Why Are Stocks So Nervous And Is The 'Fed Put' Really Dead?
- Ok, it's time to talk about Jerome Powell and the restriking of the storied "Fed put."
- On the way, I'll address what's going with stocks and why equity volatility isn't spilling over into other asset classes.
- Finally, I'll give you a snapshot of what to expect from Q1 earnings.
Lost in the fog of war (trade war, that is) on Friday was the March jobs report and a speech from Jerome Powell at The Economic Club of Chicago.
March payrolls left something to be desired, missing badly on the headline. Average hourly earnings were in line with consensus. The big miss on the payrolls print (103K versus consensus of 185K) probably didn't help on a day when sentiment was already souring rapidly amid the tariff headline hockey.
Washington and Beijing traded jabs all day Friday, with China's myriad Party mouthpiece media outlets launching a full court press. Stateside, Steve Mnuchin and Larry Kudlow were dispatched to CNBC and Bloomberg (respectively) to do a bit of damage control following the administration's decision to consider proposing another $100 billion in tariffs against Chinese imports. Notably, China's Commerce Ministry held a press conference at 8 a.m. EST to reiterate the notion that Beijing would not be backing down anytime soon - it is highly unusual for ministries to hold briefings on holidays in China. Friday was a holiday.
The 103K headline on March payrolls marked a notable downshift from February's blockbuster print. You'll recall that in addition to the blistering headline number, the February report also missed estimates on the average hourly earnings front, allaying fears that inflation pressures are building faster than the Fed was anticipating and temporarily silencing critics of late cycle fiscal stimulus who were (and still are) concerned that piling expansionary fiscal policy atop an economy operating at full employment is bound to drive inflation higher sooner or later.
While the March jobs report most assuredly did not paint the same "Goldilocks" picture as the February report, it wasn't bad enough to change the overall narrative in terms of the U.S. economy being on the kind of solid footing that makes it possible for the Fed to stick to its guns on hikes. Powell reinforced that hours later in Chicago, noting that "further gradual rate hikes" are appropriate and suggesting it's "too early" to start talking about how trade tensions might affect the outlook.
Although his message was generally balanced (he noted that an absence of wage acceleration still suggested there's slack in the labor market), there was nothing to suggest the Fed is prepared to imminently reconsider the rate path in light of market turmoil. Here's a bit of color that appeared on Bloomberg's live blog after Powell's prepared remarks were parsed:
It’s really interesting that he points out that strong global growth has boosted U.S. exports without at all mentioning the elephant in the room: the possibility of a disruptive trade war with China and perhaps other countries. The fact that he is not focused on this publicly is very consistent with the idea that the Fed will raise rates in June and several times this year.
Although correlation isn't causation and although Mnuchin's "there's the potential for a trade war" comments hit around the same time, it's probably not a coincidence that losses for U.S. equities accelerated following Powell's remarks. Here's an annotated chart of S&P (SPY) futures that shows you how things played out from Thursday evening (when Trump instructed the USTR to look into proposing another $100 billion in tariffs on China) through the close on Friday:
So while it's not at all clear that Powell could have said anything to arrest the slide, it's worth noting that with the geopolitical outlook deteriorating rapidly, his mettle is likely to be tested early and often unless some kind of negotiated settlement is reached on the trade front in the relatively near future.
Ok, so there are a couple of questions worth asking here. First, it could be that the volatility in stocks is tied not so much to people being concerned about an actual trade war, but rather to the idea that the slapdash manner in which the escalations have unfolded signals something about the administration's lack of competence with regard to economic policy. Why, for instance, if people are actually worried about a trade war, is FX volatility not reacting?
As one analyst I spoke to over the weekend put it, "my gut feeling is that the market isn't responding so much to the threat of trade wars because FX volatility remains unfazed, whereas currency should be on the front lines of any trade wars and tariffs."
Right. And that's something more than a few people have pointed out over the last several days. Here's what ING's Viraj Patel told Bloomberg on Friday:
Currency markets have taken on the role of a casual observer, with the initial trade war firing shots taking place on the equity market battlefield. The tariff threats turning into reality would be the catalyst for the trade war market dynamics to spillover into the currency arena.
What then, is driving the outsized swings in equities? If you, like many, believe that one of the reasons why stocks performed so well in 2017 was optimism around President Trump's growth-friendly agenda and, implicitly, the hope that he could implement that agenda in a way that wouldn't risk overheating the economy and forcing the Fed to effectively step in and pull the plug before late cycle fiscal stimulus engendered a sharp uptick in inflation, then you're left to wonder whether recent volatility might be the product of some folks fading that narrative.
