Fed Policy Is Already Very Restrictive
Equities continued to grind higher last week with the S&P 500 logging its fourth consecutive week of gains – the Nasdaq has a seven-week winning streak. A constructive development of late has been the broadening of participation among the equity market with both the small and mid-cap indices rallying to three-month highs. As of last week’s close the S&P 500 is up 20% from the October lows which brings out the proclamations from the bulls that a new bull market is underway while the bears push back with the fact that the S&P 500 is still 12% below its January 2022 high. To me, such a debate is trivial, and investors would be better served to focus on compounding and/or preserving capital irrespective of the classification. Truth be told, during both the 2000-2002 and 2007-2009 downturns the equity market experienced 20% rallies only to roll back over and make new lows. Eventually equities rallied 20% off the ultimate lows of those downtrends and went on to make new all-time highs, but the start of those bull markets (unknown in real-time) coincided with an upturn in the business cycle, accommodative monetary and fiscal policy, and a thorough cleansing of the excesses built up in the prior cycle – none of those pieces are in place now.
We are still dealing with an equity market that remains extremely bifurcated where the top eight companies in the S&P have contributed nearly 100% of the return in the S&P 500 year-to-date while the collective of the rest are practically flat (chart compliments of Jim Bianco at Bianco Research).
The appreciation in the mega-cap Tech names this year has managed to push valuation multiples on the S&P 500 to unappealing levels (north of 20x), but when excluding the top 50 stocks the S&P 500 trades at just 15x – a full standard deviation below its historical average of 18x. So, there are areas of opportunity for those investors with a value tilt, but keep in mind that cheap valuations are not sufficient as a standalone variable to constitute an investment.
This week markets will get a taste of the onslaught of oncoming Treasury issuance now that the debt ceiling has been raised and the TGA gets refilled. JP Morgan estimates that from now through September liquidity will fall by more than $1 trillion from about $25 trillion at the start of the year with Managing Director of JP Morgan’s Global Macro Strategy, Nikolaus Panigirtzoglou sharing the following comment:
“This is a very big liquidity drain. We have rarely seen something like that. It’s only in severe crashes like the Lehman crisis where you see something like that contraction.” … “It’s a trend that, together with Fed tightening, will push the measure of liquidity down at an annual rate of 6%, in contrast to annualized growth for most of the last decade…”
While I think all investors must acknowledge the resilience in the equity market’s ability to climb the wall of worry thus far in 2023, the ascent from here gets harder. The VIX came into the year in the mid-20’s, spiked into the 30’s during the regional banking crisis in mid-May, but has since slipped down to below 14. That’s a historically complacent level typically associated with clear skies and strong tailwinds. Investor sentiment has done an about face as well with last week’s Investor Intelligence survey showing the bull camp expanding further from 47.9% to 51.3% - the highest reading since the Nasdaq was peaking back in late-2021. Those in the bear camp have slipped into early hibernation at 21.6% - lowest level since, you guessed it, late-2021. The CNN Fear-Greed Index has moved into extreme greed territory at 79 from 61 a week ago and investor exposure as represented by the NAAIM Exposure Index just pushed above 90 – highest level since the S&P 500 peaked in January 2022. Looks like everyone is jumping into the pool as the weather warms up.
Nothing like price to change the minds of investors. I get it, positioning came into the year loaded up on the bear / recession side of the boat. As the year unfolded and the recession calls got punted further and further down the road, risk assets repriced higher on any and all data that didn’t confirm the recession forecast. Let’s be clear, it’s not as though the data has been strong, it just hasn’t validated the ‘recession is imminent’ view coming into the year. So, as equities and risk assets rallied, investors have been forced to rebalance their exposures and chase risk assets higher for fear of falling too far behind on the performance scorecard. Even now, there remains a lot of investment capital parked in money market instruments, waiting for the opportunity to get back in.
This is one aspect of the investment setup that makes me less fearful of a significant sell-off assuming fundamentals continue to bend but not break. Let’s face it, it’s the recession that is the biggest risk to asset prices and absent a recession it’s hard to fight the natural pull higher in risk assets. Even if/when a recession occurs there is no hard fast rule of how far asset prices come down. Pre-conditions matter and in my estimation the pre-conditions leading up to this window of vulnerability are a mixed bag. A lot of repricing occurred over the past eighteen months and while I still think there is more to come, I do think that limits the impact in some areas relative to others.
