Thoughts through the cycle: W3 September ’20

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The Fed – ‘moderate means not large’

  • The super-hero world created by DC Comics exists in something called ‘hypertime’ where several realities can exist in parallel. This is an excellent tool for explaining away what would otherwise be considered anachronisms and continuity errors in the story-telling process. The idea isn’t a new one. The philosopher Boethius (c. 477-524 CE) also uses the idea of the ‘nunc stans’ or eternal now to explain how god can be both omniscient (outside time) yet also the creator of the natural laws (inside time). In a world of seemingly limitless government deficits and central-bank money printing in which there appears for now to be few consequences, the financial markets sometimes feel as though they are enjoying an endless now of vaccine hopes and recovery positivity even as parallel narratives in the real economy indicate that output is stabilising at a lower level, with all the consequences that has for long-term growth and employment.
  • Underpinning the endless summer for financial markets is the assumption that central banks, particularly the Federal Reserve, will provide not only ongoing monetary support but also more monetary support should negative developments provide shocks to financial conditions. This makes central bank policy decisions and the press conferences which follow them key events in the market cycle. When markets are priced for perfection, and that perfection is a V-shaped recovery, the margin for error is small. Christine Lagarde’s recent ECB press conference saw the euro rise nearly 1% against the dollar as she failed to convince the market that the ECB was able (or willing) to control the strength of the euro.
  • Likewise, the graph below shows the S&P 500 on Wednesday 16th September (the Fed FOMC statement comes out at 19:00 BST, the conference call is at 19:30). With such modest expectations of new Fed action going into the meeting, it is perhaps a surprise that the market reacted so violently to what Chairman Powell had to say. Powell is not a good communicator. He has a tick in that he tends to cough under pressure. The ‘Zoom’ press-conference format is unforgiving, with tough questions creating an unusually adversarial atmosphere in a way similar to that in which a harshly-worded email can create a degree of antagonism out of all proportion to its actual subject matter. On this occasion, the assorted journalists pushed Powell and he did a poor job of parrying the questions.

Source: Bloomberg, 18th September 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • One of the points on which Powell fumbled most badly was inflation. Much fanfare has been made of the Fed’s shift towards average inflation targeting where the new goal is not 2% inflation in the medium term but an average of 2% across the cycle. When asked why none of the FOMC board members ‘dot-plots’ of future inflation expectations were at 2% within the forecast horizon, Powell proved particularly inept at balancing his assertion that the recovery was strong with the obvious implications from inflation expectations that the medium-term outlook for growth and inflation was tepid at best. When asked what the Fed meant by ‘moderate’ inflation, he replied, “moderate means not large”. A quote for the ages there, but likely no place for it in an ‘I wish I had said that’ anthology alongside the best of Churchill and Yogi Berra.
  • The bond market interpreted this as an unwillingness (or possibly an inability) of the Fed to do ‘more’ stimulus at the present juncture. The graph below shows the 30yr US Treasury yield spiking on the news. Along with rising bond yields and falling equities, the dollar strengthened and gold sold off sharply. Pretty much everything was going wrong for Powell at that point. One ought to take very seriously these type of market reactions when considering the extent to which asset prices simply reflect the expectation that central banks (and especially the Fed) ‘have the markets’ back’ when it comes to risk-taking. Given the recent market collapses in February 2018, Q4 2018, and in February and March 2020, central banks seem more reactive than proactive in terms of activity. This is the opposite of the narrative that the Fed spins and which underpins the logic of the ‘Fed put’.

