Bear shock warning

The Fed is on hold after taking steps to make sure it avoided a policy mistake. At least that was what the markets were telling the Fed in December. Since then, risk is back on as the first phase of monetary policy normalisation in the US has come to an end. Policy is as neutral as it has been in over a decade. By not going any further, the Fed has allowed the markets to bounce and I expect the next several weeks will be a journey to re-testing the valuations that were prevailing before Q4 of last year. That is, of course, unless the economic data really does fall off a cliff. So far so good on that, with the US labour market still generating jobs. Yet the global economy still has a trade crisis, a slowing China and potential regional disruption in Europe to deal with. We know from December what a bear-shock looks like. That should be a sobering thought for investors in 2019.

The bear turned

The first six weeks of 2019 have been very different to the last eight weeks of 2018, in terms of market performance and investor sentiment. The end of last year was characterised by increased volatility in bond and equity markets as concerns mounted about the growing risks of a global downturn and the long US expansion coming to an end. Equity and credit markets had an awful final quarter as a result. Global credit US dollar excess returns were -2.5% in Q4 (ICE BAML Global Corporate Index) and the S&P was down almost 14% in total return terms. Government bond returns were positive, with a US-dollar hedged global bond index up 2.43% in Q4 (1.35% euro hedged and 1.96% sterling hedged)as investors piled into the flight to quality trade. The parallel shift in investor sentiment was just as dramatic. From contemplating a possible slowdown in the US economy in 2020, the narrative quickly became that recession was on its way with Federal Reserve (Fed) tightening, increased trade tensions and Brexit being the key factors behind the change in economic expectations. The market descent into bearishness was quite something.

And the Fed baulked

An important consequence of all of this has been the shift in the stance of the Fed. The Fed baulked at the risk of making a policy mistake. President Trump had for some time been critical of the Fed, the markets were sending the message that monetary policy had already been tightened too much, and there were growing concerns about the economic data and the robustness of expectations for growth in 2019-2020. So after the 25 basis points (bps) hike on December 19th, the Fed signalled that it was going to take a step back and assess future monetary policy decisions on the basis of the incoming data. This meant that the Fed was backing away from any perception that it was following a pre-ordained path to get the Fed Funds rate to some kind of neutral level. By inference, and on the basis of earlier comments by Jay Powell, the markets took all of this to mean policy was now at a neutral stance and that the options for future rate moves were more balanced between further hikes (most economists still see this) and eventual cuts in rates as the economy rolls over.

But the “Put” worked, for now

Wouldn’t you know it, the change in the messaging from the Fed halted the bear market and has allowed risky assets to put in a very strong performance since the beginning of the year. Easy money is back. US equities are up 10% year-to-date and the more credit intensive parts of the bond market have put in one of the best monthly performances for some time. The US high yield index registered a 4.6% gain in January, better even than the 4.4% registered in March 2016 and only bettered by the experience of 2009 when risk assets everywhere rallied hard after the financial crisis. All credit assets performed well in January and spreads squeezed tighter – by 35 bps in European investment grade bonds, by around 90 bps in European high yield, around 80bps in hard currency emerging market debt and over 100bps in US high yield. From investors hating credit in late December (when spreads had widened anywhere between 50bps and 200bps across the global credit markets), our fixed income dealing desks tell us this week that it has been really difficult to buy bonds and that the market is extremely “squeezy”.

Buy high, sell low…how sentiment swings

It’s understandable why investors get caught up in the volatility of markets. What happened in markets in Q4 actually made the risk of an economic downturn more likely as financial conditions tightened through lower equity prices and wider credit spreads. The deterioration in sentiment could have impacted on risk-taking and real investment and hiring decisions. Consumers could have become more cautious given the “bad news” from the markets. The risk of bad outcomes from the trade talks or Brexit became heightened by the skittishness of the financial markets. But in a few short weeks we have shifted back. The concern over the imminent end of the current expansion has been dialled back. Monetary conditions have eased and paper wealth has been restored by the rally in markets. In the framework that I used to try and understand and take advantage of market developments, the story around the macro outlook has settled back down to something more sensible. The global economy isn’t falling off a cliff – because there is no significant tightening of monetary policy anywhere – but growth is easing as the US economy enters a phase where the impact of tax cuts has faded and the rest of the world struggles with a number of structural and topical issues. Valuations re-adjusted in risk markets. Maybe not by enough for some. Credit spreads didn’t quite reach the levels we last saw in late 2015 – which was a clear buying signal back then – but they did get to their cheapest levels since then. Same with stock markets. By the end of December, the price-earnings ratio on the S&P 500 index had got back down to levels last seen in early 2016. Of course, with hindsight, the best times to buy are when sentiment is its weakest and valuations are at their most attractive. December 2018 was one of those months.

