Data Source: Bloomberg
The Fed Blinks as Markets Sink
Source: wikimedia commons
Well, it turns out that Fed strangle had a narrower upper/lower volatility bound than what had been conveyed by Fed Chairperson Jerome Powell back in October when Powell stated the Fed was 'a long way' from neutral on interest rates. Powell blinked in November and helped walk market volatility back from the cliff just as it appeared markets were threatening to take a dive.
Rookie mistake by Powell during his October Q&A? Recall that past Fed chairpersons, Ben Bernanke and Janet Yellen, made similar off-the-cuff/unscripted remarks early on in their respective tenures that ended up spooking the markets. Powell just continues the tradition (although some pundits believe reading Fed tea leaves is akin to market timing, and that the proper focus should be on economic fundamentals, which remain relatively strong for the U.S., despite what the market naysayers are crying about).
As we wrote in our November blog piece, "Let's Talk Turkey," Powell backtracked his hawkish October comments by hinting that the Fed may need to slow down the pace of rate hikes in 2019 and then suggested that the current interest rate level is 'just below' the theoretical neutral rate of interest. That seemed to open the door for the market rally over the second half of November.
It also appears that the Fed is catching up to Fed funds futures contracts which only see two rate hikes (from the current 2.25% rate) in 2019 (Figure 1). If 2019 core inflation ends up around 2%, the real Fed Funds rate (r*) would come out to about 0.75% which is just under the 1% real neutral rate of interest forecast by the New York Fed.
Figure 1 - Fed Funds Futures Pricing in Base Case of Two Rate Hikes in 2019
Prospects for a Fed 'pause' combined with expectations that the G20 dinner meeting between U.S. President Donald Trump and Chinese President Xi Jinping would at least result in a 'truce' on trade tariffs both helped produce a positive November return for global stocks (Figure 2), led by emerging markets. Driven by a strong rebound in Chinese equities, MSCI Emerging Markets returned 4.1% versus 2% for the S&P 500. Ex-U.S. Developed Markets were flat with Japan returning only 0.4% while Europe returned -0.9%.
Figure 2 - Asia-Pacific and Emerging Markets Rebound from October Weakness
Within the U.S., it was more of a mixed picture based on the relative performance of cyclical versus defensive sectors (Figure 3). November's sector leader, healthcare, benefited from strong state and federal election results for the Democratic Party (viewed as more favorable to Medicaid spending). Interest rate sensitive sectors such as real estate and utilities benefited from the drop in long-term Treasury yields while Materials benefited from stabilization in industrial commodities (outside of energy).
Figure 3 - A Mixed Picture for Cyclicals vs Defensive Sectors
Technology and energy sectors were the worst relative performers, with the former hurt by ongoing earnings release disappointments while the latter was hurt by the plunge in oil prices to $51/barrel (down from $76/barrel reached in early October) (Figure 4). However, industrial metal prices appear to be finding a near-term bottom, suggesting that demand and supply are close to finding a balance.
Figure 4 - Oil Prices Plunge to $51/barrel from $76/barrel Reached in Early October
Some commentators have attributed the sharp sell-off in oil prices to technical selling pressures from hedge funds that systematically had a leveraged carry trade in place (long oil / short natural gas), but the sell-off in oil is not entirely due to technical reasons as global supply (North American shale production, easing of Iran sanctions) has finally caught up with demand producing a slight net supply balance (Figure 5).
Figure 5 - Global Supply is Now in Balance with Global Demand
November also saw U.S. small caps and value underperformance large caps and growth (Figure 6), which points to narrowing breadth (participation) in the market - not a positive sign that the U.S. economy is about to accelerate from current levels.
Figure 6 - Large Caps and Growth Barely Outperform Small Caps and Value
From a risk-factor standpoint (Figure 7), low volatility and high dividend factor strategies outperformed value, momentum, and high quality. Low volatility and high dividend both benefited from the large drop in interest rates despite widening credit spreads (see below).
Figure 7 - Min Vol and High Dividend Outperform Other Factor Strategies
What should be of some concern to investors is the ongoing weakness in forward-market indicators such as the 2-10 year U.S. Treasury Term Structure (Figure 8), which flattened following Powell's comments, although long-term inflation expectations priced between TIPs and nominal Treasuries remain comfortably above 2% even if the spread is down from 2.2-2.3% range.
Figure 8 - Term Spreads Have Flattened to Year-to-Date Lows although Long-Term Inflation Expectations (TIPs vs Nominal Treasuries) Remain above 2%
Investors should also be concerned about ongoing weakness in credit markets indicated by widening credit spreads (Figure 9) in lower investment grade and high yield fixed income. Rather than responding positively to dovish Fed comments and a possible détente in the U.S. / China trade conflict, credit markets appear to be pricing in a more adverse economic backdrop for risk assets in contrast to the backdrop implied by the rally in global equities.
Figure 9 - Despite Positive Global Equity Returns, Corporate Credit Remains Under Pressure
A drop in the 10-Year U.S. Treasury Yield to 3% from an intra-month high of 3.24% helped produce a positive return of 0.6% for the Bloomberg Barclays Aggregate Bond Index, but U.S. high yield lagged with a -0.9% return. Other higher yielding fixed income segments such as bank loans and preferred equities also came under pressure.
An Uncertain but More Sobering Macro Outlook Heading in 2019
As of the time of this writing, the U.S. and China agreed to lay down their 'trade bazookas' following the G20 dinner with China agreeing to increase purchases of U.S. farm and energy products and the U.S. holding off on further tariff increases for 90 days. However, larger issues such as resolving China's mercantilist practices (forced technology transfers, violation of intellectual property rights, support of state-owned enterprises) as well as geo-strategic issues (South Seas Island expansion) will likely not be resolved over the next 90 days, which could see trade conflicts flare up again in 2019. In addition, China still faces the prospect of having to manage its overwhelming financial leverage while pursuing longer-term efforts to delever its economy such as its Blue-Sky initiative.
Valuations across risky assets (price/earnings multiples in equities and credit spreads in fixed income) are more attractive following the October sell-off, but longer-term issues remain concerning the Fed / macro backdrop (i.e. are we witnessing peak earnings amidst a worldwide slowdown?) and U.S./China trade conflicts. It is not clear whether we will see resolution of these issues in the near future.
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