Source: Bloomberg, 18th September 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • While it would be going too far to suggest that the press corps suffers from Stockholm syndrome with respect to their relationship with central bankers, there is often a sense that journalists show a degree of deference bordering on the sycophantic with respect to pulling their punches on controversial topics. No topic is more controversial for central bankers than that of asset bubbles (not our problem mate), and Powell was once again pushed unusually hard on this. In reply, he mentioned the consequences of the previous three tranches of quantitative easing (QE) as “notable for the lack of the emergence of some sort of financial bubble, the popping of which could threaten the expansion”.
  • He added of course that the Fed would continue to “monitor [the situation] carefully”. At the very moment he was speaking, the newly-IPOd stock of the cloud-company Snowflake (SNOW.US), priced at $120, rose on initial trading to $315 before settling around $290 (graph below). At that level, the company is trading on just over 180x sales. A bit bubbly perhaps? Luckily the stock fell 11.5% on the second day of trading but without threatening the expansion.

Source: Bloomberg, 18th September 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Powell added that there was no evidence of a link between asset purchases and financial stability. This may or may not be the case as ascribing a single causal link between two market phenomena is difficult if not impossible. On previous occasions though, Powell has been very keen to point out that the Fed intervention during the market crash in March helped to sure-up asset prices. You can’t have it both ways.
  • More than anything, it is likely that the market took fright from Powell emphasising the need for more fiscal stimulus (again despite the recovery, falling jobless rates and so on). The problem here is the Republicans and Democrats appear to be at logger-heads with respect to deciding the size and the focus of the stimulus. The election looms large, and partisan issues such as postal voting are adding to divisions on Capitol Hill. The market is fully aware of this, and asset price performance thus ought to be considered in this context.
  • This essentially changes the nature of stock picking and asset allocation. What multiple does a stock deserve if there is no further US stimulus? Can the Fed only amp up QE with the pretext of preserving financial stability following a sell-off? The debate for investors must therefore increasingly focus on the consequences of policy. With this in mind, the foreign exchange and commodity markets are the forums in which policy consequences manifest themselves. These markets are harder to manipulate and control, and are in a sense an ‘outlet’ where official policy gets priced.
  • With respect to inflation, it is worth remembering how entrenched market outlooks can be, and therefore how slowly perceptions change. While the story of Paul Volcker conquering inflation while he was Chairman of the Fed has gone into legend and now fits into a narrative of the long-term decline in inflation from the early 1980’s onwards, yields in 10yr Treasuries spiked from just over 7% to 10% in 1986-‘7 on renewed inflation fears. Hindsight shows this to have been a great buying opportunity, but market reality was that the memory of the inflationary 1970’s was just too strong at the time.
  • With all the mixed signals about inflation at present, and especially with the Fed dot-plots (and the market more generally) equivocal that the Fed can succeed in reaching its 2% average inflation target, it’s worth pausing to focus on an inflation indicator like silver. From the lows in March to the high in August, silver went from $12 to just under $30, a rally of over 140% in little over 4 months (see graph below), and now sits much higher than its pre-Covid level.

Source: Bloomberg, 18th September 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • We believe a move this big HAS to mean something. Another forward indicator of inflation is lumber prices whose futures rose from around $300 to nearly $1,000 between the March low and August. There are idiosyncrasies here: seasonality, demand from restaurants building outdoor seating due to Covid-19, tariffs on Canadian lumber and so on. When you see moves like this though, you can imagine someone considering building a house either thinking twice about it or possibly thinking better do it now before the price rises more – and that, right there, is inflation. The mindset changes to an inflationary one.
  • While inflation in the US is still muted (August CPI inflation was 1.3% YoY vs 1.0% in July and the Fed’s favoured PCE deflator read 1.3% for August vs 1.0% in July), seeing price moves such as those in silver or lumber begs the question with respect to inflation about when the symptoms become the disease. We believe moves that big mean something has to be going on. Quite what it is as yet unclear – devaluation, depreciation, debasement. Take your pick. The easy bit for the Fed is deflation – just print more and keep printing, like Japan has for decades. What though if the combination of fiscal and monetary activity in 2020, almost unprecedented in its size and scope, actually ends up creating inflation? What does the Fed do then if they’ve already told us they are not even thinking about thinking about hiking rates?

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