When nothing else could derail risk markets, along comes the coronavirus (COVID-19). At this point, it is unclear what the ultimate human and economic impact of the virus will be, but downside risks abound. The market response has been to sell risk assets and buy the safety of U.S. Treasuries in a classic flight-to-quality trade. The S&P 500 is down -12.7% from the February 19th record close and is now down -8.27% for the year. Meanwhile, the yield on the 10-year U.S. Treasury fell 40 basis points to a new all-time low of 1.11% and is down 77 basis points for the year.
From a return perspective, investment grade bonds benefited nicely from the dramatic move lower with Treasuries 1 producing positive monthly and year-to-date returns of 2.65% and 5.16%, respectively. The broader Bloomberg Barclays Intermediate US Government/Credit Index returned 1.41% for the month and 2.85% year-to-date. There was no such silver lining for the equity markets as the selling was aggressive and broad-based. Meanwhile, the high yield bond market 2 was down slightly for the month (-1.54%) and year (-1.53%); it faired significantly better than equities thanks to the positive price appreciation from the move lower in interest rates in the broader risk off environment.
To us, the most amazing part of the recent equity market correction is not the magnitude or velocity of the price swings, but instead the instantaneous clamoring from market participants for additional Fed stimulus, emergency rate cuts, coordinated global easing and yes even another round of tax cuts from the Trump administration. What would they ask for if equity markets sold-off 20-30%? These types of reactions to a 12% market correction speaks to a much bigger issue in today’s financial markets that we’ve been talking about for years. Namely, the markets’ dependency on easy money. It’s an issue. The Fed knows it, but they don’t know what to do about it.
To be sure, additional easing from the Federal Reserve is not going to solve the coronavirus outbreak. Additionally, they have been clear that monetary policy is on hold until there is a material reassessment to the economic outlook or inflation is significantly and persistently above their 2% target. To date, neither has happened. Of course, markets are forward- looking and pricing in the future negative impact of the coronavirus, thus asking for easing today. We do not envy the Fed’s position. Trying to set monetary policy during a period of market turbulence, sparked by a novel virus that nobody knows a thing about, is challenging to say the least.
If the virus gets materially worse from here, the negative economic implications will be undeniable and unavoidable. The Fed would be forced to ease policy further, attempting to spur a stalling U.S. economy. However, if the Fed chooses to preemptively respond and the economic outcome turns out to be less dire, then their willingness to placate the markets will be on center stage. The Fed cannot afford to be reactionary at this moment. They can afford to be patient, evaluate the impact of the virus, digest incoming economic data and move when they must (rather than when the market tells them to). Of course, this path for policy would likely result in disappointment and another leg lower in equity markets and thus you can see the Fed’s predicament. What the Fed should do and will do can be different things and sometimes for good reason. This might be exactly one of those situations.
We came into the year with a defensive stance, expecting the U.S. economy to muddle through 2020 and maintained the view that risks to growth remain skewed toward the downside. The coronavirus is clearly one such downside risk and we expect it to have a negative impact on corporate earnings. We’re only 1/6th of the way through the year and we still have the democratic primaries, the next iteration of Brexit and the election to chew on.
In our 2019 outlook, we expected the economic expansion to become the longest on record and identified 2020 as a possible tipping point for the U.S. economy. We advocated for a healthy dose of caution due to increased downside risks, but also stressed that it was not time to panic. Throughout 2019, Performa took a defensive approach when positioning client portfolios. We maintained a slight underweight to equites while moving up in credit quality and carrying less interest rate risk than the index within fixed income strategies. While our defensive approach produced generous absolute returns, it also caused us to underperform on a relative basis. The index-relative underperformance is disappointing and especially hard to stomach when a strategy of blindly buying risk would have generated larger returns for our clients.
As we look to 2020 and beyond, we must be humble enough to acknowledge that the current financial landscape is extraordinary and nobody knows how long it will sustain itself. There is currently $11 trillion worth of negative yielding bonds globally – and that’s without adjusting for inflation. Corporate spreads are approaching historic tights and the amount of outstanding BBB debt is unprecedented. Compounding these realities is a lack of voice (at least presently) from Washington D.C. willing to admit that the current fiscal situation is as unsustainable as climate change. The ratio of U.S. debt to GDP is north of 105%, up from 64% in early 2008. Amid all of this, the Federal Reserve cut interest rates three times last year and is quietly growing its balance sheet again (this time through Treasury Bill purchases). Sprinkle in a dash of impeachment, add a pinch of Brexit and sit back to watch as the relentless appetite for risk sends equity markets to fresh all-time highs.
In the face of an aging business cycle, looming presidential election and limited upside catalysts to U.S. economic growth, now is not the time to be greedy and chase returns. The calculus for 2020 is akin to that of 2019; it weighs how much upside one is willing to forego, while still participating, in order to protect on the downside.
Media and market pundits will focus on outsized year-to-date returns, but it is important to remember that from September 20th, 2018 (prior to the Q4 2018 market meltdown) through year-end 2019, the S&P 500 returned 13.08% while the iShares 7-10 Year Treasury ETF returned 12.43% during the same time period1. So, yes, 2019 gains were impressive but observing a slightly longer time horizon paints a less rosy picture, especially on a risk-adjusted basis.