Easy money is back

It was almost like markets just had to let a lot of hot air out at the end of last year. The stretched levels of markets couldn’t live with more Fed tightening especially if we were going into a period of much slower growth. What’s changed is that monetary conditions are now much looser. As all further rates hikes have been taken out of market expectations, interest rate levels are significantly lower than they were at their peak in November of last year. For example, from the US interest rate swaps market, the 1-year – 1-year forward interest rate came down from a peak of 3.32% on November 8th to a low of 2.40% on January 3rd. A decline of almost 100bps. It is currently at 2.6% which is consistent with the Fed being on hold to slightly cutting rates over the next couple of years. The 2-year Treasury yield has dropped by 50bps over the same period and longer dated yields are all lower. These lower rates will feed into mortgage borrowing costs and other financing. Investment grade companies will be able to issue bonds with coupons, on average, 40bps-50bps lower than they could have done in late November. Over in Europe, the movement of rates has been in the same direction, although obviously starting from much lower levels. The 1-year-1-year forward Euro swaps rates is around 15bps lower, 10-year Bund yields are around 45bps lower than they were at the beginning of Q4 and borrowing costs for corporates and governments alike have dropped. If investors were worried about global monetary normalisation then I would say those worries have subsided. The first phase normalisation is over. The Fed hiked to (as good as) neutral and it shaved quite a bit off its balance sheet. Normalisation elsewhere is not really happening. It stalled in the UK because of Brexit. It has only just started in the Euro area and is not likely to accelerate at all because of cyclical weakness in Italy and Germany. In Japan, there is talk of actually more assets being in the negative yield zone. Globally, central bank balance sheets are not growing as a percentage of GDP, but the era of full-on QE is far from in full reverse.

Has this been enough to sustain the cycle?

There are research papers that suggest that stock market returns do have value in predicting monetary policy decision making. In other words, there is evidence for the existence of a “Fed put” in that negative stock market returns are a useful predictor of subsequent monetary policy decision making. December 2018 was an example of that. It’s quite easy to rationalise. The Fed wants to avoid making a policy mistake (tightening too much too quickly) and given the economic expectations embedded in the stock market, if returns turn negative (volatility rises) then the risk of a policy mistake is higher. It is impossible to assess the counterfactual as this would imply that the Fed never historically reacted to the stock market (i.e. what would rates, the economy and the market have done if the Fed had never reacted to stock market negative returns?). So we must assume that the reaction function of the Fed is normally impacted by the stock market. The question now is whether the expectations of the future performance of the economy – as embedded in stock market performance – have changed sufficiently for the positive, as a result of the Fed going on hold – to allow risk assets to sustain the strong performance seen so far this year? Is a 60-70bps reduction in interest rate expectations enough to reduce the chances of a recession sufficiently compared to where they were in November 2018? Will easier financial conditions help sustain the expansion even with the headwinds of the trade issue, Brexit and a China slowdown?

Risk on for now as the first phase of normalisation is over

I suspect markets continue to do well for a while. If there is a “Fed put” then positive equity returns since December are a reason to expect the Fed to be on hold. There is still a way to go for credit spreads to get back to their mid-2018 levels. Equity ratings are still a long way below their peak 2017 levels and even if the earnings cycle has weakened, there is some headroom in equity index levels. And the Fed is not likely to get in the way again for some time. After having backed off further rate hikes, the barrier to reversing the policy stance again is high. Growth will have to remain above trend, the unemployment rate will need to go lower still and wage growth accelerate further for the Fed to be confident that it is not at risk of a policy mistake if it makes two more interest rate hikes this year. It will take time for that evidence to build so I would see the risk rally lasting until the second quarter. Yet there is a risk that we could be back to a situation where the Fed thinks it needs to tighten more and yet the business cycle will be even more advanced with a lower commensurate trajectory for corporate earnings. The economic data flow is far from recessionary with US non-farm payrolls strong in January and the purchasing managers still pointing to solid growth. Let’s face it, there is an argument to say that the stance of monetary is still just on the accommodative side in the US and very much accommodative elsewhere.

But the cycle is still ageing

No-one is revising back up their economic growth forecasts. There remain significant risks in the outlook and it is surprising that the US economy remains as robust as it appears given the clear weaknesses in growth elsewhere. There is little spare capacity and marginal gains in employment require the participation rate to keep inching up. Without that and with fairly low productivity growth, output growth will slow naturally as the economy reaches the limits of productive potential. This is why the end of economic cycles are marked by slower growth and higher inflation and, although the marginal changes are small, this is what is happening in the US. If there is more evidence of “end-of-cycle” then I suspect bearishness will creep back into market sentiment as the year progresses. Debt levels remain high, there has been an increase in leverage in the US market and corporate earnings have been weakening. I am not sure there is fundamental justification for credit spreads to go back to the levels of last summer and stay there. In December, credit looked cheap. In February not so much.

It’s starting to get real

The top six in the Premier League are like a super-league all by themselves. Arguably there are 3 teams battling for the title and 3 for the remaining champions league slots. This last third of the season is shaping up to be very exciting. All six will be looking for maximum points this weekend but all six won’t be able to as Manchester City host Chelsea on Sunday. That should be a City win but Chelsea have the potential to stage an upset. I hope they don’t as United victory at Fulham would take the Reds above Chelsea and into the top four. Next week also sees the resumption of the Champions League and there are no easy ties at this stage. United will be looking to make a mark against PSG on Tuesday and this week really is the biggest test for Ole’s stewardship so far. A win that takes him into the top four and a result in the knock-out round of the CL will surely strengthen the case for the baby-faced assassin to be given the job as manager permanently.

Have a great weekend.

Chris

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