We are in the typical blackout period leading up to the October 29th & 30th Federal Open Market Committee (FOMC) meeting. The FOMC is a branch of the Federal Reserve Board that meets eight times a year and is responsible for setting U.S. monetary policy. Chaired by Jerome Powell, the Federal Reserve is the most powerful monetary authority in the world. Interestingly enough, even the most powerful authorities sometimes struggle to achieve desired outcomes.
Next week’s FOMC meeting will be the second-to-last of 2019, leaving December as the final meeting in what has been an eventful year for monetary policy. With little historical precedent, we’ve watched policy transition from tightening, to patience, to easing in short order. This dramatic shift in monetary policy has been characterized by Chair Powell as a mid-cycle adjustment akin to the easing seen in the 1990s. When Mr. Powell first made this comparison during his customary post-meeting press conference in July, equity markets were disappointed. At the time, markets wanted confirmation that the FOMC was embarking on a full-blown easing cycle; to their dismay, Chair Powell was unwilling to supply that transparency (rightly so) and the market sold-off.
Today, the market fully anticipates the FOMC to deliver another interest rate cut next week and we share that expectation. Intra-meeting economic data flow has been muddling, inflation is still below target, and downside risks remain present. Moreover, recent comments from Fed officials have done little to push back on current market pricing, which indicates a 90% probability of another interest rate cut next week. If they fail to deliver next week, the market will surely be caught offsides. As such, the most likely course of action is a decision to reduce the target rate from 1.75%-2.00% to 1.50% – 1.75%, the third ease of 2019. The question for next week’s meeting becomes this: what will members attempt to communicate in their policy statement?
As former Chair Yellen loved to say (we paraphrase), “if you’re wondering about Fed policy, read the statement because that’s where it’s set.”
Yellen is referring to incidences where market participants assign too much weight to a drifting median dot, or an overreaction to a hollow slip of the tongue. She would say this to politely remind the public that the post-FOMC meeting statement is where monetary policy is set – read it. This all makes for an interesting drama heading into next week’s meeting. There will be neither dots nor an updated survey of economic projections, rather, just an old-school policy statement paired with a new-school press conference.
We see two likely avenues for the policy statement. First, the FOMC could cut 25 basis points, make the customary changes to the first paragraph of the statement and leave most everything else unchanged (e.g. the status quo). Second, they could cut 25 basis points, make the customary changes to the first paragraph and then change the end of the second paragraph and/or add a new third paragraph prior to the commonly used closing paragraph. Whatever form it might take, the purpose of any new verbiage would be to signal to the markets that they feel they have done enough to address global uncertainties. They are confident that with the support of three interest rate cuts (oh, not to mention hundreds of billions in short-term funding), the U.S. economy is in a strong enough position that they are going to employ a wait-and-see approach, again.
Whether the outcome of the FOMC’s policy update lies behind door number 1, 2, or a 3rd alternative, a few things are clear: job creation and economic growth have slowed; fiscal policy that was supportive last year is now fading and we’re left with a ballooning U.S. deficit; and while consumers remain somewhat optimistic, business confidence has waned due to persistent trade uncertainty and late cycle dynamics.
The Fed has been clear that they have no interest in implementing negative interest rates during the next recession. As such, the preemptive easing over the last few months was an effort to avoid the effective lower bound and bring inflation back to their 2% target. Unfortunately for the Fed, even the most powerful authorities in the world sometimes struggle to achieve desired outcomes. Which is to say, the Fed alone can’t solve the problems that currently face the U.S. economy. Despite the known limitations to monetary policy, the Fed will do their best to support this expansion and that might mean changing their policy framework down the road or, possibly, another shopping spree (data-dependent, of course).
It’s mid-August, liquidity is thin and markets are volatile. Between the tariff war, flagging European growth, Brexit and Argentina’s regular demise, investors are skittish and global yields are falling faster than Central Bankers can cut rates.
There are millions of pundits out there with myriad competing opinions on what is happening right now and why. Our role is to guide our clients’ portfolios through volatile periods and come out the other side with capital intact as well as potentially taking advantage of opportunities that may arise from periods of extreme market weakness. In times like these, we are focused on having dry powder and keeping the riskier parts of the market (e.g. equities and high yield bonds) below their targets.
During periods of volatility, we will always err on the cautious side, and this time is no different.
Our current portfolio positioning reflects this side of caution. Here is where we stand with respect to the major asset classes in which we are currently invested:
We are underweight target on an asset allocation basis. Within our High Yield strategy, we have ample cash as we feel it is important to have that cushion and will deploy it as spreads widen and yields increase. Our fund also has a higher credit quality than its benchmark as we remain underweight the riskiest CCC rated bonds. At a time where energy-related bonds are underperforming, our exposure has outperformed that part of the index.
Like High Yield, we are slightly underweight overall long equity exposure versus our asset allocation targets. Within our U.S. Equity strategy, large cap exposure is overweight relative to small cap, as small cap names overlap with the high yield market and tend to underperform when market sentiment declines rapidly.
We remain short duration, having positioned portfolios over the previous 12 months with an index to index-plus portfolio yield with only ~70% of each index’s interest rate risk. While yields briefly touched our 3% target at the longer end of the yield curve last year, our “across the curve” level was not hit. In hindsight, we missed an opportunity to gain some additional capital appreciation, however with absolute returns above 5% for the year, we now shift towards how to protect from giving that back.
Outside of the individual strategies, the asset allocation underweights have provided some additional cash to use as dry powder when market conditions become more attractive.
