In evaluating the current weight of evidence, it’s important to examine what has changed since the stock market began its sharp sell-off during the 4th quarter of 2018 — starting with interest rate risk, asserts Jim Stack, money manager, market historian and editor of InvesTech Research.
While interest rates are still relatively low, their recent drop has given equities a much-needed reprieve and has taken some pressure off the Fed — suggesting that they can afford to pause in adhering to their data-driven approach.
If the economy accelerates and yields begin to rise again, however, the Fed will likely be forced to abandon their newfound patience to resume their path of gradual interest rate hikes. Furthermore, a rise in long-term interest rates back above 3.0% will once again present strong headwinds for equity markets, as it did in the latter part of 2018.
While today’s monetary spotlight shines brightest on the Federal Reserve’s path for interest rates, this isn’t the only iron in the fire for the Fed today.
In addition to cutting interest rates to zero for an extended period, the Fed has also inflated its balance sheet during this cycle in an attempt to buoy markets and aid the U.S. economy through a program known as Quantitative Easing (QE). QE is a massive expansion of the open market operations of the U.S. Central Bank.
Specifically, the Central Bank uses credit to buy debt securities from its member banks, effectively “printing money” by adding liquidity to capital markets. The primary goal is to stimulate the economy by making it easier for banks to make loans to businesses, thus encouraging spending and creating expansion.
In its first iteration, QE targeted the purchase of U.S. Treasury notes and mortgage-backed securities (MBS) at a time when the U.S. economy and entire financial system were vulnerable during the Financial Crisis. QE1 helped not only to prop up the fallen housing market with low interest rates, but also to get subprime MBS off bank balance sheets.
The Fed briefly halted QE in 2010 before renewing the program (QE2) when the economy began to falter. Near the end of 2012, the Fed announced QE3 in what many viewed as an act to boost the economy, not just avoid contraction.
The Fed promised to continue purchasing securities until one of two conditions was met: either unemployment would fall below 6.5% or inflation would rise above 2.5%. This extension of QE3 is sometimes referred to as “QE Infinity,” as it didn’t have a limit or end date, but rather a data-driven mandate.
By mid-2013, positive economic developments led Fed Chairman Ben Bernanke to announce that the Fed would likely start slowing the pace of its bond purchases later that year. In response to the Fed’s suggestion, global equities sold off and U.S. bond yields shot higher in what came to be known as the “taper tantrum.”
By the time they stopped asset purchases in October of 2014, the Fed’s balance sheet had ballooned to $4.5 trillion. The Fed’s experiment with QE was a success in the sense that it provided liquidity at a time when financial markets were severely constrained. It spurred lending, demand, and employment. It also raised the prices of virtually all financial assets.
The dilemma today is that between historically low rates and a massive balance sheet, the Fed has limited ammunition to fight the next recession. Today, the Fed remains in uncharted waters as no one knows what impact Quantitative Tightening (QT) — the inverse of QE — will have on markets and liquidity.
Undoing the actions of the past decade may be easier said than done, as it will have a less visible but potentially powerful tightening effect on monetary policy. The Fed’s balance sheet began its gradual progression towards normalization at the end of 2017. This unwinding increased to $50 billion per month during the fourth quarter of 2018, which is when equity market volatility spiked.
In response, the Fed has stressed patience and flexibility and even opened the door to tweaking its balance sheet strategy in the future. What began as a supportive mechanism has arguably become an addictive stimulus, and now the Fed finds itself between a rock and a hard place as it aims to de-engineer its grand experiment.
Looking back at the volatility last year and the sharp year-end losses, one could hardly call this a low risk market. In fact, cash was the only major asset class to show a gain for 2018. The obvious reversal in the Federal Reserve rate hike outlook has given investor confidence a boost.
But we’re unsure how long that will last if leading economic evidence, such as consumer confidence, starts to weaken. Our safety-first strategy will adapt as evidence unfolds, but we advise keeping seat belts fastened tight as this year progresses.
Today, the Fed hasn’t actually reversed policy, but they have clearly reversed their stance. In other words, the Fed has not initiated any interest rate cuts, however all planned rate hikes for 2019 have seemingly been put on hold.
That is a huge psychological boost to stock market sentiment. And it is definitely the stimulus behind the strong breadth thrust and leadership reversal shown inside. We don’t want to downplay the importance of this development as it could — like 1998 — help propel the bull market back up to new highs. From our analytical viewpoint, the real bear market still lies ahead.
We have not erased the excesses in subprime debt or leverage that have been built up over the past 9+ year bull market. Margin debt (money borrowed to purchase stocks on margin) peaked a year ago, and is locked in an ominous downtrend as speculation starts to unwind. The badly inflated housing prices, driven by the Fed’s quantitative easing and 0% interest rates, are going to continue to deflate in our view.
And the sudden drop in new manufacturing orders and consumer expectations are the first macroeconomic evidence to confirm we should not discount the possibility of a recession in 2019-20. All-in-all, we believe the shift in Fed policy has bought time along with this rally for the market.
Whether or not that will develop into long-term stability or potentially another bull market leg is highly debatable. And although we might reduce the defensiveness of our allocation slightly, we are unlikely to join the euphoric bullish camp seeking 20% gains this year.
Instead, we will maintain a more conservative course that is designed to err on the side of caution. And we plan to remain vigilant and flexible as more technical, macroeconomic, and anecdotal evidence unfolds in the months immediately ahead.
