Fed Pauses: In Search of a Soft Landing

6 February 2019

During these Winter months,  my breakfast typically consists of a big, steaming bowl of porridge! As in the Goldilocks fairy tale, however, getting the recipe right requires some experimentation. Often the same is true of monetary policy decision-making. In search of a soft landing for the US economy — neither too hot, nor too cold — the Federal Reserve announced at its January meeting  a pause in its four-year campaign of normalizing monetary conditions. This represents a dramatic U-turn in US monetary policy. As recently as December, Chairman Powell’s team forecasted at least two rate hikes in 2019, indicated financial conditions were still accommodative, and that balance sheet reductions would continue on a preordained timetable. Seemingly, all that has disappeared, as a “patient” Fed now suggests that monetary policy is already “neutral”, balance sheet reductions will end earlier than expected, and indicated further rate hikes will require additional signs of accelerating inflation, e.g. hinting the next rate move could be lower!

Nots surprisingly, financial markets are celebrating the Fed’s more dovish posture. Indeed, the S&P 500 has already recouped virtually all of December’s dramatic decline. To be sure, the soft landing in the economy — capping inflation without causing a recession — would be a bullish outcome. Just like Goldilocks after finishing her porridge, can we now rest easy? Or, as happened to her, will markets be awakened suddenly by a big Bear staring down at us??!! Does the Fed’s policy shift, which has been accompanied by dovish commentary from policymakers in  both Europe and Japan, create opportunities in other parts of the world?

The Fed: Some Like it Hot!

Let’s consider what may have  prompted the Federal Reserve to  change course — some of the possibilities are less bullish than others. Do they know something we don’t know, e.g. is the economy already sliding toward recession? To be sure, signs of slowing growth are evident in US capex, housing, and foreign trade. As I wrote in my earlier blog “Heading for Global Recession in 2019?”, however, I do not expect an US recession in 2019, as the fundamentals for the American consumer remain healthy. In addition to rising wages, for example, monthly employment gains have averaged 260,000 during the past six months, topping 234,000 during the past 12 months. Indeed, a more “patient” Fed reduces the risk of recession, at least in the near term — a bullish outcome.

However, did the Fed capitulate to pressure from the Trump Administration? Is the Fed simply reacting to December’s financial market volatility? Both are unlikely.  In the run-up to next year’s election, however, the US central bank would quickly lose credibility if the market perceived political considerations influenced policy. Likewise, responding overtly to market conditions would run the risk of creating asset price bubbles. Under either of these conditions, the unintended consequence of the Fed’s shift would be to raise the already non-trivial risk of a 2020 recession. At the very least, the Fed needs to improve its communications with the market, which has been highly inconsistent in recent months.

However, the truth is that the Federal Reserve thinks the risk of running the economy a bit too hot are lower than if the conditions were too cool off excessively.  Bear in mind, this is the first tightening cycle after the Global Financial Crisis; consequently, the Fed has less knowledge than usual about how the economy will respond to policy decisions. In particular, despite the low US unemployment rate (and some acceleration in wages), inflation remains below the 2% target. And, most importantly, core PCE inflation has actually decelerated to 1.4% (annual rate) during the last six months. Therefore, with the economy slowing and lower oil prices likely to cap headline inflation this year, the Fed appears to be erring on the side of caution, as they have done since the GFC.

What are the implications for US markets? In our 2019 Strategy blog (released last September), we signaled that the S&P 500 would be highly volatile within a 2400 to 2900 range. We have not dramatically changed our thinking. To be sure, the Fed’s pause, combined with the lower risk of a near term recession, are more bullish, but the market still confronts meaningful headwinds. First of all, we still think the Fed will eventually raise interest rate further, albeit not until late this year or into 2020. On the other hand, US corporate profits (EPS) will slow dramatically in coming quarters (Chart above). Part of the explanation is that the impact of last year’s tax reform is running its course. However, the following Chart illustrates that rising wages are taking their toll on profit margins. I expect 2019 EPS growth of only 2% to 4%.