We are watching markets closely and will look to deploy cash at more attractive levels. The next step will be to move riskier sectors from underweight back to neutral. Should the markets overreact at any point and move to extremes, we would then move some sectors to overweight. We do not know if that scenario is in the cards, but we will be ready should it arise.
Last week there was a change in U.S. monetary policy. Gone is the regular drumbeat of ¼% short term rate increases that we have seen since December 2016. The straight-talking and pragmatic Federal Reserve Chairman, Jerome Powell, announced a dramatic about-face after the January 30th FOMC meeting. This striking shift towards a dovish policy tone surprised the markets. We believe that it warrants careful consideration as monetary policy is a key macro input when evaluating intermediate and long-term positioning for all asset classes.
First, the conspiracy theorists have been loud and particularly ill-informed when harping on the Fed and its duties. Neither Chairman Powell nor the other FOMC members are influenced by political pressure or any public chastising that may come from this, or any other, White House administration. The Fed always focuses on its dual mandate from Congress (manage inflation and achieve full employment). An independent Central Bank is at the core of the U.S. economy and its governmental structure. Sometimes those policies will align with perceived political pressures (January 2019 meeting) and other times they won’t (December 2018 meeting).
Second, the Fed needs to gather as much ammunition as quickly as possible to fight the next economic downturn. Rate hikes continuing toward a 3% Fed Funds Rate will achieve the goal and, in our view, should continue until economic data no longer provides the cover. While the markets are not fond of continual increases (they never are!), they will be happier in the long run. If the Fed fails to gather enough ammunition, the unconventional, “extraordinary” monetary policy measures used after 2008 will become normal. It is not practical to address each recession with a bazooka of quantitative easing (QE). The longer-term effect of using more QE to fight normal policy battles is akin to a vaccine wearing off and leaves the U.S. economy to turn down the same road as Europe and Japan.
Third, the Fed’s greatest fear is stagflation or deflation. While these carry a low probability today, the expected long-term costs of stagflation would be high. Rising inflation and slowing growth would be the worst-case scenario for financial markets and the Fed understands this risk. If markets perceive that the Fed has lost control of its inflation fighting powers, the volatility experienced this past December would feel tame. As such, it is incumbent on the Fed to maintain its prior hawkish streak to keep hold of its credibility on the inflation front. The best way to do this is to continue with gradual interest rate hikes.
As we enter 2019, there are several stories worth watching. Whether it comes from a Brexit resolution or an end to the U.S./China trade war, a reduction in uncertainty should provide solace to the markets. Investors will still have to deal with the Federal Reserve raising rates in 2019. While the Fed has lowered its signal to two rate hikes this coming year, those calling for one or zero may be missing the point. The Fed, with sufficient cover, must continue to raise rates to gain as much ammunition for the next recession as possible. Speaking of recessions, we continue to believe the current expansion will become the longest on record; however, we have continually targeted 2020 as a potential tipping point and our view has not changed.
The dovish pivot, while aggressive and unsettling, was not a concession to President Trump. Instead, the Fed felt that the outlook for global growth is cloudier today than in the fall of 2018. Drawn out trade negotiations, Brexit and U.S. government shutdowns are all moving dynamically and hard to handicap. Sprinkle on the healthy dose of financial market volatility during December and January and the Fed decided to hide behind a wall of well-behaving inflation and change its stance.
Unfortunately, this change of heart comes at the cost of further progress on points two and three previously mentioned and risks further market volatility down the road. If the U.S. economy is as healthy as Powell portrayed in his press conference, then the Fed just fell behind the curve.
Last week the Fed tried to communicate they are in full data dependency mode. What everyone heard, and what the markets quickly priced in, was that rate hikes are done for the foreseeable future. Additionally, they made it clear they are willing to stop shrinking their balance sheet. They also made a point of including the following text in a post meeting press release regarding balance sheet policy:
“The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.” -FOMC statement January 30th, 2019
Compare the above with this statement made six and a half years ago on July 26, 2012 by Mario Draghi, the longtime Head of the European Central Bank (ECB):
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
From our perspective, the Fed’s message is inconsistent. It does not match the economic outlook Powell spoke to during his January 30th post-FOMC meeting press conference. It also has a close ring to the Draghi statement which was made to save the Euro in the height of the southern European meltdown in 2012. Why did the Fed choose to go through the effort of reminding everyone they have a bunch of big weapons when there is no crisis in sight and their outlook on the U.S. economy still has a positive bias? Forget about Fight Club – it’s like bringing nukes to Book Club.
All we can surmise is either the Fed is much more worried about the possibility of a recession than they are willing (or scared) to divulge. If that is the case, then the expectation for zero rate hikes in 2019 is valid. Conversely, if the Fed starts to walk back their late January statements, they have set the markets up for another unnecessary bout of volatility.
In Zion National Park there is a famous hiking trail, Angels Landing. After the ascent, hikers walk a narrow spine with steep drop-offs on both sides. From this 1500ft high vantage point, hikers can see rock climbers appearing like spiders as they cling to the sheer rock face.
After last week’s Fed meeting, we are left to question if Powell is a hiker slowly navigating his way on an increasingly narrow trail or a rock climber scaling the mighty wall. No matter the choice, the margin for error is shrinking while the costs associated with a policy mistake are compounding. The Fed has painted itself into an extremely tight corner and operating monetary policy is now contingent on well behaved inflation.
After being enamored with Jerome Powell and his communication expertise, he leaves us with a lot to be desired after January 30th. Time will tell if the Fed folded like a lawn chair, but we have moved from a position of absolute trust in Powell’s style to “trust but verify.” We will give him another chance or two before jumping off the bandwagon completely.