What’s all the fuss? Higher rates, the Fed & the stock market

On October 3rd, in an interview with Judy Woodruff of PBS, Federal Reserve Chairman Jerome Powell uttered these words in a Q&A session:  “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.”

Within 36 hours, after the full impact of this statement had been absorbed, the 10-year interest rate had spiked from 3.0% to over 3.25%–a move of gigantic proportion.  At the same time, equity markets sold off in an aggressive stance for a week straight—only to slightly settle last Friday, the 12th.

Yep, Just in time for the Halloween season the Fed is donning a mask and is putting a scare into financial markets.  There’s no question that the latest market sell off has to do with a concern about higher interest rates.  But once again, if you follow the politicians, the general news media, and even the financial press and market pundits, you’d be confused as to the potential ramifications of the latest developments.

I’ll attempt to concisely explain the context of this rate rise, the reasons investors need to be concerned and any silver lining.

How these things usually work
The natural state of a capitalist economy is expansion.  That’s what we’re experiencing now.  Expansions go on until they don’t.  In other words, economies expand, continue to expand, over heat and then recess.  In an attempt to prevent economies from becoming too hot, central banks will raise interest rates (as a refresher, central banks only control short term interest rates, long term rates are influenced by factors such as expectations for inflation and economic growth, corporate credit quality, and demand for fixed-income securities by U.S. and foreign investors).  Raising rates, or “tightening”, has the effect of slowing down the economy.  Unfortunately, getting the balance right—in other words, raising rates by just the exact amount—is a difficult task and central banks have a history of pumping the brakes for too long and too hard when attempting to contain growth and inflation.  By doing this they have been the cause of many a recession.

Where are we now & what really matters with an increase in rates
Let’s take a step back at this point and examine where we are.  We know that interest rates have risen as can be seen in the red line on the graph several paragraphs below. The main question is whether rising rates are bad for stocks?  The conventional wisdom holds that stocks will decline once rates rise on a sustained basis.  It’s true that higher interest rates mean increased borrowing costs for individuals and businesses, which lead to lower consumer and business spending.  Additionally, higher rates mean lower valuations as the future cash flows are discounted back at a higher rate to the present. It’s also true that a spike in any macroeconomic indicator—let alone the most important variable—can cause some amount of uncertainty.  But in actuality, the statistical evidence on whether higher rates are bad for stocks is very mixed.  There are many examples to counter conventional thought where rates have risen along with stock prices.

Think about this: if growth picks up in the economy without excessive inflation (will get to inflation in a bit) then corporations will capture all sorts of additional revenues even at the expense of higher rates.  At the end of the day what really matters is the rise in interest rates relative to growth rates in the economy (growth rates in the economy are also referred to an “equilibrium real interest rate” or a “neutral” rate).  To the extent that growth rates either match or are higher than market interest rates then economic conditions will improve.  But if interest rates in the market exceed these growth rates (“equilibrium rate” or “neutral rate”), then this will slow down the economy and potentially cause problems for the stock market.

So, back to Chairman Powell’s answer in the Q&A.  By moving interest rates to “neutral”, what he’s saying is he wants to do is move market interest rates to a level that approximates the “equilibrium rate” or growth rate or “neutral rate” in the economy.  Or, more realistically, the Fed’s best estimate of the equilibrium/neutral rate, which is not directly observable.  But investors do have access to studies on what the so-called neutral rate is and how you get to it.  Most of those suggest the neutral rate is somewhere between 2.5% – 3.0% or maybe 2.5 – 3.25%.  At today’s Fed Funds rate of 2.25% they’re clearly below the bottom of the range.  This is telling us that the cost of capital is still significantly below the economic growth rate, thus, the Fed is still in an “accommodative”, or supportive, position for the economy.  Sure, the rhetoric has changed, but their actions must take a drastic turn for them to become restrictive.

Inflation Expectations
A primary goal of the Fed is to fight inflation. Inflation, when present, erodes purchasing power and can be difficult to contain.  It’s an important development that the higher long-term interest rates we’ve been experiencing do not seem to be driven by expectations that inflation will soar higher.