Lots of variables coming through our work continue to guide us to remain skeptical and cautious, but not frozen in a state of stasis. The 2s/10s Treasury curve at -86 basis (its deepest inversion in the last three months) is not an all-clear market signal. WTI crude prices at $67.50 per barrel (down from $80 at the start of the year and $116 this time last year) and copper prices near six-month lows with an uber constructive secular setup does not comport with the ‘economy is strong’ narrative being pushed by the bulls. A favorite indicator of Alan Greenspan when he was Fed Chair was the year-over-year change in cardboard boxes as he viewed it as an accurate real-time gauge on the level of economic activity. As you can see from the below chart, we are reaching depths only experienced during the last three recessions.
If/when the U.S. economy goes into recession remains an open question. What is no longer a question is that the peak of the economic growth cycle is behind us, and that growth momentum is waning. There are four main components of the NBER measures in its recession call and all four have rolled over.
• Industrial production: September 2022
• Aggregate hours worked index: January 2023
• Real business sales: January 2023
• Real personal income: March 2023
To be clear not all four are contracting, but all of them are slowing. Then there is the Fed and the embedded lags from the policy tightening already enacted. The evidence is spelled out pretty clearly in the following chart from TD Securities where they look back at the last nine tightening cycles dating back to the early 70’s and illustrate that in only two of those tightening campaigns did the U.S. economy not slip into recession. The mid-80’s, which I would argue was buoyed by stimulative fiscal policy on the back of Reagan’s Tax Reform Act of 1986 which simplified and reduced personal income taxes while removing government regulation. The mid-90’s had the internet revolution just getting underway and perhaps A.I. can play the part of the white knight today to offset this tightening cycle.
Perhaps many of you reading this are growing as tired of this backdrop as I’m archiving it on a weekly basis. But impatience is not a substitute for diligence and prudence. Cycles take time to play out, just as risk happens slowly, then all at once.
The reality remains that this is the largest and swiftest interest rate hiking cycle any of us have experienced in the past five decades (see below chart). Don’t forget what the Fed’s objective is in pursuing this course – to slowdown the economy, cool the labor market, and moderate the rise in inflation. This increases risk in capital markets, not the other way around. The Fed's actions over the past sixteen months should leave little question that they are committed to achieving this objective. Powell himself, in his Jackson Hole speech last August went out of his way to make it known that it wouldn’t be ‘painless’. They are willing to accept collateral damage such as job losses and lower asset prices. We’ve had episodes of both during this tightening cycle with a regional banking crisis sprinkled in, yet their messaging remains one of a tightening bias going forward. Market pricing for Wednesday’s FOMC meeting has just 26% odds of a 25-basis point hike at this meeting, but nearly 80% odds of a 25-basis point hike in July. This is a far cry from just a month ago when investors were actually thinking that there was a near 30% chance that the Fed could be cutting rates at the July meeting.
So, what’s an investor to do? Just that, invest! Money market and short-term debt instruments are investments that yield 5%. That’s an investment and the best return investors could garner on these types of securities in fifteen years. If you’re feeling more froggy and want to leap into the risk pool, there are plenty of options available there too. Just do so with an open mind and a willingness to adjust your sails when/if you need to. One thing that is catching my attention as I type is the fact that the equity market is up and so is the VIX index. That’s the type of price action you see from two historically negatively correlated assets at the tail end of a trend. One day is not a trend so something to keep our eyes on over the next several days and into the quarterly options expirations at the end of the week. These quarterly option expirations over the past six quarters have tended to coincide with major pivot points in asset prices. We’ll see what this one brings.
One last thing on the Fed and a hat tip to Kevin Muir who put out a great post on his Macro Tourist substack over the weekend. Kevin’s work focused on the level of the ‘real fed funds rate’ and why he thinks future Fed action is dependent on inflation expectations given the real Fed funds rate is at its most positive level since the GFC. Stated simply, Fed policy based upon future inflation expectations is the most restrictive it’s been in over fifteen years. The Fed no longer needs to hike at all to maintain restrictive policy. If inflation expectations remain tame and they just hold interest rates steady, inertia will do the work for them. Kevin did a great job elaborating on this notion, but unfortunately, I can’t share its entirety as it's behind a pay wall and wouldn’t be fair for me to share it for free. However, I did pull out a couple relevant charts below that clearly articulate the message.
First chart, the sequence of interest rate hikes by the Fed and subsequent change in the real fed funds rate.
A different way of viewing the same data, but with Kevin’s narration of the sequencing.
Lastly, a longer term look at the level of the Fed funds rate minus 1-year inflation swaps (real Fed funds rate).
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