The Fed At Center Stage

Capital Market Comment
December 19, 2018
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer

The equity market has experienced increased volatility over the last several months with a clear bias to the downside. The increased level of uncertainty generated from the budget crisis in Italy, the Brexit controversy, the trade crisis with China, the slowing of growth in Europe and China, and the political turmoil in Washington have provided the framework for the quant models and computer algorithms to create trading havoc. Trend and momentum strategies do not work in a volatile market environment and many leveraged hedge funds are faced with forced liquidations at the same time. Given their poor performance, redemptions have increased and are placing additional pressure to sell. Against this background, the market uncertainties have provided the media with material to “feed the fear” which only adds to the volatility.

Recognizing fully the uncertainties that exist and the market’s dislike of “uncertainties”, it is not surprising that near term pressures exist.

Investor sentiment has become decidedly negative as reflected in the American Association of Individual Investors data (bullish = 21%, bearish = 49%, neutral = 30%). Such “bearishness” is usually a good contrary indicator, suggesting that prices could move higher in the future.

Such sentiment coupled with valuation parameters, which suggest that equities are becoming increasingly attractive, may indicate that a rolling capitulation phase may be near an end. Fundamentally, the S&P 500 has an estimated earnings yield of 6.5%, and a dividend of 2.2% and growing. In contrast, the 10-year U.S. Treasury yields 2.9%, and the comparable German and Japanese bonds yield 0.25% and 0.05% respectively. Furthermore, through mergers and acquisitions and stock buy-backs, the supply of equities of non-financial corporations has been shrinking since 2008 (with an annual rate of liquidation for 2018 running at $400-$500 billion).

Current valuations are bringing about another round of stock buy-backs. Facebook, Lowe’s, Broadcom, Zoetis, Pfizer, and Boeing are some examples. Recent mergers include CVS buying Aetna, United Technologies buying Rockwell Collins, Northrup acquiring Orbital Sciences, and Redhat is being acquired by IBM.

Of note, intertwined within the economic, political, and financial landscape is the Federal Reserve and to a lesser degree the European Central Bank. These central banks are the primary supplier of liquidity that can sustain or suppress the economic expansion.

In the case of the European Central Bank, it has recently indicated that the risks are broadly balanced, but moving to the downside due to geopolitics, trade protectionism, and market volatility.

The Bank is planning to end quantitative easing this month, but maintain the size of the quantitative easing portfolio by investing the proceeds for an extended period-of-time past the date when it starts to raise key European Central Bank rates. It has indicated rates are to remain at record lows at least through the summer of 2019.

Given the slowing in European growth this year and next (1.7% and 1.8% respectively) as compared to prior forecasts, and an inflation rate below 2%, the accommodative stance of the European Central Bank is likely to persist beyond its current expectations. The uncertainty of Brexit only adds to the murky European outlook. With China’s slowing economy, as evidenced by the recent reduced growth rates in industrial and retain spending, European sales to China are likely to be affected, thus monetary stimulus remains a viable tool.

The Federal Reserve will be making policy against this international backdrop and the risks to U.S. economic growth will not go unnoticed. Moreover, U.S. economic growth is likely to slow to the 2.5% area in Q4 and less than 2% in Q1 of 2019. At the same time, the monetary authorities have not achieved their inflation target of a symmetrical 2%. With slowing worldwide growth and decelerating inflation rates, financial market volatility and the consumer’s balance sheet coming under pressure, a change in Fed policy is emerging. It appears that Fed projections are giving way to a lessening of rate increases as we move into 2019. Many Fed Board members and some Presidents of the Regional Federal Reserve Banks do not want an inverted yield curve, and they have lowered their estimate of the neutral rate. Some members have indicated they are now at the lower end of the neutral range. Also, they have articulated the lagged effect of the eight rate increases that have occurred. With the Fed’s December rate hike taking the Federal Funds rate to 2.25 – 2.50%, the notion of a pause in the expected rate increases in 2019 suggests a change in monetary policy is underway. The growing risks to world economic growth, the lowering of inflation and inflation expectations, and financial market instability should become the catalyst for change. Even though the plot diagram suggests fewer increases, missing their inflation target, and growing differences among Federal Reserve participants may suggest that the end of the rate rise cycle is near.

Reduced uncertainty will go a long way toward market stability, and greater clarity on the monetary front is one important factor that is emerging.