How do we know this? We can easily measure expected inflation by comparing the yield of inflation-protected bonds with the yield of traditional bonds. In fact, that’s what the chart below does. By looking at the flat blue line below you can see that yields of inflation-protected bonds have moved mostly in lock step with traditional bonds over the recent weeks & months, suggesting that traders haven’t become more worried about inflation.

For example, inflation of 2.16% a year over the coming decade was implied by the price gap between the two types of bonds as of the middle of last week, up only slightly since August and below its level in May.

The rise in longer-term interest rates is driven mainly not by a rise in inflation expectations, but rather by a rise in investors’ expectations for what the Fed will do and for how much compensation bond investors are demanding in lending over long time periods. Put more simply…the rise in interest rates appears to be driven by real growth expectations!

The Fed has indicated that it expects to keep raising their target interest rate to around 3.4% by the end of 2020, up from the aforementioned current level of just above 2%.

In previous years, financial markets had their doubts whether the Fed would follow through with its forecasts for rate increases. Now the Fed’s own projections are consistent with the path of rate increases priced into markets removing a level of hated uncertainty from the market.

So, growth without any undue inflation, which is simultaneously anticipated by bond investors is a healthy combination.

In conclusion
Given that the Federal Reserve has now shifted away from its so-called third mandate of financial stability, which dominated most of the post crisis period, and back to worrying about faster inflation, concern about too much tightening is warranted. This is true because the Fed has a difficult task of raising rates to cool the economy with just the right balance and we know that they have pushed the economy into recession many times in the past.

We also know that not all stock market corrections are caused by recessions. But that every recession causes stock market corrections. So, given the risk with the Fed’s future actions on rate tightening, the recent stock sell off (especially with stocks still at high valuations) was a rational response.  Yes, the complexion of the market has changed.

At the same time, we have proven that the Fed, up until this point, has set interest rates just below the growth rate in the economy (and that their actions speak louder than words).  This means that they can be supportive of further growth even in the face of higher interest rates.  Furthermore, we’ve seen that, even in light of those higher rates, inflation isn’t a present concern and that the Fed’s own projections are consistent with the path of rate increases priced into markets.  Again, all of this is supportive of an expansion that could very well continue.

The chances that the Fed finds the right balance over the intermediate period are slim. And yes, the dynamic could change in an instant.  The risks are also elevated given the fact that the stock market is richly valued.  For that reason it would not be surprising to see this correction continue.  But it appears that in this exact moment that the amount of accommodation and low inflation expectations are still supportive of an expanding economy.

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market sell off

What happened?  Could it be…the first days on the job for a new and untested Fed chairman?  High valuations?  Higher interest rates? The XIV—an exchange traded note—that is blowing up?  Margin calls that are coming in?

We want to know.   We feel we need to know.  Markets correct 5% or more, on average, at least 3 times per year.  But rarely do we witness a 1650-point one day drop. In fact, it’s so rare that it actually has never happened.  The drop yesterday was especially painful because it came one day after Friday’s 700-point decline (by the way, we have seen much bigger one day percentage declines, but at this level on the Dow, we’ve never seen this type of point decline).

Don’t get me wrong.  Attempting to ascertain the cause of market moves is an essential practice for every investor and money manager.  A thesis is important because it should help guide our future investment decisions (hopefully within a disciplined framework so that we’re not trying to aggressively time the market).

To that end, I think it’s important to express my current thesis on the market, along with some context:

First, equity markets have run-up…and run-up hard.  You’ve heard this from me before. Here is Shiller’s price-to-earnings (P/E) chart as of the end of the year (2017):

shiller pe ratio

All else being equal, you’d rather have a market with a lower P/E ratio than a higher ratio.  As the higher ratio indicates an expensive market. The chart above shows a market that has rarely been this expensive (and yes for those in the know, Shiller’s P/E ratio does show valuations at an extreme, however, just about any valuation metric will show a market at high levels).

Second, the domestic economy is doing quite well.  And even of greater importance, the global economy is doing well, too.

global economy

In the above chart, green equates to positive quarter over quarter growth.  For the first time in many years, the world is growing in sync.

Third, as we have discussed repeatedly in the past, lower interest rates act as a boost on the economy.  They make it easier for us to afford a house, car and to pay our credit card bill.  They make it cheaper for corporations to borrow and easier for banks to earn profits on their loans.  Lower interest rates also provide an impetus for investment, as the yield earned on savings accounts is so low.  It’s for these reasons that the Fed helped to keep interest rates low.  Most importantly, there should be no debate that low interest rates have unquestionably pushed up asset prices—most notably, stocks.

