Camelot Portfolios Market Commentary
IS THE FED PAUSE ENOUGH?
By Paul Hoffmeister, Chief Economist
· As we see it, the strong equity market rebound in January transpired along the lines we anticipated at the start of the year, as the outlooks improved for both Fed policy and US-China trade.
· Chairman Powell and other Fed officials have emphasized throughout the course of the current rate-hiking cycle that policy will be data dependent, and in our view the data in late 2018 turned unquestionably negative to justify their about-face.
· Amid the significant market and economic weakness in Q1 2016, the Fed backed away from the two to four rate increases they were telegraphing for that year (it only raised a quarter point in December 2016), and the dovish pause correlated with a major stock and credit market rebound. The 2016 market narrative creates a compelling analogue for market bulls today.
· But the parallels aren’t perfect between 2016 and today. Although some credit spreads have narrowed substantially in recent weeks, the spread between Moody’s Baa and Aaa-rated bonds is only narrowing a little bit so far. Furthermore, the slope of the Treasury curve is much flatter today than in 2016.
· The significantly flatter yield curve today signals, in our view, a more vulnerable economy than the one in early 2016 when the Fed last paused. If anything, we believe a major revitalization in market conditions will be harder to achieve in 2019 than 2016; new pro-growth policies are more important today than they were three years ago.
· The easy part of the stock market rally seems to have occurred in January. Indeed, equity indices in late December could have been viewed as having been asymmetrically favorable to the upside given the extreme pessimism at the time. With the relief rally now over, we believe financial markets will need to see that structural macro foundations are sound or improving, and that many of the looming uncertainties today are resolved.
As we see it, the strong equity market rebound in January transpired along the lines we anticipated at the start of the year, as the outlooks improved for both Fed policy and US-China trade. This reversed the seemingly pessimistic sentiment in late December, when it appeared to some that the Fed would stubbornly raise rates in 2019 and a trade deal was a low probability event. As the outlook reversed in January, the S&P 500 rallied 7.9%, marking its best start to the year since 1987, according to Dow Jones.[1]
For the moment, it appears that the US and China are on the verge of reaching a trade deal. On January 31, President Trump met Chinese Vice Premier Liu He in the Oval Office and said: “We’re trying to work out a new trade deal with China. I think it’ll happen, something will happen. But it’s a very big deal. It’ll be, if it does happen, it’ll be by far the largest trade deal ever made.”[2]
Many anticipate that the expected meeting in late February between Presidents Trump and Xi will iron out the final details of an agreement.[3] Note, March 2nd remains the deadline before President Trump is expected to raise tariffs on Chinese imports again.
But in our view, the major macro variable – the elephant in the living room -- remains Fed policy and the interest rate outlook, and it has turned decidedly dovish.
The January 30th FOMC statement announced that the Committee will be “patient” in determining the future path of short-term interest rates. This is in sharp contrast to the December 19th announcement where the Committee telegraphed more rate increases for 2019.[4]
Chairman Powell, when explaining what changed in the course of the prior six weeks, highlighted in the post-meeting press conference slowing global growth, the federal government shutdown, and tight financial conditions.[5]
Interestingly, Powell was asked by Jim Puzzanghera of the LA Times whether the Fed caved to President Trump’s demands to stop raising rates. The Fed chief responded:
… we’re always going to do what we think is the right thing. We’re never going to take political considerations into account or discuss them as part of our work. You know, we’re human. We make mistakes, but we’re not going to make mistakes of character or integrity. And I would want the public to know that, and I want them to see that in our actions.[6]
The statement that the Fed is human and makes mistakes could be perceived to be a tacit acknowledgement that the FOMC made a mistake in December by sounding a hawkish policy path for this year. While it is hard to recall such an abrupt and significant U-turn in Fed policy, it is also hard for us to find such an admission from the Fed. If this interpretation of Powell’s statement is accurate, then it suggests to us that the Fed will be extremely cautious in raising rates during the next twelve months.
Of course, Chairman Powell and other Fed officials have emphasized throughout the course of the current rate-hiking cycle that policy will be data dependent, and in our view the data in late 2018 turned unquestionably negative to justify their about-face.
In the United States, the Richmond Fed manufacturing index for December showed the largest month-over month decline in history, and the Dallas Fed survey showed the largest decline since the 2008-2009 financial crisis. Furthermore, the S&P 500 declined nearly 14% in the fourth quarter, which possibly foreshadows a major deterioration in the U.S. economy and corporate profits. This prospect seems to have been validated by the slope of the Treasury curve at the end of December, which according to the New York Federal Reserve was predicting a 21.35% probability of recession occurring by the end of 2019. This compares to an approximately 4% chance of recession within twelve months at the beginning of 2018.[7] As we see it, the macroeconomic environment deteriorated substantially during the course of the last year.
