The Clash Of Market Expectations

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Douglas Adams


  • The release of April's FOMC minutes (May 18th) shed renewed light on just how divergent market expectations and FOMC projections have become.
  • The Chinese renminbi is overvalued by most estimates and is already feeling the squeeze from a resurgent U.S. dollar.
  • While market expectations now assign a 30% probability of an increase in the federal funds rate at the June FOMC meeting, foreign headwinds will likely stay such a move.
  • Utilities, telecommunications, marketable REITs and royalty trusts should outperform in current market conditions. Predictable revenue and dividend streams are the investors' best friend.

Last week's release of the FOMC minutes from its April meeting resurrected the erstwhile fear of yet another round of forex instability, with the Chinese renminbi again at its epicenter. The surprise devaluation of the renminbi in August 2015 and another bout with forex instability in January of the New Year rattled equity markets worldwide. The fear of plummeting markets and a continuing stream of weak economic data in the first two months of 2016 stayed the hand of the FOMC yet again as the second increase in the federal funds rate at their March meeting fell victim to unanticipated market events.

The interim period between the March and April FOMC meetings saw economic fundamentals and markets alike broadly stabilize across both the developed and emerging economies. West Texas Intermediate crude clawed back some of its losses after peaking in June of 2014 for a 48% advance through the market close of May 23rd after hitting a year-to-date nadir in the latter part of January, according to market data. Just how sustainable such a move is remains questionable. U.S. crude in storage through the week ending the 20th of May came to 537.068 million barrels, down slightly from a record high of 543.394 million barrels set in the last week of April. U.S. oil reserves are up 11.36%. The dovish pronouncements by the Federal Reserve in late January clearly signaled to markets that a March increase in short term interest rates was off the table, trimming the sails of a two-year bull rally of the dollar. During the period, depressed crude oil prices started to rally. The yen and the euro were on the rise in world currency markets confounding both the Bank of Japan's and the European Central Bank's historic forays into negative interest rate territory. Corporate balance sheets were granted a reprieve from forex costs on U.S. profits earned abroad. By early May, the U.S. dollar was headed for a 15-month low.

In recent years, 1st quarter output weakness has been a frequent occurrence, followed by robust 2nd quarter posts as the economy shook off one-off setbacks from frigid winter temperatures. Statistical shortcomings in seasonal adjustments and other temporary events were widely cited for the April 2015 estimate of 1st quarter output barely escaping contraction. GPD growth in the 1st quarter of 2014 was similarly constrained, eking out 0.1% gain in the April 2014 estimate. In both instances, pent-up demand that failed to hit in 1st quarter numbers surfaced in 2nd quarter output, sending 2nd quarter output to subsequent highs for both years. The FOMC minutes readily acknowledged the pattern which sent dormant market expectations on a rate hike in June soaring, shedding new light on just how sharp the divergence between market expectations and FOMC projections have become. On the Monday (16 May) prior to the minutes' release, market measures assigned about a 5% probability of any move on interest rates in June. By Thursday (19 May) that probability had soared above 30%--as a June increase in the federal funds rate lurched back into play.

The FOMC minutes released after the usual three week delay, appeared to have provided just enough of a nod across the miles for the Hong Kong renminbi to choke, falling to a trading level of Rmb6.14 to the dollar--its weakest post since February. The renminbi is up almost 15% on the dollar since January, a function of dollar weakness and the relative strength of both the yen and the euro which are part of the basket of currencies against which the People's Bank of China (PBOC) sets its trading range for the currency.

With a federal funds rate hike, a weakening dollar and the stabilization of the Chinese economy of the past few months are likely headed in very different directions. April proved to be a disappointing month for Chinese industrial output and retail sales while exports fell year-over-year. Meanwhile, imports fell almost 11% on April 2015, on top of a 7.6% drop in March. And while there is evidence that residential property values in major Chinese cities have stabilized since January, housing prices in Beijing, Guangzhou, Shenzhen and Shanghai remain some of the highest in the world. The renewed strength of the dollar, both in anticipation and after the fact, will likely have a domino effect across a wide swath of the global economy as the Federal Reserve again attempts to tighten monetary policy while its counterparts in Europe, Japan and China pursue monetary policy solutions in the opposite direction:

  • A renewal of the downward pressure on the renminbi which recent estimates by HSBC deem overvalued by as much as 15%;
  • Upward pressure on commodity prices in dollar terms could place downward pressure on local currencies and upward pressure on local interest rates in commodity driven economies throughout the emerging market space as capital outflows seek safe-harbor vehicles, particularly dollar-based assets;
  • Crude oil prices could pull back from their current market highs as downward price pressure reasserts itself in the face of excess supply and weak demand. A resurgent dollar is likely to challenge the current market rally based largely on a weak dollar and long, speculative bets on the direction of oil;
  • Falling oil prices could moderate the 0.4 percentage point uptick in core PCE inflation through the end of the 1st quarter here in the U.S., splashing cold water on prices across the breadth of the economy. April's purchase managers' index PMI for manufacturing rocketed almost 46% on top of a 32% price increase in March year-over-year in dollar terms.

Total U.S. output barely escaped contraction in the April report on 1st quarter GDP performance. The trifecta of jobs, output and inflation during the interim period between the March and April FOMC meetings painted more of a mixed picture as the 2nd quarter appears poised to capture at least some of the spillover of lost and pent-up 1st quarter demand. The June FOMC meeting remains untimely for an uptick in the federal funds rate. And it goes without mention, Britain's June referendum on membership in the EU--a scant eight days later--looms large on the horizon.

Market uncertainty remains all but certain. For the immediate term, predictability becomes the investors' best friend. Utilities, marketable real estate investment trusts, telecommunications and certain oil and gas-based royalty trusts should drift into view. The red ribbon streaming through these issues?--predictable revenue and dividend streams. Many of these issues are U.S.-based companies who derive much or all of their revenue from domestic markets--skirting forex costs that punished profits earned abroad throughout the 2-year bully rally of the dollar in the process.

Remember, the U.S. economy weak by many historic measures, is alone among rich countries in its efforts to tighten monetary policy. And in the absence of organic growth, corporations continue to shower shareholders with wealth via buybacks and enhanced dividend payouts. On the buybacks side alone, the S&P 500 Buyback Index has gained 267% in market value during the current bull rally of equities that began in the first week of March of 2009, according to market data. The S&P 500 benchmark has gained 209% over the same period.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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