Even if you want to argue that some of the recent gyrations in markets are technical in nature (i.e. attributable to some of the same type of dynamics that caused problems in early February), there is no question that some of the volatility is down to the fact that economic policy is effectively being made in real-time on Twitter. Equally disconcerting for investors are the ongoing tweets from the President about Amazon (AMZN), a market darling and a key pillar of support for the market as a whole. As I've said dozens of times over the past two weeks, it's entirely possible to argue that Trump's approach to trade is correct. It's also possible to argue that he has a legitimate gripe with Amazon. You could even plausibly suggest that Twitter is an effective/appropriate means for a President to communicate with the public. But what you cannot do is say that the tweets aren't keeping markets on edge, because they absolutely are. For more on that, you can skim "Tweet Risk".
Given all of this, it is entirely fair to suggest that recent events are causing investors to reconsider whether the Trump administration is capable of presiding over the type of economic boom the President has promised. And look, there are numbers to this. For instance, Barclays recently suggested that under some assumptions, an all-out global trade war would more than negate the fiscal tailwind to S&P earnings from the tax cuts. For those who need a refresher on this, here's the key excerpt from a note dated last month:
For simplicity we provide estimates based on a uniform 10% tariff on U.S. exports (by U.S. trade partners) and all U.S. imports (by U.S. in retaliation). The results can then be easily scaled for different tariff assumptions. Under these assumptions we find that trade tariffs will hurt the S&P 500 2018E EPS by ~11.0% (Figure 4). This compares with our estimate of a ~7.3% positive impact of fiscal stimulus from tax reform. Thus an all-out “trade war” could potentially offset the positive impact of fiscal stimulus from tax reform.
Playing out alongside this is the restriking of the Fed "put." That's the subject of the latest note from Deutsche Bank's Aleksandar Kocic, who regular readers will recall is one of the most talented guys on the Street, in my opinion. There's a lot to digest in his latest and I talked at length about it on Saturday morning over on my site, but for our purposes here, just note this bit:
With equities selling off and Fed staying the course, strike of the Fed put has been moving further out of the money on both accounts: short end of the curve continues moving higher while equities are selling off. Effectively, convexity is being withdrawn from the market and equities are reacting to it. While in the short run, such divergence/dispersion could be reinforcing, in all likelihood, there would be a breaking point when further weakness in equities tightens financial conditions that the market begins to take additional hikes out of the curve.
In other words, Powell's purported intention to stick with a more rules-based, data-dependent, straightforward approach notwithstanding, there will likely be a point beyond which further equity weakness will begin to feed through to financial conditions, forcing market participants to rethink their assumptions about the Fed path. Kocic goes on to note that while the market is still behind the dots, positioning in the short-end clearly suggests most folks are buying into the idea that Powell is committed to sticking with the program. And while Kocic concedes that the propensity for the market to price out further hikes if equities continue to selloff "could be residual of the expectations from the times of Fed’s market-pleasing period, it would be difficult to dismiss it a priori as the determination of the new chairman has not been fully tested."
The idea there is that eventually, falling equities will act as a circuit breaker (and there's a kind of market double entendre in there if you're really looking). Here's Kocic one more time:
Transmission of equity selloff through financial conditions could act as a circuit breaker and trigger repricing of the rates path. This could lead to bull steepening of the curve. This could be seen by the market as restriking of the Fed put and supply of convexity that should be embraced by risk.
Long story short, until that plays out, markets could continue to express their concern about the ultimate viability of Trump's economic strategy via equities, which are seemingly the least stable asset to own despite not necessarily being the asset that one would think should be the most vulnerable to a trade war/tariff scenario.
Some of this could be ameliorated by earnings season. As Goldman reminds you, "consensus EPS estimates have been lifted by 5% since the passage of tax reform in late December [and] consensus expects S&P 500 EPS will grow by 17% versus 1Q 2017, the fastest quarterly growth since 2011." 80% of S&P 500 companies will report between April 16 and May 4.
Of course, with higher expectations comes the possibility that results will ultimately fail to clear the raised bar. For their part, Goldman thinks that creates a scenario where "the reward for EPS and sales beats will be limited this quarter, but the downside risk for misses will be substantial."
You can take all of the above for what it's worth, but if you ask me (and implicitly you have asked me, because after all, you're reading this post), the main takeaway is as follows.
Until we see volatility spilling over from equities into FX, credit, and rates, you should interpret falling stocks not so much as a sign that market participants fear an actual trade war, but rather as a referendum on whether the way in which the administration is communicating its stance on trade is saying something foreboding about their ability to manage the economy. Until the Fed put is restruck/rate path repriced, equities could continue to fall irrespective of whether earnings live up to expectations or not.
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