- Fed rate cut implies recession is underway.
- Worsening economic data reason for rate cut.
- Effects of coronavirus won't change because of easy money.
Despite what the consensus believes - that the Fed is trying to allay fears related to coronavirus - the reality may be far worse. The Fed sees much more data that the rest of us, and to me they've just confirmed a recession is underway. The 50 basis point surprise cut suggests the data is looking so sour that they couldn't even wait a couple of weeks for their scheduled meeting. The coronavirus is certainly accelerating the downturn.
I've coined the phrase "inflession" to describe what it's in store for us over the next few months or longer. 'Stagflation' is when there's inflation and no growth. The yield curve warned us months ago (when first inverted) that a recession was in the offing. What is unusual this go around is that there is evidence that inflation is rising while there's negative growth (recession). As a result, the usual defensive measures such as moving into financials won't be effective investment strategies.
For example, the cut will be devastating for banks (already wrestling with skinny margins) who's balance sheets are unprepared. The Fed would have known this and acted anyway. Normally in a recession, inflation falls and so do interest rates, but excessive liquidity (now but also in prior years) has created the odd scenario where real rates were already negative. If not the financials for defense then where? This uncertainty has caused the price of gold to balloon - considered at least an inflation hedge in many circles.
The data related to U.S. manufacturing (see chart) just keeps getting worse. Just how bad things are won't be clear for a couple of months when the full impact of reduced global trade, supply chain disruptions, travel restrictions and growing fuel inventories are evident. Negative surprises will keep coming, which will send market indexes lower with an occasional dead-cat-bounce.
Imagine a town and the only employer assembles vehicles. All of a sudden, the plant cannot get brake pads, and cannot complete vehicles. Similar circumstances are occurring in other towns with other businesses. Firms are reluctant to fire people, since they know the supply disruption will ease eventually. However, they have to lay off people for an unknown time; those folks don't go to their favorite coffee shops, don't buy items they normally would (and aren't available anyway due to supply interruptions) and so on. Despite the slowdown in economic activity, prices are rising due to shortages. Sounds like the Russian economy at the height of its doldrums? Except this is occurring on a global scale.
The economy was bound to revert to the mean sometime but the coronavirus has triggered something more pronounced that just a slowdown. Low unemployment has more to do with demographics than GDP. Governments were (and still remain) loathe to let interest rates normalize for fear of causing political unpopularity – masking their true motives by citing worries of instability. This latest rate cut confirms that the U.S. and global economies are in trouble.
As recently as January, the outlook was optimistic (IMF World Economic Outlook), but tentative.
Global growth is projected to rise from an estimated 2.9 percent in 2019 to 3.3 percent in 2020 and 3.4 percent for 2021—a downward revision of 0.1 percentage point for 2019 and 2020 and 0.2 for 2021 compared to those in the October World Economic Outlook (WEO).
Projections are already being revised down some more by economic think-tanks.
The money supply (see below graph) in the U.S. has grown enough in the past year to stimulate the economy without the rate cut - two years from now if you believe the teachings of Milton Friedman, who identified that the real economic benefits have a substantial lag. Any short term benefits of a rate cut on market sentiment are just that - short term (days, maybe weeks). This is because the shorter term 'effects' are exclusively sentiment-related rather than economic. A rate cut surely cannot cure the COVID-19 virus. My guess is that the FED is seeing real time data on consumption patterns (as well as other info) and it's ugly.
Despite evidence of a possible recession, prices for various goods in the PPI have jumped concernedly year-over-year: Vegetables +21.4%, Pork +14.9%, Gasoline +23.1% and Home Heating +12% for example.
If financials aren't a good defense, is there a good investment offense? The 'inflession' presents some challenging realities. Real estate (prime beneficiary of lower rates) and consumer staples (beneficiary of inflation) are perhaps obvious candidates as prices can be passed along, but reduced activity (volumes) presents an offset to profitability.
Investors will have to try to identify those businesses that can compete more effectively (technological or marketing advantages) and gain share of market. It will perhaps mean the resurgence of stock selection over indexing. In the technology space, it is a similar scenario. Advertising is the mainstay of some businesses such as Facebook (FB) for instance, whereas volume for others like Amazon (AMZN). Still others depend upon the ability of the consumer to spend such as Netflix (NFLX). Again, those with real competitive edge will provide investors with the best offensive investment strategic advantage.
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