The late 2019 euphoria that swept through financial markets, stemming from accommodative Fed policy and a Phase 1 trade deal with China, has our inner contrarian stirring. We suspect that the recent exuberance is overdone and will fade as we progress through the New Year. With plenty of questions unanswered, 2020 should be approached with humility and restraint.
At present, maintaining current exposures with an eye toward the downside is a sensible course of action. In doing so, our clients will continue to participate in any remaining upside in risk markets, albeit to a lesser degree, while providing downside protection should market confidence stumble or economic performance disappoint.
In mid-December of 2018, U.S. monetary policy maintained a clear tightening bias. The Federal Reserve forecasted two interest rate hikes in 2019, while allowing the size of their balance sheet to slowly decrease in the background. This was by no means new policy, as the mantra of gradual tightening had been in place for years, thanks to a solid U.S. economy supported by a healthy labor market and deficit-financed expansionary fiscal policy.
Entering 2019, Performa forecasted the Federal Reserve to deliver two interest rate hikes. We expected that the expansion could endure the additional tightening and benefits of moving away from the zero-lower bound (accumulating ammunition for the next economic downturn and attempting to restore some sort of normalcy to interest rates and broader capital markets) would factor into the Fed’s decision tree. As it turns out, we, much like the Fed, missed the mark by 150 basis points or the equivalent of five quarter-point moves. Instead of hiking twice in 2019, concerns over slowing global growth, destructive trade rhetoric and tepid inflation coaxed the Federal Reserve into delivering three interest rate cuts. A generous amount of easing in the second half of the year, to be sure.
The dramatic U-turn in monetary policy has little historical precedent and worked to buoy sentiment while sparking activity in the interest rate-sensitive housing sector. The question for 2020 becomes this: will the Fed’s preemptive easing be successful in extending an already old expansion and ultimately avoiding a recession?
For quite some time we have targeted 2020-2022 as the likely end to the current economic expansion. Then poorly timed deficit-financed expansionary fiscal policy that juiced the U.S. economy in 2018 caused us to focus on the earlier part of that range. At this time last year, we expected the current expansion to overtake the 1990’s as the longest expansion on record but identified 2020 as a possible tipping point for the U.S. economy.
Today, we would feel much more confident in this call had the Fed followed through and delivered two interest rate hikes in 2019. But as the facts change, so too must our outlook. The unexpected and abrupt monetary policy U-turn has buffeted the near-term prospects for recession but has not removed them from the table. 2020 is still likely to be a pivotal year for the current expansion and financial markets in general as many questions remain unanswered. Not the least of which is who will win the 2020 election?
For now, economic weakness has been contained to business spending and the manufacturing sector. While the Phase 1 trade deal has removed some headline risk, we expect corporations will approach 2020 with prudence as they consider longer-term strategic plans. This caution is more than warranted given considerable political and economic uncertainty and will act as a governor on the broader economy.
To date, consumption has underpinned U.S. economic growth and will be a requirement if the expansion is to sustain itself. Job creation continues to surprise to the upside while initial claims track historic lows and wages show modest year-over-year gains. Consumer sentiment is below cycle highs but still hovers at lofty levels. It is worth noting that consumer surveys have plenty of exposure to equity markets and thus are susceptible to quick and somewhat dramatic swings. With that said, the savings rate has been undeniably strong, which should, at a minimum, temporarily support consumption in the event of a negative shock.
Call us paranoid, but the recent developments in short-term funding markets have us concerned. Back in September 2019, without notice, overnight rates rocketed higher indicating a lack of liquidity in short-term markets. The spike was quickly discounted as a “perfect storm” borne from sizable corporate tax payments which created a temporary shortage of dollars. Since then, the Federal Reserve has implemented a slew of measures designed to increase liquidity and calm markets. The massive amount of liquidity that the Fed is now injecting into short-term markets could be there to alleviate legitimate technical disruptions (as the Fed describes them), or to potentially mask a deeper, more worrisome issue in funding markets.
At the time, the Federal Reserve was attempting to unwind years of excessively easy monetary policy when their plans were derailed. The message from the market to the Fed was a clear and definitive “we still need your liquidity.” Hardly a resounding vote of confidence from market participants. While the Fed has been prepping for the new world of conducting monetary policy in an ample reserves regime, we believe that they failed to anticipate finding the new floor in reserves so quickly. Doing so probably came as a rude awaking for the Fed and its long-term plan for its balance sheet. The last 10 years of experimental monetary policy are going to have a lasting impact as we move into the 2020’s. Exactly where the fallout from these practices will land remains one of the biggest unknowns in financial markets today.
In totality, we expect the U.S. economy to muddle through 2020 and maintain the view that risks to growth remain skewed toward the downside. The recent shift in Fed policy has taken out some of the downside risk, but we see little in the way of catalysts that would produce meaningful upside surprises in the New Year. From a more skeptical perspective, where we find ourselves most frequently, one does not have to work too hard to find potential downside impulses that would send confidence meaningfully lower. Buckle up – it’s going to be an interesting year.
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).