But now, with a slew of strong economic reports culminating with Friday’s unemployment report, there is real risk that the economy is heating up too quickly.  If it does, the result will be higher interest rates and an end to the tailwind that helped fuel the stock market growth since the Great Recession.  Below, you can see the trend in wage growth from 2014.  Friday’s print of a 2.9% increase in wages was the largest gain in years.

fred

After the print on Friday, interest rates went aggressively higher.  We saw a spike in the 10-year yield as it almost hit 2.9%.  The fact that rates have spiked in the face of a market with high valuations and abnormally low volatility over the past 24 months is as good an explanation as any for the harsh selloff.  One reason that I’m not panicking is that we saw the 10-year yield stabilize, and even decrease, yesterday through the market sell off.

At this point in time, interest rates will be the single most important metric that I will be evaluating.  If we see rates move to the upside, then this will necessitate taking some risk off individual accounts (remember, I do not attempt to aggressively time the market, but do move money— on the margin—to safer areas when necessary).

We also must acknowledge that the market is a complicated beast.  Sometimes it doesn’t fit into easily related narratives.  Knowing this is a crucial element to managing money. As Josh Brown wrote, “There’s no reason to believe that things will get better or worse in the near term because the emotions of millions of people cannot be predicted in real-time – and emotions are what dictate short-term prices, regardless of economics or underlying fundamentals.  Traders will place their bets, some will win and some will lose.”

After a prolonged almost 2-year absence, we now know that ‘uncertainty’ is back.  Uncertainty brings volatility.  Stock markets are traditionally volatile.  But, over the long term, stock market uncertainty also brings a higher return stream than can be gained with any other investment class.  Yes, I believe we need to adjust strategy on the margin when the data dictates, but we must also be mindful that we are investors, not traders.

As always, call or write at any time with any questions or concerns.

Chris

Tuesday Morning Reads–Wall Street hits another record high

Some things I’m reading this morning:

  • Wall Street hits another record high (NYtimes)
  • Howard Marks, nobody knows what will happen (FinanzUndWirtschaft)
  • Goldman:  no signs of a recession (PragCap)
  • Obama tried to give Mark Zuckerberg a wake up call about fake news on FB (LAtimes)
  • Warren Buffet makes a big bet on truck stops (BusinessInsider)
  • Global housing market looks like its in a bubble (PragCap)
  • Tom Petty is dead at 66 (RollingStone)

Brexit

I was off to my tennis match with a clear head on Thursday night as the S&P futures were comfortably higher given the clear indication that the Brexit vote was solidly moving in favor of the ‘remain’ camp.  The polls had been closed and initial results were rolling in.  Betting odds (typically the most reliable indicator in these scenarios) continued to show a 85% chance that the UK would remain in the European Union at this point.  Even beyond those odds, every prognosticator was still predicting that the UK would remain.  That included me.  This was the logical thing for UK citizens to do.

When I got home later that evening the complexion of the futures began to change.  Volatility became the norm as they switched from positive, to slightly negative, then to significantly negative.  By 11 pm central time it was becoming clear that the ‘leave’ contingency would win the referendum.  The futures showed a triple digit loss in the S&Ps.  This continued as I checked Bloomberg throughout a sleepless night.

Equity markets opened this morning at 55 points down.  This was half of the loss the futures were predicting in the wee hours of the morning.  By mid-morning the market recovered to down 38 points, or less than 2%.  But we then experienced a slow melt down throughout the rest of the day to end down 76 points, or 3.6%.  Emerging markets ended the day down 6%+ while the European bourses were off 11%+.

This was an ugly day for sure.  But we didn’t see panic in the market as compared to what the futures were indicating the night before and by what most seasoned investors had anticipated.

What happens next?  The Brexit vote is clearly a negative for the UK, no matter what some of the disillusioned politicians and voters say.  Not even an island is an island as uncertainty will slow investment spending.  Even the most conservative of assessments will lop off at least a point of growth.  As GDP forecasts are for 1.5% growth in the UK, this could very easily push the UK into recession.

