Not Buying It

Nov 11, 2018 | Dann Cushing


Global equities recovered 2% - 4% in what felt like an unconvincing market bounce...

...Headlines focused on stronger checks & balances in Washington after the mid-terms. However, volatility remains high despite an excellent Q3 earnings season wrapping up – S&P earnings were up 25%, revenues +8% and forward guidance was more positive than average – and equity sectors also continue to move in a textbook defensive manner in spite of this.


With earnings and estimates revisions effectively wrapped-up until next year, fear of a Yuan devaluation remains the most likely near-term negative catalyst for equities. The G20 Leaders’ Summit is at the end of this month, which creates a reasonable chance of China and the US resuming their trade threats and directly impacting the Yuan. We have previously made the case that a devaluation would impact investor perceptions temporarily (i.e. a market correction), but that it alone would not meaningfully affect the fundamentals of global GDP growth.


Something that would affect those fundamentals is reduced liquidity for banks, which in turn would slow lending. Since the Financial Crisis, the Fed has used interest on excess reserves (IOER) rather than open-market operations to ensure that market rates stay within the Fed Funds target range. The main drawback of IOER is that it can only put a floor on rates, not a ceiling – but in a bank system awash in excess liquidity for the past decade, this of course has been adequate.


Signs are emerging that reserves are becoming more scarce though. European banks bid up the Fed Funds rate in Q2, causing the Fed to move IOER below their target rate. Despite this, interbank rates for Fed Funds have continued to approach the Fed’s upper-bound target, a notable change from the past. This month’s primary-dealer survey by the Fed put heavy emphasis the IOER, suggesting that the Fed is highly focused on this development. It is not coincidental that this dynamic has occurred in the same year that the Fed’s balance sheet unwind began; after all, the Fed itself estimates that 90% of excess reserves are held by only 5% of banks (i.e. JP Morgan, Wells, etc.).


Putting it together, conditions appear to be starting to tighten for US regional banks and USD operations of international banks. If these conditions persist, the Fed’s only solution will be to stop its balance sheet unwind sometime in mid-2019. This would represent a major change to current market expectations about the Fed’s tightening bias relative to other countries, the biggest impact of which would likely be a drop in the USD. Through the volatility of the coming months, it is therefore worth looking at opportunities to moderately reduce US-denominated equity exposure in favour of CAD, EUR or (arguably) GBP equities. You can expect to see us evolve the equity portion your portfolio somewhat to reflect this view over the coming months.