“Don’t Fight the Fed!”
Old Wall Street investing mantra credited to Marty Zweig.
What a difference a year makes! In 2019, investors enjoyed strong returns in pretty much all assets in almost unrelenting fashion right up into the closing days of December. This was almost the exact opposite experience of the rather challenging year that was 2018. In that year investors had to endure 2 full market corrections (drops of greater than 10%) and overall negative returns that culminated in a very miserable December. While there were many factors at work, the most influential was the pivotal change in the behavior by the US Central Bank. After methodically raising interest rates for 3 years, the Federal Reserve abruptly reversed course and cut interest rates 3 times last year.
While most investors know that the Fed lowered interest rates several times in 2019, another very significant development received less attention. In late August, stress in money markets caused overnight interest rates to soar without warning. In response, the Fed injected about $400 billion back into money markets over the course of the fall. This is significant because it took the Fed about 2 years to unwind around $1Trillion in outstanding Quantitative Easing balances and it took just 4 months to put about half of them back in place! So the Fed eased directly and indirectly allowing markets to march higher in lockstep fashion with this new liquidity. While the Fed maintains that this new program is not another round of QE, most observers are of the opinion that if it “walks like a duck and quacks like a duck”….it might in fact be a duck!
Liquidity is the lifeblood of markets. There is a direct relationship between the cost of money and the value of any asset. We don’t have to look any further than our own housing market to appreciate the correlation between low interest rates and high house prices. Cheap money has caused asset inflation in almost all assets over the last decade. Central banks are confident that asset inflation will cause a reinforcing wealth effect that keeps the global economy growing without risks. Central bankers seem to believe that they are the modern day alchemists, perpetually growing economies and wealth without any consequences.
The USA is the largest global economy and by extension this makes the US Federal Reserve the most important central bank. The U$ is also the world’s reserve currency in that almost 70% of all global financial transactions are denominated in U$. So while other central banks such as those controlled by the European Union, Japan and China are important, the US is the engine of global monetary policy so hence the expression, “Don’t fight the Fed!” And in 2019, the Fed’s actions became a tailwind once again.
The Fed has 2 stated mandates and only 2 mandates. Full employment and price stability, anchored to the 2% inflation target. The 2 mandates are thought to be in constant tension with each other as full employment has always eventually lead to wage inflation. For the last couple of years, the US economy has been running at record employment and currently there are almost 2 million more job postings than the actual unemployed! Record low unemployment did not justify emergency low interest rates and also the Fed wanted some ammunition for the next downturn so it began slowly normalizing interest rates in late 2015. But no other major central bank followed their lead and in fact, Europe and Japan seemed to double down with their negative interest rate policies! This divergence in central bank policies conspired to drive up the U$ at a time when President Trump is banging the drum on trade policies. A strong U$ depresses exports and works against his Make Amercia Great Again agenda.
The Fed’s second mandate of a 2% inflation target has proven to be more of a challenge. Long time readers of mine are familiar with my consistent diatribe on posted inflation rates not fully reflecting reality due to such influences as Hedonic Adjustments and Automatic Substitutions (call me if you really want to learn more!). I recently had a thoughtful conversation about this very issue with our chief US economist, Tom Porcelli when he presented at a conference that I attended. Tom’s work shows that the over the last 20 years, the posted US inflation rate has been lower than the 2% target rate almost 80% of the time! So the Fed has achieved its 2% inflation target only 20% of the time! Astonishing!
The average Social Security recipient in America will receive just $24 more per check this year over last year based on a posted inflation rate of 1.6%. This “math” saves the US government from adding more debt at a time when the US annual budget deficit is back over $1 Trillion/year. And since all private labor negotiations use the same inflation number, many employees have been forced to change employers to get any meaningful income growth.
I have said for some time that the Canadian stock market will eventually play some serious catch up to the US market in later stages of this economic cycle which at 11 years old is already the longest on record. When the inflationary winds start blowing, our commodity based companies catch a tailwind. However, in a world with high government and corporate debt levels and inflation rates that are carefully managed, I am not sure the Canadian catch up trade will materialize anytime soon. Meanwhile the Canadian economy continues to be overly reliant on construction with 7%+ of our GDP dependent on residential construction versus less than half that number in the USA! The Bank of Canada would like to cut interest rates but is understandably concerned about how that may lead to higher consumer debt levels. The catalyst for much higher Canadian stock prices is difficult to identify so we continue to invest for dividend income in Canada and look for better growth opportunities outside of our borders.
My outlook for 2020 is constructive and I remain cautiously optimistic for several unrelated reasons. The US and China trade war has gone from a boil to a simmer. The millennial population is fast becoming an economic tailwind as they move into household formation (they want yards and cars like every other demographic cohort despite what some say!). Almost all central banks are being very accommodative and are keeping interest rates very low and have shown a willingness to increase liquidity at the first signs of any market difficulties. Lastly, the US senate is very unlikely to remove Donald Trump at the end of the impeachment inquiry and his re-election is looking more and more probable (markets favor the incumbent). While the democratic primaries will likely create some turbulence, Trump will roll out plans for Tax Cuts 2.0 for the middle class by the time the presidential debates start.
Last year 91% of the market bump was on the back of higher valuations due to lower interest rates as well as progress on China trade and what is looking like an orderly Brexit. On the corporate side, some earnings growth needs to show up to support all of the recent appreciation, so don’t expect another 2019 but I think high single digit returns on stocks is very possible.
As always feel free to call anytime!