The Fed would be perceived much differently without the corporate stock buybacks that have driven this cycle. We bet that “Have you hugged a CFO today?” is now a common refrain around the Eccles Building. The staff at the Fed also likely praises the powers that be in China for going into an incredible $30 trillion in debt over the last decade. That overseas madness helped the global economy move forward more than anything the Fed did. Now China is growing at the slowest pace in decades. U.S. corporations have broadly exhausted debt capacity in pursuing buybacks. The central bankers find themselves with little conventional firepower left as growth stalls. All that’s left is the really weird stuff.
When will stock indices figure out that central bank stimulus isn’t a stimulant? Money flows suggest the Fed may be running out of tricks and/or investors may be changing course. Over the last several months, stocks are broadly losing momentum even as the U.S. indices are able to muster rallies but with important divergences in lagging small caps, banks, and transports. Meanwhile, bonds and gold are breaking out to new highs. All of this could be interpreted as signs that the markets think the Fed will be unable to deliver as promised after a ten-year debt binge that has led to weak growth and unflattering long-term consequences like trillion-dollar federal deficits that no one seems to worry about anymore.
We would remind the Fed’s faithful acolytes that the ultra-nutty policies like negative rates, corporate bond buying, and even stock buying tried by foreign central banks has not been met with enduring success or lasting enthusiasm. One might think the Fed would be gun-shy about attempting more dramatic intervention after ushering socialism into this country with its coddling of the elite since the last crisis, but we’ve learned it knows no shame. Its latest practice of hiding behind small wiggles in inflation data to argue for rate cuts when we all know it’s only trying to prop the stock market shows that.
We are left wondering if the data will allow the Fed to act as recklessly as it might like to defend stocks in coming quarters. The perfect construct for future stock manipulation rests on the official inflation data and/or growth remaining softer. Those may not happen. Of course, the clear weak spots in the entire Fed-led levitation are deteriorating corporate credit metrics after years of runaway debt issuance with incredibly little covenant protection in the high yield domain. The corporate bond market will decide the fate of the Fed narrative and it looks like a bubble waiting for a pin. Cracks are emerging.
After Chairman Powell’s recent dovish Congressional testimony, even some of the usual cheerleaders seem to be losing faith. They ask why it needs to ease now with such loose financial conditions already in place and stock indices at the highs. However, even with many credit friendly measures like spreads and rates, the inversion of the Treasury curve is making it clear that monetary policy is too tight given the landscape. The curve needs to steepen like yesterday.
Stocks are staging a narrow rally on the notion that the news is so bad, the central banks will have to ease policies in a counterintuitive, but typical late-cycle fashion. Most of the bad news relates to surveys of industrial activity along with generally slower domestic activity in places like retail, autos and housing. Slowdowns are more pronounced overseas. Job growth in the U.S. is at a recessionary 1.5% year-over-year growth level and the labor force is shrinking despite all the narratives about a strong economy. Rail traffic was down 6% in June. Factory production is declining at a 2% annual pace, but inventories continue to rise. Something is afoot.
We have been concerned about the Fed losing credibility for years because markets rest on that faith, not on valuations. The Fed is now quite concerned as Treasuries have forced its hand into easing mode because most market participants see little room for even slightly tighter monetary policy. Importantly, although financial conditions in the U.S. are already at record levels of easiness, borrowing is failing to respond to lower rates.
What can the Fed really do from here other than encourage asset speculation which has become its primary function? The practice of analyzing and investing in discounted future corporate cash flows at attractive levels has taken a backseat in U.S. equities. Basing decisions on future central bank activity has become the major endeavor for many.
With investors expecting three rate cuts by the Fed, the big assumption out there is that inflation will remain tame, paving the way for central bank largesse. However, it’s entirely possible that inflation picks up because of Chinese supply chain disruptions or cycle dynamics. We already think low growth will be a problem, but it’s entirely possible that GDP does not sink to levels that fit with the Fed becoming as ultra-dovish as stock investors seem to demand. We don’t think the China trade issues will go away soon, but perhaps the most acute pain is over for now.The slow demise of Deutsche Bank is coming to a head. It is amazing how little notice is taken of this banking giant’s troubles over recent quarters. Because it is so heavily involved in the global derivatives markets, the implications are negative but unclear. It also demonstrates how the ECB is crushing the banks in Europe. What kind of monetary policy is that?
With growth slowing, bonds have outperformed stocks over the last year. Assets that did not inflate in recent years like precious metals, non-U.S. stocks, value stocks, and commodities offer more attractive investment profiles. Maybe money will flow to them one day because they are all cheap relative to major U.S. stock indices.
Easier than normal monetary policy took place during the up part of this cycle, but what happens when the central bankers face the down part without as much room to ease. Those celebrating the levitation of the S&P 500 are ignoring the fact that the narrowness of the move is concerning much like it was at prior instances of misplaced confidence.
Investing is ultimately about buying future cash flows at attractive yields. Over the investment horizon, U.S. stocks are priced for returns near zero. As it stands, the celebration of new highs for the S&P 500 in the face of a lot of deteriorating data and earnings reductions seems like a New Orleans jazz funeral to us.
Meanwhile, few are asking if the globe’s central banks and government spenders will be able to keep behaving so recklessly without bonds or currencies staging a rebellion. Even if they can, will this make absurdly priced assets more absurdly priced when the cyclical tailwinds become headwinds, exposing the limits of monetary accommodation. Of course, a no-deal Brexit, a Chinese currency devaluation, or some other shock may provide an excuse for profit-taking, but the ascent of risk aversion seems inevitable regardless of what unforeseen events may unfold.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.