Updated: Dec 21, 2018
With 2018 winding down, what's become ostensibly clear is that this is no 2017--not for stocks, not for the U.S. and not for the world. A spike in volatility can be attributed to a few major themes namely : the Federal Reserve.
"U.S. markets tumbling to a 15-month low! The NASDAQ on the brink of a bear marker! The Dow in the negative for the year! Yield's come tumbling down!"
These are just a few of the headlines that have come into play the last few weeks with regard to U.S. stock performance and its impact on other asset classes like the bond market. Analysis from Reuters and Fox Business News, to Bloomberg and CNBC to CNN have captured much of the turmoil in negative headlines adding to the tense feeling most get when they hear the markets have tanked. Analyst's have been busy trying to work out an extremely volatile time and reflecting on what this means for 2019.
To make sense of this all, the team at InvestCEE has been prepping for a series of economic and financial reports examining all the facets that have impacted the markets not just in the U.S. but in Emerging Market economies such as Central & Eastern Europe--one of the fastest growing markets in the world.
Today however, I will shed some light on one of the biggest drivers of the turmoil experienced these last few months on the U.S. side--and one particular scapegoat most people have seen is the Federal Reserve.
Since late September, market volatility has rapidly increased resulting in violent fluctuations in stock prices.
Part of the volatility can be attributed to uncertainty in conditions:
1.) U.S. Politics - In the U.S., the political landscape has been confrontational from within due to changing policy directions, scandal news headlines and unprecedented conflict between governing branches. On November 7th, 2018 U.S. elections resulted in the once unified Congress being split between the Senate and House of Representatives between the two major political parties: Republicans and Democrats. Although markets expected a divided government--evident in the warm market reaction--there is also an expected slow down in government policy initiatives. This can range from further tax cuts for businesses, to a halting in deregulation (regulations slow businesses in general and can hinder growth), to challenges on trade policy with major economic partners. One can conclude, this is a major potential headwind for businesses as a divided legislative branch will prove even more problematic for U.S. President Donald Trump and his administration from accomplishing their economic agenda. This can lead to more infighting with Budget agreements (think Government shutdowns), fiscal policy and conflicts on handling the trade deficit with partners.
2.) Threats to the European Union - The Global economy has operated under certain structures that have been in place for decades since the Cold-War and post-World War 2 global order. 2018 has seen a rapid increase in protectionist policies that have epitomized a growing backlash against the current globalizing world order. Globalization has brought many benefits, but as many academics and research are also showing--some negatives. These negatives have alienated certain populations and has been affecting the European Union for the better part of 2 years. Coupled with a snail like growth rate in major economies such as Germany, Great Britain and France, to budget problems affecting Italy's place in the EU and Brexit being the standard-bearer in highlighting prominent issues that can come with being in a massive multi-national conglomerate. The European Union has many headwinds moving forward that has disturbed international supply chains. Brexit in particular has been especially harsh on British markets due to growing uncertainty of a clean exit from the EU, with Britain being the world's 5th largest economy, that has profound effects on economies all around the world especially the U.S.
3.) China's Economic Pivot - Although predicted for many decades to become a global super-power on par with the United States, China has continued to experience sharp economic pains domestically which has hindered it's ability to usurp the United States as the largest economy in the world and has faced an uphill battle carving out it's strategic influence throughout the world as it faces resistance from Western countries. President Xi Jinping has put a tremendous effort in making China a global leader and those efforts have been vastly successful in some areas' such as their Silk Road Initiative and forging international ties in Emerging markets throughout Central and Eastern Europe and Africa. The latter half of 2018 however, has upended much of that momentum as the tariff war with the U.S. has exacerbated an already slowing economy. This has put great pressure on Asian markets and the global system overall as China is the second largest economy and a major exporter of the worlds goods. This proves a signifiant headwind with U.S. companies. For one, they are looking for a solution to the trade war between the U.S. and China, and two--better positioning when it comes to doing business in the historically protectionist Chinese markets--markets which have yet to fully be tapped.
A Lesson on the Federal Reserve
These major themes all have major implications upon one another, however one of the major determinants of any economy is its central bank. For a brief refresher, The Federal Reserve (the Fed as it's known) of the United States has the daunting challenge in helping the economy not veer out of control by using its dual mandate of keeping low employment and keeping inflation in check. The Fed does this by manipulating money supply (monetary policy) through myriad of ways. One of the prominent ways is by raising the Federal Fund's rate, which set's the standard lending rates for banks. The Fed's Fund rate is then used by banks to set the Prime Rate which is what they charge consumers for taking out loans.
We won't get into all the idiosyncrasies of how this mechanism is done. What should be understood in general is that, when an economy slows down, the Fed attempts to reverse this by increasing the money supply. That is, to reduce interest rates, to spur both people and businesses (banks included) to spend and loan out more money. The increase in money supply allows for businesses to grow faster and everyday people to afford to buy things like cars, houses and personal loans for anything (education, renovations, etc). Increasing the money supply in theory spurs people to spend more, and if an economy is slowing down, this can prevent a deadly spiral into something worse like recessions or depressions which are examples of de-inflation. On the flip side, if an economy is doing well, the Fed will raise interest rates to curb demand. Raising interest rates, lowers the supply of money and attempts to stifle spending by making the cost to borrow money more expensive and making things such as savings accounts more attractive by paying more interest. This prevents a growing economy from growing too fast in moving inflation into a hyper-inflationary environment which is problematic as it erodes the buying power of consumers and businesses making things much more expensive.