But the question remains, how will Brexit impact global financial markets?  Many smart analysts state that this is a political crisis while our last debacle in ’08 was a credit crisis.  A credit crisis revolves around payments and settlements.  If a bank isn’t going to be paid by its debtor or other creditors, well then, the whole system gets gummed up.  So, the thinking goes, so long as the payment systems are in tact and well funded then the risks are significantly muted.

Furthermore, the size of the UK limits it potential damage to the global economy as it contributes less than 4% to world GDP.  So some perspective is necessary due to the small size of the UK.

At the same time, the UK is not Greece in that the UK was a member of the European Union but not a part of the common currency, the Euro.  This makes a transition out of the European Union much easier given that UK already has its own currency (the pound).  Thus, there could very easily be an orderly transition for the UK as well as the European Union.

And finally, those that tend to view the Brexit with an optimistic lens point to a Fed (as well as other central banks) that will remain accommodating in the face of improving domestic growth (2.5% forecasted real GDP growth) and even a whiff of some much needed inflation.

You can read more about this type of optimistic take on the situation from Cullen Roche here or from Paul Krugman here.

The counter to this optimistic take could be easily summed up from a quote I read from Peter Goodman earlier this morning, “No one really knows what happens now. The collective imagination leads to dark places.”  I believe that the rationale by the ‘glass half full’ camp is sound, but markets can be driven by emotion and uncertainty.  And emotion can be filled by a wave of nationalism that has the possibility of dismantling the Eurozone, taking away the currency which could be a catastrophe for the banking industry.  I do not think this is the base case, but one would be foolish to dismiss the fact that this political crisis could morph into the next financial crisis.

One day of selling in the market is not enough for me to panic.  The backdrop for stocks given a bumbling along economy and a Fed that wants to juice financial markets is not bad (even though valuations have become a bit rich).   At the same time, I will be watching the price action of stocks to determine if more defensive positioning is necessary over the very short term.

As always, please call or e-mail with any questions or concerns.  Have a nice weekend!

Chris

Fiduciary Standard

As I’ve written in the past, Independent Registered Investment Advisors (RIAs) are considered fiduciaries.  Brokers, the guys and gals who work for the banks and brokerage firms work under a suitability requirement.  This requirement literally gives the brokers to rip-off their clients.

I read a good article in Gawker this morning that discusses the fiduciary standard.  Here it is:  Gawker

Gut Wrenching Drawdown

From a post written yesterday, February 10th, by Michael Batnick, titled “You are owed Nothing”.

As you’re probably painfully aware, the S&P 500 hasn’t made any progress over the last two years. If you’re feeling a little frustrated, I have some bad news for you, this is how stocks works. The stock market doesn’t owe you anything. It doesn’t care that you’re about to retire. It doesn’t care that you’re funding your child’s education. It doesn’t care about your wants and needs or your hopes and dreams.

I absolutely believe that stocks are the best game in town. I don’t think there is a better way for the average investor to grow their wealth. However, this is called investing and the price of admission is gut wrenching drawdowns and sometimes years and years with nothing to show for it. If you can accept that this is the way things work, you can be an enormously successful investor.

Trying to comprehend the stock market’s drop?

Asset bubbles are rarely recognized by those inside them. But when the market correction materializes, the story is typically easy to relate.  In March 2000, for example, when the dot.com bubble burst it didn’t take long to understand that valuation metrics based on customers per click or “eyeballs” really weren’t enough to justify such lofty stock prices. No, a 107 Price-to-Earnings ratio (or, PE Ratio that is a time tested metric that, at 107, was showing an inflated stock market) in the Nasdaq stock index was, in retrospect, a simple rationalization for the precipitous drop in equity prices.  Or, in September 2008, when the credit bubble burst and investors figured out CDOs, “liar loans”, and bank balance sheets stuffed with worthless assets that were levered up 35-to-1, the subsequent run on the banks and stock market meltdown was easily validated.

But this is not 2000. Arguably, asset prices in certain areas of the market such as biotech, private equity and social media are frothy, however, the major stock indexes have reasonable valuations—which are rich, for sure, but still reasonable.  This is also not 2008. Domestically, we are not involved in a credit crisis.  Of equal importance there is little bank “counterparty” risk (the risk that banks won’t get paid back by other entities for loans made) so our entire payment system is not gummed up as it was in 2008.  Sure, there are real concerns.  But in past violent stock market corrections, the flashing red signals were smack dab in front of us upon the market’s decimation.