In China, the Caixin/Markit Manufacturing Purchasing Managers’ Index (PMI) registered 48.3% in January, marking the second consecutive month of contraction in China’s manufacturing sector. [8] Furthermore, the Chinese economy grew 6.4% in Q4 2018, a 28-year low.[9] And in Europe, Italy officially entered into recession in late 2018, and growth in the Eurozone, according to the EU statistics agency, slowed in 2018 to 1.8% from 2.4% in 2017, the weakest pace in four years.[10] [11]
Fortunately, we have seen in recent weeks some stabilization in the growth trajectory in the United States. ADP payrolls data at the end of January showed better-than-expected hiring: 213,000 jobs were added versus the consensus estimate of 178,000, with medium-sized businesses adding the most jobs.[12] Importantly, too, the ISM manufacturing index rebounded in January to 56.6%, from 54.3% in December.[13] As we have said before, we want to see the job and manufacturing environments remain strong, otherwise we believe the U.S. economy will start veering toward recession.
We believe the biggest question today is: will the Fed pause be enough?
In other words, will it be enough to enable global growth to stabilize or re-accelerate? Or will it be insufficient in forestalling the economic slowdown of late 2018?
Amid the significant market and economic weakness in Q1 2016, the Fed backed away from the two to four rate increases they were telegraphing for that year (it only raised a quarter point in December 2016), and the dovish pause correlated with a major stock and credit market rebound. The 2016 market narrative creates a compelling analogue for market bulls today.
But the parallels aren’t perfect between 2016 and today.
Although some credit spreads have narrowed substantially in recent weeks, the spread between Baa and Aaa-rated bonds is only narrowing a little bit so far. Furthermore, the slope of the Treasury curve is much flatter today than in 2016.
Approximately speaking, by the end of January 2016, the 3-month/10-year Treasury spread was 160 basis points; the 2-year/10-year spread was 114 basis points; and the 2-year/5-year spread was 55 basis points.[14] As of January 31, 2019, they were 23, 17, and -2 basis points, respectively.[15]
The significantly flatter yield curve today signals, in our view, a more vulnerable economy than the one in early 2016 when the Fed last paused. If anything, we believe a major revitalization in market conditions will be harder to achieve in 2019 than 2016; new pro-growth policies are more important today than they were three years ago.
Importantly, major currency prices, particularly the dollar, appear healthy; but we do not see significant growth-incentivizing tax cuts around the world, on net. Furthermore, markets are facing a range of policy and political uncertainties, including Brexit and the results of the Mueller investigation. Indeed, we want to see positive developments in these variables, much like what occurred in January with the Fed and US-China trade variables.
The easy part of the stock market rally seems to have occurred in January. Equity indices in late December certainly could have been viewed as having been asymmetrically favorable to the upside given the extreme pessimism at the time. With the relief rally now over, we believe financial markets will need to see that structural macro foundations are sound or improving, and that many of the looming uncertainties today are resolved.
[1] “Stocks Post Best January in 30 Years,” by Amrith Ramkumar, Wall Street Journal, February 1, 2019.
[2] “Trump Optimistic on Trade Deal with China, But May Keep Tariffs Anyway,” by Alan Rappeport and Mark Landler, New York Times, January 31, 2019.
[3] “Xi Jinping and Donald Trump May Meet in Da Nang, Vietnam, at the End of February,” by South China Morning Post, February 3, 2019.
[4] Federal Open Market Committee statement, Federal Reserve Board of Governors, January 30, 2019.
[5] Transcript of Chairman Powell’s Press Conference, Federal Reserve Board of Governors, January 30, 2019.
[6] Ibid.
[7] Source: New York Federal Reserve Bank: “The Yield Curve as a Leading Indicator”.
[8] “Another Number Paints a Bleak Picture of Manufacturing in China,” by Yen Nee Lee, CNBC, January 31, 2019.
[9] “China’s Economy Cools in Q4, 2018 Growth Hits 28-year Low,” Reuters, January 21, 2019.
[10] “Mama Mia! Italy Now in Recession Stunts Europe’s Growth Prospects,” by CBS News, January 31, 2019.
[11] “Eurozone Slowdown Feeds Fears about Faltering Global Growth,” Paul Hannon and Eric Sylvers, Wall Street Journal, January 31, 2019.
[12] “Private Companies Add 213,000 Jobs in January, Easily Topping Expectations,” by Fred Imbert, January 30. 2019, CNBC.
[13] ISM Manufacturing Index Rebounds in January, Easing Worries about the Sector,” Greg Robb, February 1, 2019, MarketWatch.
[14] Source: St. Louis Federal Reserve Bank.
[15] Ibid.
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