The Fed's Dot-Plot Effect on Markets
Bringing this brief economics lesson to 2018, the Fed as of December 19, 2018 has raised rates for the 4th time in one year. This is the 9th time the Fed has raised rates since its tightening policy has been enacted in 2015. Before that, the Fed held rates at .25% since December of 2008 in an effort to pull the U.S. economy out of the Great Recession. This became significant because in an unprecedented policy move, the Fed held the rates at effectively 0% for nearly 7 years, and in historical standards, the rate to this day is still remarkably lower than usual.
After Jerome Powell, the Federal Reserve chairman who took over for the generally more dovish Janet Yellen, had made it effectively clear that he is very hawkish and believed that the rates should have been raised a long time ago--it was clear for much of 2018, that the Fed had planned on raising rates 4 times this year, up from 3 in 2017. This move looked rather aggressive to markets as interest rates have a tendency to have an inverse relationship with stock prices. Analyst must account for what the expected borrowing costs will be to determine appropriate cashflows which help determine company valuations which result in higher or lower stock prices.
The day following the 4th rate hike (Dec. 20th) resulted in a massive sell-off in U.S. equities who have already been subjected to a "sell the rip" mentality by traders and analysts alike. As one looks at this, you have to look at broader macroeconomic trends to see why this is primarily Fed driven other than the rate hike itself.
As it is known, volatility will increase as money supply decreases and that has been the case over the course of the year. In the Fed's view, a strong economic backdrop should eventually lead to more inflation--a key piece the Fed and everyone in academics to Institutional bodies have had a hard time figuring out as it has not increased substantially. Employment has been exceptionally low currently at 3.7%. On an economic and financial basis overall, the economy is pretty strong. Not exceptionally great, but certainly not weak. From all other core measures to core PPI and CPI levels (consumer and producer price levels have steadily been increasing but not at a rate fast enough to cause inflationary concerns), housing starts (a steady indicator of consumer health overall) has been great for most of 2018 and experiencing a slowdown since September due to heightening prices largely in part to increasing interest rates and shorter supply due to price inputs for manufacturing firms derived partially from tariff war e.g. metals, steels, lumber, wage-growth (an inflation sensitive reading, hasn’t been where it should be considering employment is historically low, meaning low supply of workers should drive up wages), ISM Manufacturing (durable good orders, etc) has been pretty steady but starting to show signs of wear from the trade war, and consumer and business sentiment has only recently started to lower on optimism of the economy in 2019.
Market Expectations Were Wrong
To market analysts, with no sign of strong inflation why continue on such a hawkish path with regards to the Dot-plot projection. A strong economic indicator I've been following and has been something keen to watch for the last two years has been the steadily flattening yield curve. In early December, the 3 Year (3YR) and 5 Year (5YR) yield inverted. Commonly, a foreshadowing warning for a recession has been predicted by an inverted yield curve (the 2YR and 10YR specifically). This term spread has accurately predicted a majority of recessions since the 1970's. With the speed at which the Fed has raised rates, the flattening had become more extreme as near term rates closed the gaps and the 2YR and 10YR had narrowed to about 16 basis points where at one point it was as wide as 154 basis points in early 2017. Another rise could actually cause a slight inversion in the coming days and weeks. The stock market is as we know sometimes is nothing if psychology. Well today, that spread has narrowed even more to 11 basis points. Already, the 7YR is within 4 basis points of both the 3YR and 5YR. This has been a major factor in market turmoil especially with respect to the banking sector.
Banks as an Industry within the Financials sector is down 19% for the year. The tightening spread is bad news for banks, which make most of their money by borrowing from the government at a low rate and charging customers a higher one. When the difference between short-term and long-term rates is small, there's less money to be made from lending and banks likely will do less of it, which could choke off economic growth. One of the main insights of why an inverted yield curve has been successful in predicting recessions.
This has impacted stocks across the board as analyst had recently began suspecting the Fed will back off its aggressive dot-plot in 2019 which had forecasted for another 3 rate increases, and historically may not even raise rates at the December meeting due to recent soft data when it comes to inflation (and weaker readings world-wide) in conjunction with market's quickly approaching bear market territory where many are trading nearly 20% under their recent highs. The pressure the Fed has received from the U.S. government had analysts lowering expectations to such an extent that it was surprise in the press conference following the Fed board meeting, that Powell gave no indication of being swayed by recent volatility and didn't sound dovish despite lowering the dot-plot to two hikes in 2019 versus the original 3.
Looking at all this, the tenseness in the markets led to a panic sell because they were expecting an even more dovish Powell. Something which has surprised me considering the track record in Powell's statements for much of 2018 has consistently been hawkish and optimistic on the trajectory of the economy. With the sharp decline in market prices, it has triggered debate as to whether markets reacted poorly or the Fed is making a policy mistake. This years Santa Clause rally might not exist with mounting concerns of an economic slow-down that will finally end the longest bull market in U.S. history.
Much more will have to be uncovered as our InvestCEE team prepares more in-depth analysis over the last quarter of 2018. Stay tuned for more insights.
By: Saul Ellison, the Co-Founder and Director of InvestCEE
This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.