While I rarely rely on technical analysis, it is worth observing that after the recent rally the S&P 500 is now trading in line with its 200-day moving average, which is now trending lower. When the same situation occurred in 2015, the stock market traded sideways for over 6 months before confidence was restored (and sharp, periodic market setbacks occurred during that interval).

In an interest rate-driven market, I believe the most relevant valuation metric is comparing Equity Earnings Yields to Bond Yields (equity risk premium). Following the volatility of the past two months, the equity market valuation relative to bonds is near the middle of the range of recent years. So, no compelling valuation case for equities exists unless bonds rally further, which I do not expect. On the other hand, equities are unlikely to suffer unduly unless US bond yields rise beyond  3%, which also seems unlikely until later this year. Overall, therefore, I believe while the S&P could test the top end of my target range (2900) this year,  slower earnings and technicals suggests most of the recovery rally has taken place. Indeed, I do not rule out another market correction of 10% as earnings results disappoint during the next six months.

Meanwhile, soon the Federal Reserve’s pause is likely to cap any further strength of the US dollar. Indeed, if the European economy avoids recession this year, as I suspect, the greenback may be in the final stage of its multi-year appreciating trend.

Europe and Japan: Clearer Opportunities Exist

Unlike the uncertainty caused by the Federal Reserve’s abrupt U-turn, recent commentary from the ECB and BOJ suggests that interest rates may well remain steady throughout much (or all) of 2019.   Provided recessions can be avoided in Europe and Japan (see my earlier blog “Europe: Slipping Into Recession?” for why I do not expect a European slump), clearer market opportunities exist. In Japan,  past corporate restructuring has lifted the return on equity to earlier pre-bubble levels (Chart above). At the same time, valuations relative to other developed markets (including Price to Book Value) are at their most depressed levels in decades.

Likewise, Europe remains at an earlier stage of the economic cycle compared to the USA. If the economy stabilises this year, as I expect, European EPS growth has considerable scope to grow, as corporate earnings remain well below the peak of previous cycles (next Chart).

As European markets trade at a deep discount to the USA, opportunities exist if the economy gains traction (Chart).

The United Kingdom deserves particular attention. As you know, I am no fan of Brexit!! And, I agree with Otto von Bismarck’s comment that “laws are like sausages, best not to see how they are made”. To be sure, the Brexit process has been mishandled (don’t get me started), but I suspect that a deal will be reached in the coming weeks. However, Article 50 will need to be extended through June. Continued economic uncertainty will keep the Bank of England on hold, probably all year. The following Chart illustrates the FTSE is very undervalued (as is sterling). Both should rally if a deal is reached!

Emerging Markets: FX and Equities Set to Rally Further

In 2018, Emerging Markets confronted formidable headwinds: higher US interest rates, USD appreciation, large short-term external financing needs, overvalued exchange rates, and the prospect of a Sino-US trade war. The following Chart illustrates that the trade dispute has already created downside economic risks throughout Asia. Trade talks between the USA and China seem to be making progress. Frustrated by Congressional deadlock, I suspect President Trump will look abroad for a political victory. This improves the likelihood of a deal in the coming months.

External short-term financing needs remain large in certain EM nations, especially Turkey and Argentina. However, with the Fed pausing and the US dollar weaker, the prospects for rolling over ST debt have improved. In addition, unlike last year, most EM currencies are now undervalued (Chart).

As the global environment has improved and the likelihood of a replay of last year’s EM FX crisis has been reduced, the value that exists in EM equities should begin to be realised. You have not missed the rally!

Strategic Implications
  • 2019 may prove a quiet year for monetary policy. G4 central banks are likely to remain on hold until Q4 2019, or longer.
  • With the Fed pausing, US bonds are attractive compared to international markets.
  • The US dollar is in the final stage of its multi-year appreciation. Euro/$ could reach 1.25 over the next 12-18 months.
  • European and Japanese equities will outperform the USA.
  • UK equities and sterling could be amongst the top performers.
  • If Sino-US trade tensions ease (and if Brazil enters a period of reform), the outperformance of EM equities could continue for some time. EM FX opportunities exist, but be selective and tactical.