of small-business owners say they expect changes in trade policy will have a positive effect on their businesses in the next 12 months, a new low for the survey. What's more, 1 in 5 business owners surveyed do business with China, and they were nearly twice as likely as others to expect a negative impact on their business.”
From the Bond Buyer, “Business activity “continued to expand, though growth was noticeably slower than in recent months,” the December Empire State Manufacturing Survey, released Monday by the Federal Reserve Bank of New York, suggested.
The general business conditions index plunged to 10.9 in December from 23.3 in November.”
There is plenty of evidence that the economy is cooling. This is most likely (in our opinion) the key premise behind the dovish tone from the Fed.
We think it’s important to note that Germany, Japan and China are suffering economically.
The Wobbly Stock Market
From Bloomberg, “Donald Trump’s hectoring aside, it’s exceedingly rare the Federal Reserve raises interest rates when stocks are behaving this badly.
In fact, were policy makers to follow through with their widely expected hike Wednesday, it would be the first time since 1994 they tightened in this brutal a market. Right now, the S&P 500 is down over the last three, six and 12 months, a backdrop that has accompanied just two of 76 rate increases since 1980.”
“While the role of markets in the Fed’s policy calculus is endlessly debated, the fact is, since 1980, rate hikes have almost always come amid equity buoyancy. On average, the S&P 500 is up 4.1 percent, 6.9 percent and 11 percent over the previous three, six and 12 months when tightening occurs. The exception was in the 1970s, when the Fed ignored market turmoil to combat inflation that was running at 7 percent a year.
Of course, the economy looks nothing like that now. Consumer prices have stayed below 3 percent for the past six years and at a growth rate of 3.5 percent, it’s hard to frame gross domestic product as overheating. The opposite concern seems to be driving equities, with recession mentions getting more numerous in professional commentary.”
We believe the market has reacted to the waning effects of the tax cuts on corporate profits. While forward earnings projections are still calling for growth, it will be at a much slower pace than seen in the past.
One can see from the chart below that stock have sold off aggressively while the 12-month forward EPS forecasts for the S&P 500 have started to level off.
When we look at the slope of the EPS forecasts, one can visualize the change in earnings momentum that has been a key driver to lower prices.
From Knowledgeable Leaders Capital, “2018 has been kind to corporate profit margins. In fact, the margin expansion we’ve seen so far in 2018 is unprecedented in a late cycle economic environment when wages are rising briskly, at least looking back over the last thirty years. What has been different this time around is that the corporate tax rate was lowered from 40% to 25%, allowing profits to expand even in the face of rising wage and variable cost pressures. So the question moving forward is, can companies maintain this level of profitability for another few years, or have we seen the best of it? Based on at least the few factors we highlight below, we think 2019 and beyond will look much different from 2018.
As we can see in the first chart below, there is a strong negative relationship between profit margins (blue line, left axis) and average hourly earnings (red line, right axis, inverted). When average hourly earnings rise, margins invariably fall with a two year lag time. Average hourly earnings have been rising in a strong trend (red line going down) since early 2017, but profitability was able to buck the consequent drop off due to tax reform. However, now that hourly earnings have so clearly broken out to the upside and are rising at the fastest pace since 2007, we have serious doubts about the ability of profit margins to not follow the path of least resistance, which is down.”
“And we further have reason to expect hourly earnings will continue to rise even more briskly in the year ahead, which of course will add duration and magnitude to the pressure on margins. As the next chart below demonstrates, small business hiring plans lead hourly earnings growth by 15 months. Hiring plans (blue line) remain near an all-time high and in a strongly rising trend. As such, hourly earnings growth (red line) has every reason to follow hiring plans higher for the next year or so.”
“But it doesn’t stop there. Profit margins also tend to closely follow the unemployment rate. As the unemployment rate falls (especially as it falls to very low levels at the end of an economic expansion), hourly earnings tend to rise, which puts pressure on margins. Here we overlay profit margins (blue line) on top of the unemployment rate with a two year lead (red line). In this chart it’s easy to see the disconnect between the drop off in the unemployment rate since 2016 and profit margins. Part of this is due to structural factors (historically low employment to population ratio, tax cut) and part of it due to cyclical factors (fiscal stimulus). However, with the unemployment rate now at a 50 year low and falling, our confidence is low that either structural or cyclical factors will prevent margins from reverting to their historical relationship with employment.”
“Finally, we’ll review one element central to the margin question that is unrelated to earnings and employment: import prices. As of now non-petrol import prices are set to rise on the back of tariffs on Chinese imports, and steel & aluminum imports from elsewhere. There is plenty of upside risk to import prices if trade talks with China fail to produce results acceptable to the US. Some of the cost of higher import prices are likely to be shared by corporations, which would pressure margins. As we can see below, there is a clear, although loose leading relationship between import prices and changes in profit margins. As import prices rise (red line going down) margins tend to contract (blue line going down). Any upside materialization in import prices would simply add to the already strong forces putting downward pressure on profit margins.”