In this context, former chief economist of the International Monetary Fund, Olivier Blanchard states, “The stock market movements of the last two weeks are puzzling.” (I urge you to click here on this link and read Mr. Blanchard’s full article)  Mr. Blanchard disassembles the major concerns for global financial markets:  namely, China and oil prices (for a further bullish opinion on China’s significance on global markets, click here: Alan Blinder WSJ 01.20.2016).   Blanchard then goes on to offer his favored explanation for the selloff, which basically states that money manager are acting based upon some “herd” mentality by selling assets based on nothing more than “uncertainty”.  The implication is that there is no fundamental reason whatsoever, but just due to the fear of the unknown—“political uncertainty at home and geopolitical uncertainty abroad are both high.  The Fed has entered a new regime [basically impotent at this point].  The ability of the Chinese government to control its economy is in question.  In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fear mongers to gain popularity.”

Although we can’t explain the market’s recent sell off with the exact precision of past sell offs, the theme of “uncertainty” is common to all major market routs.  When the internet bubble burst we knew the why but we didn’t know how far (the PE ratio shouldn’t, or couldn’t, have rationally been set at 107, but it should have been reduced by precisely what amount?).  In 2008, we knew the banks were in trouble, but their mere survival was in question leaving us uncertain as to the appropriate market valuation in a world that might not have major commercial banks.  What we should not dismiss in today’s market then is the emotion/human psychology of the fear of the unknown that drives investors to hit the sell button.

Some of the greatest investors of our time have asserted that the market is not always efficient.  George Soros, William O’Neil and even Eugene Fama himself have dismissed the idea of market efficiency in one way or another.  Soros’ theory of “reflexivity” is a commentary on the human capacity to change events by taking actions ahead of perceived expectations (that are inherently flawed) only to distort the outcomes expected in the first place.  So, for example, the expectation that slower Chinese growth will lead to lower stock prices—no matter if the premise is inherently flawed or not—can lead to lower stock prices.  In other words, lower stock prices beget lower stock prices.  It only takes this perception.

So, what is the strategy?  As Ron Lieber wrote in the NY Times, “Plenty of research shows that if you miss just a few days of the market’s biggest gains, your long-term portfolio will suffer badly.  If you decide to put a lot of your money in cash right now, how will you know when to get back in the market?  You’ll probably be looking for a sign, and that sign will be the rebound days on which you missed out.”

I agree.  It’s not time to panic.  Remember, corrections are normal.  “It would take decades of systemic economic erosion to prove otherwise, and a few weeks of market declines do not suggest that anything like that is upon us,” says Lieber.  Each year the stock market has averaged one 10% correction per year.  We are now down approximately 9% in the S&P in the first few weeks of January alone, while down close to 12% from a November 2015 high.  A brutal selloff, for sure.  But as I don’t recommend going to all cash, some paring back of positions to become more defensive (for accounts that were more aggressively positioned) is a strategy that has been in order.  Historically, half of these 10% corrections turn into 20%+ corrections.  If and when stocks break through to the downside to the next level of support (1823ish on the S&Ps) it will be time to become even more defensive as the odds of a recession will increase (the idea of reflexivity where stock market declines impact the economy).

The next few weeks are critical. As Blanchard writes, “If it becomes clear within a few days or a few weeks that fundamentals are in fact not so bad, stock prices will recover, just as they did last summer, and this will be seen as a hiccup. If, however, the stock market slump lasts longer or gets worse, it can become self-fulfilling.”

As always, please call or write with any questions or concerns.

Friday Afternoon Reads–be scared of China’s debt, not its stocks

cartoon-golfer-008

Some things I’m reading this afternoon:

  • A new economic era for China goes off the rails (NYT)
  • Be scared of China’s debt, not its stocks (Bloomberg)
  • When China stumbles (NYT)
  • More downside coming in the S&P (AllStarCharts)
  • The man who crashed the market (TRB)
  • Fear & greed index (CNNmoney)
  • Wicker Park’s Double Door location could be sold to investment firm (Chicagoist)