Fed Has A Mindset Change And Markets React

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by: Bill Ehrman

The Fed finally acknowledged in their comments and revised economic/interest rate forecasts that low inflation is not transitory and that Fed policy needs to be more equally balanced between employment and inflationary considerations.

It was just as clear that foreign economic and financial data points have moved up a notch or two in Fed deliberations. Clearly there was a mindset change at the Fed, which has tremendous ramifications for all financial markets and asset classes.

Other noteworthy data points last week came out of the BOJ meeting last Tuesday and an announcement by both OPEC and non-OPEC producers, comprising about 73% of global oil production, that a meeting will be held on April 17th in Qatari to reach a global production deal. Hope springs eternal that a deal will be announced then to curb global production.

The bottom line is that there has been a continuation of a mindset change by investors, which we discussed at length last week. Not only has the glass for investing gone from half empty to half full and certain risk assets are back on, there has been a paradigm shift in investors perception toward energy, industrial commodities and the future path of the U.S economy.

We fully anticipated these changes as written in prior blogs and as a result, our performance continues to significantly outperform all indexes in both absolute and relative terms. The traders once again got caught short and the majority of money managers continue to significantly underperform. Ask yourself why.

You need a global perspective today to manage any asset class. You need to understand the inter-relationships between all global economic/financial variables to various markets. A systems approach to investing will bring you to your core beliefs that I discuss week after week. Unless you have that compass, how do you know where to go and when you need to change course if any of the variables shift.

Think as an investor and not as a trader. Look for change, both positive and negative, and manage risk at all times. Finally you need to be patient, as change does not occur overnight.

Clearly the Fed meeting and Janet Yellen's press conference were the key data point of the week. What can I say other than the Fed capitulated! They changed their mindset from their last meeting. They turned more cautious and lowered their targets for the Fed funds rate for each of the next three years. The Fed is now forecasting two Fed funds rate hikes this year, down from a previous forecast of 4, ending at 0.875% by year-end. The Fed lowered its inflation forecast too and is now projecting 1.2% in 2016, 1.9% in 2017 and hitting its 2.0% inflation target by the end of 2018. Economic growth targets were cut to 2.2% this year, which is within our 2-2.5% forecast, and then decelerating to 2.1% in 2017 and only 2.0% in 2018. It is interesting to note that the Fed is forecasting higher inflation and higher interest rates over the next few years while the rate of growth is falling. What does that mean?

By the way, the Fed target for short-term rates is 1.875% by the end of 2017 and 3% by the end of 2018. Pretty amazing! Note that real rates according to their forecast decline each of the next three years, which I doubt. The Fed is forecasting that unemployment falls to 4.5% by the end of 2018.

Yellen commented during the news conference: "You have seen a shift in time in most participants assessment of the appropriate path for policy that largely reflects somewhat slower projected path for global growth…" She added that Fed officials are monitoring inflation closely and it appeared that Fed officials are focusing in on inflationary expectations.

Bottom line is that the Fed is concerned with contagion meaning deflationary fears increasing here as in Europe and Japan which then would present a whole new set of problems for the Fed. Therefore the Fed is more focused on stimulating the economy, which in turn would increase inflationary expectations rather than tapping on the brakes. Here is the mindset change.

Economic statistics reported last week were a mixed bag but still support our forecast of 2-2.5% real growth without any inflationary pressures: wholesale prices fell 0.2% in February and down 0.2% over the last year but are up 1.2% excluding food and energy; retail sales fell 0.1% in February but rose 0.2% excluding gasoline; manufacturers shipments fell 0.4% in January while inventories rose 0.1% translating into an inventory/sales ratio of 1.40 up from 1.36 from a year ago; the Empire State Manufacturing Survey improved for the first time since last July and finally the Consumer sentiment index fell to 90 in March from 91.7 in February.

Negative yields in Japan hit new lows on Friday as investors are turned off by the BOJ's monetary policy and quite frankly are losing confidence, if they have not already, in the governments ability to stimulate the economy. As I have written, negative yields have a negative connation and investors are reducing risk assets buying yen, which is just the opposite of what the BOJ and Japan's government wanted to happen. A rising yen hurts exports and impedes growth. Clearly deflationary fears are rampant in Japan and explain the rush to take risk off and put money in the mattress even with no income.

The BOJ, at its meeting, did exempt short term money reserve funds from its negative rate policy as we anticipated and mentioned last week but unfortunately did not give added incentives for banks targeting loans to promote investment and growth as the ECB did last week. Premier Shino Abe will attempt to front load about 10 trillion yen in public works projects set for the 2016/17 fiscal year beginning April. We remain cautious on Japan's prospects.

The Chinese Premier Li Keqiang says that it would be "impossible" for China to fall short meeting its growth targets of 6.5-7% this year and that China won't suffer a "hard landing…and can achieve growth and reform simultaneously." While I continue to maintain a conservative growth forecast for China between 6-6.5%, it misses the point that I continue to make which is that China has a plan, is flexible and is doing what is needed to build a stronger foundation for continued relatively high real growth for many years to come. Don't forget how big the base is now from which to grow.

Note that the Chinese yuan continues to hit new highs to the dismay of the speculators and the stock market continues to recover. Our investments favor consumption over production for many years to come.

So let's wrap this up and return to our core beliefs:

  1. The wind is to our back, as monetary policy will remain ultra easy here as well as in the ECB, Japan and in China, which is favorable for financial assets;
  2. A conservative bias remains at every level, which will extend the global economic cycle although growth will remain well below potential;
  3. Inflation and inflationary expectations will stay stubbornly subdued due to global competitive forces and technology.
  4. Financial institutions will continue to build their capital ratios reducing systemic risk.
  5. Change is in the air everywhere and unless you change too, you will slowly wilt away. Positive change can lead to a revaluation of a company's equity and no change just the reverse.
  6. M & A activity will remain strong for a multitude of reasons. Have you noticed what Chinese multinationals are doing?
  7. Speculation is now only in art as real estate prices and private equity valuations are coming down to earth. New issues are non-existent.
  8. Dollar strength is a long-term core belief and has been interrupted near term for reasons discussed in many of our recent blogs. Long dollar was an overcrowded trade similar to being short energy and industrial commodities. The dollar is just correcting after an overbought position. Notwithstanding a weak dollar is good for U.S multinationals who have been penalized over the last year due to the punitive impact of a strong dollar on reported results.
  9. Earnings will surprise on the upside due to dollar weakness and continued productivity gains by major corporations.
  10. I no longer expect further weakness in energy prices and industrial commodity prices therefore made several adjustments to the longs and shorts in our portfolio.

The biggest change over the foreseeable future is that the Fed is your friend and no longer in your face raising rates stopping out the economy. As it gets closer to election in the states, the Fed will become frozen for sure.

I want to make one comment on banks, which most pundits downgraded on the Fed move, as rates will stay lower, longer. I own banks for several reasons and a rising yield curve is only one of them. Banks have changed their business mix, increased their capital ratios, earnings and dividends while rates were declining and are now so low. Clearly something has changed. Banks offer high yields and are selling beneath real book. As a class, banks are cheap and some are cheaper than others. Banks are a call on economic growth too.

This market is all about capital allocation and stock selection. The upcoming Presidential election continues to temper my enthusiasm as none of the candidates impress me nor have presented concrete economic and regulatory plans to stimulate our economy longer term.

So remember to review all the facts, take a deep pause and reflect, consider changes in mindsets and their implications for investing, review your capital allocation and risk controls, and finally do in-depth research on each investment.