Just two notes on earnings forecasts. Analysts are still projecting 9.3% annualized EPS growth for the S&P 500 over the next three to five years. If we use the three-year average P/E based on forward EPS projections of 16.9x, then our three-year annualized IRR is 16.5%. An IRR this high usually corresponds to positive market returns in the coming twelve months.
Current market multiples in this inflationary environment certainly can support multiple expansion from here. Based on trailing EPS of $146.26 for the S&P 500 and a 2.2% CPI rate of inflation, we can see from the following chart that we are sitting below trend (red dot) as it related to market valuations.
One Major Caveat! If we enter an economic recession in the US, all bets are off with this analysis and analysts will start tripping over themselves to lower guidance. This EPS analysis is useful as a coincident indicator and the greatest benefits come from it within a growing economy. We are not completely in the US recession camp just yet but are watching closely.
Pressure from the Executive Branch (Trump Tweets)
A recent article in the WSJ notes President Trumps focus on the stock market. “As the stock market churned this week, President Trump anxiously called advisers both inside and outside the White House looking to ensure that his talks with China were not driving the selloff.
Fresh off what he described as a historic weekend meeting with China’s President Xi Jinping, Mr. Trump has questioned why the markets weren’t reacting more positively to the news of the potential breakthrough with Beijing. In consulting with advisers, he remained convinced that the volatility wasn’t his own doing, but rather, the product of the Federal Reserve’s plan to raise the benchmark interest rate.”
It is obvious that this President places great importance on market performance as a gauge of his success as our President. Personally, I think this is a mistake. I said so in a tweet back to the President.
Since that tweet, the S&P 500 is off 13%, the Nasdaq Composite is off 16% and the Russell 2000 is off 18%. I haven’t seen any tweets taking responsibility for market-hindering policies, but I’ve seen plenty placing blame on the Fed.
It seems that monetary and fiscal policy are not on the page. It is this type of loose communications that have had an impact on the market in our opinion. When two of your advisors (Kudlow and Navarro) go on two separate television shows (CNBC and CNN) and contradict each other, the market doesn’t take kindly to it.
Richard Bernstein from RBA summed it up eloquently in his Year Ahead: 2019 research note. “The Federal Reserve, except during the Volker era, has consistently been a lagging indicator of economic activity. The Fed reacts to data rather than anticipates it, but many have suggested the current market volatility is attributable to the Fed’s preemptive stance. Blaming the Fed for the markets’ ongoing volatility seems convenient but unjustified.
Profits recessions (multiple quarters of negative earnings growth) are one of the primary drivers of bear markets. RBA does see corporate profits growth slowing in 2019, but we do not see an imminent profits recession. Chart 3 shows the US profits cycle (based on reported GAAP EPS). 3Q18 profits growth looks to be about 22%, and our forecast for 4Q18 is about 24%. We think profits growth will slow, but remain healthy during 2019, and our current forecast for 3Q19 is 10%.
Fundamentals, primarily earnings and liquidity, seem to be following their normal late-cycle paths. Sentiment still appears unusually scarred and wary. None of these factors would suggest the levels of volatility that are in the markets.
The prime sources of uncertainty for investors, in our view, are trade policy, tariffs, inconsistent foreign policy, and the frequency and impulsive nature of decisions that impact economic growth. Planning is normally difficult for corporations, but CFOs trying to plan employment and capital investment for 2019 must be having an unusually challenging time. It seems exceptionally difficult to assess credit risk when borrowers’ input costs could be up 25% or down 10% and their export growth and market share could potentially be eroded by foreign retaliatory tariffs. Consumer confidence remains high, but leading indicators of employment seem to be losing some strength. How does a CFO plan capital allocation, how does a credit analyst assess risk, how does an investor assess profit margins, and how does a factory employee buy a car or a home when 2019’s economy could dramatically change with the stroke of a tweet?
The cause of market volatility does not appear to be primarily attributable to traditional fundamental variables such as profits or Fed policy. Those factors are following very normal late-cycle paths. It is much more likely that market volatility is increasing because household and corporate planning has become nearly impossible in a highly capricious political environment.”
Our Final Thoughts
We believe the Fed will take an increasingly dovish stance towards monetary policy due to several factors including economic softening, market weakness (earnings slowdown) and to a lesser extent, pressure from the President.
We do not believe an economic recession in the US is eminent – but given the market technical action, yield spreads and leading economic indicators, we can’t rule out the possibility.
We have taken a tactical year end position in the broader market to take advantage of any year-end rally (hasn’t worked out that well to date).
We will be “data dependent” as we head into 2019 as to whether we continue with our previous GARP strategy or get much more defensive.
Short-term bullish – longer-term neutral (but leaning bearish).
Joseph S. Kalinowski, CFA
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