Jackson Hole Recap: The Fed’s Playbook is Intact
In our previous perspective, “Getting Ready for the Jackson Black Hole,” we were concerned that the Federal Reserve was going to reveal (or hint at) different procedural guidelines for policy implementation. Given recent statements from Fed officials, namely John Williams and James Bullard, we worried that there would be a paradigm shift in monetary policy, one that would be considerably more reactive to coincident economic data, and heighten the risk of the Federal Reserve falling behind the inflation curve. While Fed chatter is fluid, and “data dependent,” Janet Yellen alleviated much of our fears.
Janet Yellen recognized that the case for a rate hike has “strengthened in recent months,” and Stanley Fischer, in an interview went so far as to say that one or two rate hikes in 2016 are still on the table. Of course, the Fed will still be data dependent, and so all eyes will be focusing on the August payroll report this Friday. Also pay attention to the BEA’s personal income and spending report on Monday. The core PCE is expected to slip to 1.5% year-over-year, and although it is still notably below the 2% Fed target, Yellen has reiterated her belief that the historical relationship between tightening labor markets and rising prices is not broken. It is reassuring that the Fed will still be focusing on this relationship, and since they will be implementing a familiar playbook, our worries about a paradigm shift in Fed policy have been assuaged, at least in the near-term.
As a result, we can look to historical correlations to forecast market action based on the macro-data that emerges over the next month, especially since Q2 earnings are in the rear view mirror. Incidentally, 55% of S&P 500 companies beat revenue estimates and 79% beat earnings estimates in the most recent quarter—one of the major reasons for the positive price action that we have witnessed this Summer. The other major reason, which we have been pounding the table since the beginning of the year is dire investor sentiment. The AAII Investor Survey has been below its 5 year moving average for 17 out of the last 18 months. This has never happened. Moreover, there is only one reading in the history of the survey that was lower than the May 30th reading of 17.75%, and that occurred in October of 1988. Currently, Bullish sentiment is at 29.42%, well below its historical average. Such low sentiment usually results in robust six-month and twelve-month forward returns for the major indices. On May 26th, we wrote a piece, “Pocket Aces: Play or Fold,” and we stated the following:
“Over the next six months, market pundits are going to continually question why this market keeps moving higher. They will try to pinpoint fundamental reasons why the equity market is undervalued, or that economic conditions are improving. These may be true. They may not be. But the reason we will move higher, is because of positioning. Bearishness prevails, and the street is underinvested.” –May 26th
The chart below illustrates how bearish investors still are, a necessary pre-condition for this market to continue to climb the “wall of worry.” This is especially important as market indices continue to register new highs without changing the mindset of traders and investors alike. This rally has legs. Believe it.
Our largest concern has not been the U.S. economy, but rather the risk of policy response to what we consider transitory economic weakness, including the collapse of the energy market, the Brexit, the stronger dollar, and manufacturing weakness. Now that we have some reassurance from the Federal Reserve that its procedural integrity is intact, we believe that this risk has diminished. The equity markets will not go up in a straight line, and they are always vulnerable to a 5-15% correction, but those corrections should continue to be good buying opportunities, and I suspect they will be few and far between.
It is often premature to affix any meaning to market action during the doldrums of Summer. Volume is low. Trading desks are under-staffed, and many are still on vacation. However, Friday’s response to Yellen and Fischer’s comments was as it should be. The dollar rallied, treasuries sold off, gold weakened throughout the day and into the close, and rate hike expectations increased. The ten-year yield, at 1.63%, has broken out of its two-month range, and is now the highest since the day after the unexpected Brexit vote. The dollar strengthened and managed to recoup its weekly loss, however, is still off approximately 5% from its Winter highs. I suspect robust economic data over the next week will continue to bring a bid to the greenback, however, year-over-year price measures should benefit from weaker comps and enable the Federal Reserve to push ahead with rate normalization. The Fixed Income market is now pricing in a 42% chance that the Fed raises in September (highest since early June), and a 65% chance that they raise in December. Remember, post-Brexit, the market briefly priced in the possibility of a rate cut. The market took notice on Friday, and gave credence to Yellen and Fischer’s statements. Positive economic data will accelerate this trend.
With term-premiums for longer-dated treasuries still negative, inflation expectations benign, and an aura of disbelief that the Fed will normalize and adhere to its traditional playbook, there is considerable risk in the treasury market. The foreign demand for U.S. treasuries, because of the low global rate story, is waning. Currency hedging costs have now brought treasury yields, denominated in foreign currencies, negative. As a result, pension funds, sovereign debt funds, and other foreign investors, in order to generate positive yield, will have to look elsewhere. The equity markets? High yield? Investment grade corporates? All of these asset classes have less duration risk, and are looking more and more attractive. Meanwhile, the argument that U.S. treasuries represent considerable value over other sovereign debt, will continue to lose traction. The chart below shows that the 10-year treasury spread over a comparable Bund broke its trend line on Friday. The dichotomy between U.S. economic strength and global weakness is about to be revealed in increasing treasury spreads over their global counterparts.
The equity markets have benefited from under-investment and bearish sentiment since the end of the Great Recession. This will continue to provide a floor for any equity sell-off that could occur this Fall. In the short-term, hawkish remarks from the Federal Reserve will likely induce nausea among equity participants. Any September sell-off should represent a good buying opportunity, especially if it is accompanied by further deterioration in sentiment. However, investors should not expect treasuries to buffer portfolios in such an event. Rising rates are the ipecac that will induce such equity nausea, and bullish sentiment in the treasury market is every bit as acute as bearishness is for risk assets.
This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the author which are subject to change without notice. Forward looking statements, estimates, and other information contained herein are based upon proprietary and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.