Powerless Powell's Jerome Jeremiad

by: Steven Jon Kaplan

With the Fed having created unsustainable overvaluations through quantitative easing and waiting six years before starting to raise rates, the Fed is hopelessly trapped.

The Fed won’t want to create a recession by raising rates or tapering too aggressively, but being dovish will stoke inflation with a falling U.S. dollar.

Investments which will benefit from the Fed’s dilemma include small-cap non-U.S. equities along with mid- and small-cap commodity producers.

Jerome Powell (photo: Bloomberg.com via Getty Images)

A Slowing U.S. Economy and Rising U.S. Inflation Create a Fed Dilemma

The U.S. Federal Reserve since 1977 has been required to follow a dual mandate in which it must simultaneously "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Okay, that probably sounds like three goals instead of two, but who's counting? The problem with achieving any set of two or three goals is that they sometimes conflict with each other. If the Fed wishes to maintain maximum employment then they may have to sacrifice stable prices and/or moderate long-term interest rates. If they are obsessed with stable inflation and moderate long-term interest rates, as Paul Volcker had been during his tenure as Fed chief, then maximum employment has to be sacrificed at least for two or three years. In the New Testament book of Matthew 6:24 it states that "no one can serve two masters. Either you will hate the one and love the other, or you will be devoted to the one and despise the other." This is precisely the dilemma in which the current U.S. Federal Reserve finds itself: even after a sharp pullback during the final third of 2018 the valuations for U.S. stocks, corporate bonds, and real estate remain near their highest levels in history. The Fed would like to prevent runaway asset inflation which has made these essential wealth builders unaffordable for millennials and many others, but it doesn't want to either raise interest rates or continue its Treasury tapering program too emphatically if either action would tip the U.S. economy into recession. The quantitative-easing plan caused many people to take money out of the bank to buy stocks and corporate bonds, while unusually lenient FHA mortgage down payment requirements foolishly allowed almost anyone to purchase a home with no down payment, thereby generating artificial demand and driving up prices well above income growth. What does this imply for the U.S. economy going forward?

The Fed Is Boxed Into a Corner

Here are the wonderful choices the U.S. Federal Reserve can make: 1) continue to steadily raise interest rates and to continue its quantitative-tightening plan by not reinvesting expiring U.S. Treasuries, thus deflating U.S. asset bubbles while maintaining stable inflation; 2) stop raising rates or actually cut them, while going back to their previous policy of reinvesting maturing Treasuries; or 3) some combination where the Fed tries to pretend it will raise rates and continue quantitative tightening while actually doing the opposite.

The problem with the first approach is that it will almost certainly cause a hard landing for the U.S. economy, since merely a return to fair value for U.S. financial assets and real estate will require huge percentage losses for both. The Fed's foolishly maintaining near-zero overnight lending rates for several years after the U.S. economy had recovered from the 2007-2009 recession induced U.S. stocks and U.S. corporate bonds to trade dangerously above their average inflation-adjusted levels of recent decades, while real-estate prices today--as they had been during their 2005-2006 bubble--are incredibly inflated, and are generally more overvalued than they had been during the previous bubble in many coastal cities. In some neighborhoods the ratios of average housing prices to average household incomes are three to four times their long-term average levels while even in less-overpriced regions real-estate prices are well above fair value. Not only will a regression to the mean cause serious losses, but as people see their retirement assets and houses being worth less they will feel poorer. This negative-wealth effect will by itself create enough of a cutback in spending to cause at least a moderate recession, even if there is no increase in unemployment and we enjoy continued steady U.S. wage growth. Especially if prices for average consumers climb along with a falling greenback, employers will be put under continued social, political, and media pressure to increase wages especially at the lowest income levels.

Being Dovish Could Be Worse Than Maintaining Price Stability

If the Fed is afraid of the above consequences and decides instead of hiking rates to keep them steady while implementing renewed U.S. Treasury purchases, as nearly all investors are currently anticipating, then this will almost surely encourage a new bout of inflation. Especially since inflation has been kept under control for decades, most investors don't even consider a U.S. inflationary surge to be a serious threat in 2019 and take for granted that it can't happen.

One serious risk of the Fed's making no rate hikes in 2019 is that postponing rate activity until 2020 will be widely perceived as interfering with the U.S. election cycle.

There is a risk that U.S. Treasury yields could climb substantially just as the U.S. budget deficit is soaring from a combination of increased spending and the disastrous 2018-2020 tax cuts which will be more than reversed but not until 2021. Recently over 200 House Democrats have been supporting a radical increase in the Social Security payroll tax. Newton's Third Law is proving itself to apply in finance as well as in physics, as tax rates in 2021 and beyond will likely far surpass those from the Obama administration to reach their highest levels since at least 1980.

