While low inflation may allow the Fed to ease interest rates, in today’s market environment at the end of a long growth cycle that appears to be slowing, it is not a positive sign, notes Landon Whaley.
This week’s “Headline Risk” focusses on the U.S. Tweeter-In-Chief.
From a political perspective, I don’t care if you’re a donkey or an elephant, it would be foolish as a market practitioner not to acknowledge and monitor a Commander-in-Chief who isn’t afraid to speak his mind publicly, and directly, at the Federal Reserve.
President Trump’s two-pronged motivation ahead of next year’s election is to avoid a market collapse and an economic recession. His tweet at the Fed last week regarding the U.S. dollar’s strength plays right into avoiding a market correction. President Trump knows that one proven way to ensure rising equity prices is to burn your currency like a Salem Witch.
I’m much more interested in unpacking Trump’s tweet calling low inflation “a beautiful thing.” Trump isn’t alone in this belief, many people think declining, or low inflation is a beautiful thing, no matter when it occurs.
As is usually the case in life, context is critical. If growth is accelerating, then from a risk-taking investment perspective, low or falling inflation is indeed a beautiful thing. We refer to this panacea for growth investing as a Spring Fundamental Gravity. During a Spring-like market environment, one of the best risk assets to own is basic material stocks because they average a quarterly return of +7.1% and are positive 88% of the time. But by no means are material stocks alone; all the growthy equity sectors thrive in this environment, and the S&P 500 has its best performing season as well.
However, if growth is slowing, like it is now in the United States then falling inflation is as ugly for markets, and we call that a Winter Fundamental Gravity. Those same basic material stocks we love so much in Spring average -3.3% every three months and post positive returns just 38% of the time. Here again, all the growthy equity sectors experience this flipping of the risk-return coin during Winter market environments. And while the S&P 500 has historically averaged a small 85-basis point quarterly return, the likelihood of it posting positive returns during a weak (Winter) market environment is no better than 50/50.
President Trump is clearly in re-election mode and can’t afford either a recession or a stock market crash. While I can’t say whether the U.S. economy will enter a recession before November 2020, I can tell you the likelihood of a 20% peak-to-trough drawdown in U.S. equities is increasing by the week. If you thought Q4 2018 was a Winter Wonderland to behold, wait until Q3 2019. Get your popcorn ready because as we discuss in this past Monday’s Playbook, this time really is different, and I don’t think President Trump will consider what’s likely to happen to be “a beautiful thing.”
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