Capital Market Comment
January 4, 2023
Frank Mastrapasqua, Ph.D.
What Is The Fed Trying To Prove?
Is the Fed trying to correct for past mistakes? Or is it attempting to regain credibility? Or both?
The monetary authorities have a history of forecasting errors, inconsistencies, and ignoring factors that they themselves said were important. As has occurred in the past, mistakes are followed by more mistakes. This time looks no different. The lagged effect of the very restrictive Fed policy is largely being ignored. How does the Central Bank go from 50% monetary growth in 2020 to zero in 2022 and essentially ignore the fallout? How does the Central Bank continue to buy bonds into March 2022, adding to liquidity while raising rates that same month? Do they really have much credibility?
A policy based upon data that is backward looking, i.e., year to year, and not focusing upon current dynamics – latest month’s data, recent three-month’s data annualized, leading indicators, ISM surveys, commodity prices, etc. – does little to engender confidence that future policy will be any different. Credibility is earned through consistency, clarity of thought, transparency, and appreciation for the inherent risks in forecasting, as well as a level of humility in knowing that even the most sophisticated models can fail.
The Fed model makes many assumptions which inherently can cause significant forecasting error. Behavior is constantly changing and the economy is dynamic and in motion. There are certain principles that exhibit a consistent pattern and provide guidelines to future outcomes. But externalities, such as the Ukraine war and COVID, time lags, and technology can alter predicted outcomes. As Future Babble author Dan Gardner points out, the record is poor for the most adamant prognosticators, as opposed to those who appreciate and respect the variability of human behavior and the adaptability of business to the changing times.
The Fed’s preoccupation with a 2% inflation target, as if it were cast in stone, and constant reference to the 1970-80 period (the Volcker period), does little to instill confidence in the policymaking process. During the Volcker Period, T-Bill rates were 16% in March 1980, then down to 6% in October 1980, then back up to 16% in October 1981. Ten year treasuries yielded 16%. During that period, inflation expectations were very high. The inability of the economy to handle the energy shocks of the oil embargo and the quadrupling of the price of oil, a commodity upon which the US economy was highly dependent, made the economic models obsolete. Oil was a critical feedstock for chemicals, plastics, gasoline, diesel, heating oil, etc. The cost structures of practically all companies were upended and major behavioral changes followed.
In contrast, the 10-year treasury is now in the range of 3.5 to 4%, down from the recent peak of 4.5%. Market participants’ expectations of future inflation and future short-term rates stands in stark contrast to the Volcker era. In our judgment, these constant references to the Volcker period in an economy that is markedly different does little to instill confidence in the Central Bank.
Given the Fed stance, and its preoccupation with past data, not forward-looking data, and the multitude of cross currents impacting the economy, the equity discounting mechanism has performed reasonably well. The excesses – dream stocks, no path to profitability, crypto, SPACs – have essentially been punished and have fallen precipitously and have in part been reflected in the Ark ETF. NASDAQ has experienced the biggest decline, while the Dow and the S&P 500 have performed significantly better.
It is interesting to note that the public pension funds have been under a great deal of stress. As reported in the Wall Street Journal on Wednesday, December 28th, the California Public Employees’ Retirement System (CalPERS), which manages the largest public pension fund in the US, had only 1% cash. In a 30 day period, CalPERS would have paid $11.3 billion in private equity capital calls and $14 billion in derivative margin calls.
The weakness in the private equity market has brought about a significant increase in capital calls, thus requiring more funds to be sent to the managers of those funds. To do so, some of the biggest pension plans have little choice but to sell some of their large cap equity holdings, most of which were in the tech sector. Some funds are now even increasing their commitment to private equity.
Some comfort might be taken in the fact that the financial markets do not believe the Fed. With all the tightening and even an expectation of a 50 basis point increase at the February meeting, the 10 year treasury is still below 4%. At the same time, companies are adjusting to the tight credit environment (rolling recessions – housing, semi chips, manufacturing, durable goods, retail, and now the weakness in the automotive sector). Monetary data (no growth in a year) continues to support declining inflation and the growing weakness in economic activity.
Any reasonably intelligent CEO is not relying on the Fed’s outlook. They are employing their own inputs and expecting at best anemic growth in 2023 and at worst a recession. Expect evidence of their actions in the Q1 earnings that will be reported in late January. At that juncture, the equity market is likely to begin discounting the second half of 2023 and into 2024, a time when excess inventory should be cleansed and a return to growth is likely to emerge.
It should not be overlooked that the excesses in the equity market in 2021 and into 2022 from zero interest rates – SPACs, dream stocks (no road to profitability), hyper valuations, crypto, meme stocks, excess leverage – in part can be placed at the feet of the Fed. It subsequently engaged in a very restrictive policy to purge those very excesses they helped create.
It seems that trillions of dollars of asset values were created and then destroyed because of poor policy. The Fed may try, but cannot escape, the responsibility for what it has done. In our judgment, in 2023 the Federal Reserve is likely to be putting into place anti-recessionary policies. Even a subtle move in that direction would be greeted very favorably by the equity market. Any move in that direction would be a move toward financial stability and away from the financial instability that current policy has been creating.
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The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.