The Fed's Balance Sheet Might Be More Important Than Overnight Lending Rates

Probably too much attention regarding the Fed is focused on whether or not overnight lending rates are changed or not in 2019 and beyond. While this is important, it is equally critical how the Fed adjusts its balance sheet which it had foolishly allowed to balloon far beyond what was required to help lift the U.S. economy out of its previous recession. The Fed has trimmed its U.S. Treasury holdings from roughly 4.5 to 4.0 trillion U.S. dollars since its plan to stop reinvesting expired Treasuries began in October 2017. The Fed is well aware that their tapering or quantitative tightening is having a contractionary impact on the U.S. economy and doesn't want to be held responsible for the next recession--which is inevitable no matter what the Fed does or doesn't do since its quantitative easing had been equivalent to putting the economy on steroids and there is no way to get out of such a mess once you have created it. The Fed will likely adjust its tapering based upon how financial assets have been recently performing; significant declines for U.S. stocks, corporate bonds, and/or housing prices will likely encourage future Fed buying of U.S. Treasuries regardless of the potentially serious long-term side effects from such a misguided policy.

The Fed Is Attempting to Act Dovishly While Talking Hawkishly

The only realistic way for the Fed to thread this needle is to try to convince investors that it will do whatever it takes to fight future asset inflation while actually doing as little as possible in that regard. Investors will allow themselves to be fooled until either asset prices fall sharply or inflation rises substantially or we suffer a toxic combination of both in 2019 called stagflation. Like the Wizard of Oz, the illusion of false Fed control cannot be maintained indefinitely.

It's Mostly Bernanke's and Yellen's Fault, Not Powell's

To be fair to Powell, it's hardly his fault that he is stuck in this predicament. Both Ben Bernanke and Janet Yellen kept interest rates steady far too long--not just by months, but by years. In any decade prior to the last one, the Fed would have begun raising rates as early as the final months of 2009 instead of waiting an astonishingly tardy six years later when the first Fed hike was made in December 2015. Quantitative easing was also a huge failure, wildly inflating asset valuations while having minimal impact on average wages and standards of living. The economy has persisted so long with subpar growth and subdued inflation that it has encouraged increasing acceptance of the latest absurd economic fantasy known as modern monetary theory, essentially concluding that a government can spend indefinitely without creating serious negative side effects. One of its primary proponents, Stephanie Kelton, has become a rock star in the socialist wing of the Democratic Party. It doesn't require a degree in economics to figure out that continued economic stimulus and overspending, implying even greater deficits, will necessarily lead to double-digit interest rates and soaring inflation within the upcoming decade, although the financial markets often act with a delay so this is not necessarily an immediate threat. However, the Fed's loss of credibility and the end of global confidence in the Fed's ability to keep raising interest rates has already caused the previously rising U.S. dollar to begin a downtrend several weeks ago which will likely continue for most of 2019 and perhaps into early 2020. In addition, the diminished confidence in U.S. assets will likely lead to a surprise decline for U.S. real estate in 2019 which could continue for a few more years no matter what is happening with the economy; if we enter a recession at any point than housing prices will probably accelerate their losses. The falling U.S. dollar will help some U.S. companies with minimal imports and major exports, while other U.S. stocks and corporate bonds will probably disappoint investors in 2019 by forming mostly lower highs for another year or more, with many indices like the Russell 2000 and the Nasdaq Composite Index remaining well below their all-time tops from the final days of August 2018 and eventually accelerating their downtrends probably in 2020.

Investors Are Irrationally Almost Unanimous in Expecting No Fed Action in 2019

According to the Fed rate monitor tool, even if we go all the way forward to the Fed announcement scheduled for October 30, 2019, appropriately one day before Halloween, it is frightening to see the nearly unanimous consensus of a 94.7% projected chance of no change in overnight lending rates over the next nine months. Only 3.3% of investors expect rates to be hiked once while 2.1% of investors are expecting the Fed to make a single rate cut by October 30, 2019. Even if this amazingly static perception changes later this year, it will almost certainly occur too late to reverse the fate of the sliding U.S. dollar which will probably retreat to multi-year bottoms versus many global currencies.

Which Investments Will Perform Best With a Cornered Fed?

Fortunately there is ample past history illustrating how assets worldwide are likely to perform during the upcoming year. The Russell 2000 is almost certain to remain in its bear market that began from its all-time zenith on August 30, 2018, which refers not to the magnitude of the percentage loss since then but by the presence of repeated lower highs at key resistance points. Investors worldwide will become increasingly convinced that the 2018 outperformance by U.S. assets of all kinds was a temporary response to the sugar-high tax cuts and other factors, and will lead to underperformance throughout 2019. Nearly all developed markets will end the year with much better percentage behavior than U.S. stocks as U.S. equity indices probably end with net losses as compared with their current valuations. Emerging markets in general will likely be among the biggest winners after having suffered significant losses from their January 2018 highs to their fourth-quarter 2018 lows.Since small-caps and value shares fell much more than large-caps and growth names throughout 2018, 2019 will likely reverse that kind of behavior with notable significant gains for small-caps and smaller mid-cap shares which had become the most glaringly undervalued. Other kinds of assets which benefit the most from a falling U.S. dollar, such as commodity producers, will probably be among the top winners of 2019. As the U.S. dollar declines and the Fed mostly watches, U.S. inflation by early 2020 could increase to its highest level since 2008.

Here Are Specific Exchange-Traded Funds Which Should Be Major 2019 Winners

Small-cap non-U.S. stock funds which had fallen sharply in 2018 such as ASHS (small-cap China) and SCIF (small-cap India) will likely be among those assets which enjoy the largest percentage gains in 2019. Other funds which fit into this category are EWGS (small-cap Germany) and RSXJ (small-cap Russia). In the energy sector, funds which intentionally avoid large-cap favorites like XES (mid-cap energy services) and PSCE (small-cap energy) are already surging in price from their lows around Christmas. Mining shares which usually perform well at this stage during U.S. equity markets, sticking with the small- and mid-cap theme, include GDXJ (mid-cap gold/silver mining), REMX (rare-earth extraction), URA (uranium mining), and COPX (copper mining). Two related securities which usually outperform at this point of the economic cycle are SEA (sea shipping) and SLX (steel manufacturing).

Assets which had become irrationally undervalued in 2018 will tend to be among 2019's biggest winners. Chinese equities sported price-earnings ratios averaging between 8 and 9 as of January 3, 2019, with ASHR (large-cap China) probably not increasing as much as ASHS in the upcoming year but providing a high degree of liquidity. Other bargains in Asia include PAK (Pakistan), VNM (Vietnam), and JOF (small-cap Japan closed-end). Europe features a surprising number of compelling purchases as overblown political fears over Merkel's decision not to run for re-election, the Brexit fiasco, Parisian yellow vests, and parliamentary wrangling in Italy and elsewhere have created bargains for EWG (Germany), EWI (OTCPK:ITALY), EPOL (Poland), EWQ (France), EWN (Netherlands), EWK (Belgium), EWD (Sweden), EWO (Austria), and much-disliked GREK (Greece) which perhaps has the greatest potential upside with the usual somewhat-justified fears over Greek government insolvency. With their lowest valuations in decades relative to U.S. equities, investors are finally noticing Europe's worthwhile equity undervaluations.

For those who prefer less risk, emerging-market government bond funds including ELD and LEMB are likely to continue to provide above-average gains with yields roughly twice those of the United States and with limited potential downside.

There Will Be Disheartening Disappointments

U.S. stocks overall will mostly disappoint investors especially as many of them have already experienced the lion's share of their total 2019 gains. While emerging-market shares and commodity-related securities listed above will continue to form higher lows and higher highs for most of 2019 and perhaps into 2020, U.S. equities as soon as the second quarter of 2019 could form lower highs as compared with their eventual first-quarter peaks. This would be consistent with past U.S. equity bear markets. U.S. bonds, both corporate and otherwise, will likely also disappoint investors. Long-dated U.S. Treasuries, like many U.S. equity indices, could actually experience overall net losses for the remainder of 2019. It is not often that U.S. stocks and U.S. Treasuries both end up with overall net losses during the same calendar year, but 2019 could be such an occasion and will definitely disappoint those who have typical vanilla 60/40 portfolio allocations or are following other Boglehead-style approaches. Just as blind passive index investing had become a trendy fad in recent years, it will be a major loser until this strategy becomes unpopular again.

Finally, I can't fail to mention that the New England Patriots' victory in the Super Bowl is notoriously bearish for U.S. equity indices, with the U.S. stock market probably ending 2019 below its levels from the date of the Super Bowl on February 3, 2019.

The Real Danger Arises in 2020, Not 2019

The major problem with the Fed waiting six years too long before raising interest rates will come to roost not in 2019 but in 2020 when global risk-asset rebounds run their course near the end of this year or in the early part of 2020 and transition to downtrends. We are likely to enter a worldwide recession in 2020; because U.S. interest rates are so low this deeply into the expansion there is much less room to cut them. With the Fed already holding a huge balance sheet even after the tapering process, the Fed also cannot intervene significantly in any other manner. With so little ammunition available, the Fed will end up mostly observing the acceleration of the U.S. equity bear market in 2020 rather than being an active participant. One could even argue, as Richard Fisher has done, that the primary purpose of the Fed is to raise rates aggressively during an economic expansion so they have much more flexibility in making rate cuts during a subsequent economic downturn. The overall top-to-bottom descent for U.S. equity indices in 2018-2020 could therefore end up being among the greatest total percentage losses since the extremely volatile period from 1929 through 1942. U.S. political uncertainty throughout 2020 with primary elections followed by the general Presidential and Congressional elections on November 3, 2020 will tend to exacerbate investors' fear and encourage new all-time record net fund outflows whenever we are experiencing the next major bear-market bottoming pattern perhaps in the second half of 2020. Real-estate valuations will probably take roughly two additional years after that before they finally complete their nadirs.

Wizard of Oz (photo: FT.com)

Disclosure: I am/we are long GDXJ, SIL, XES, OIH, FCG, PSCE, PEO, EZA, TUR, ASHR, ASHS, SEA, VNM, GXG, EPHE, EPOL, ARGT, ECH, FXF, FXB, SLX, COPX, REMX, LIT, EWG, EWGS, EWI, EWU, EWN, EWQ, EWK, RSXJ. 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.

Additional disclosure: I am long roughly fifty different exchange-traded and closed-end mutual funds, primarily favoring small-cap equities along with mid- and small-cap commodity producers.