The cheering on CNBC has been short-lived. The sell-off we had expected irrespective of the Fed’s decision has ensued. Selling pressure in the markets may only intensify in coming weeks as uncertainty regarding Fed policy continues to take center stage. Broader market valuations remain stretched, market technicals remain weak, and sentiment is the worst it has been in some time.
On September 17, the Fed announced that it has reaffirmed its view that the current 0%-0.25% target range for the federal funds rate “remains appropriate.” Though acknowledging US economic activity is expanding at a moderate pace and that both the housing sectors and labor markets have improved, it also indicated that “recent global economic and financial developments may restrain economic activity somewhat,” and that it is “monitoring developments abroad.” The crash in the Dow Jones Industrial Average (DIA) on August 24 and the severe contagion risk associated with the collapse in the equity markets in China were, in our view, the primary sources of concern, as export-dependent countries including Australia, Brazil, and Canada continue to feel residual economic pain.
The major takeaway from the Fed’s near-unanimous decision (only one dissenter, Richmond President Jeffrey Lacker) to hold rates steady, in our view, is that the global economy remains vulnerable, and quite possibly, it may be far worse than even some pessimists believe. A look at the failure of US housing prices in most depressed communities to reach pre-bubble levels coupled with commodity prices from crude oil (USO) to iron ore having been cut by more than half in recent months may be all that is needed to assess that inflation, by traditional measures, is running below Fed targets. The Fed may be most concerned that ZIRP and three rounds of quantitative easing haven’t created runaway inflation, suggesting that perhaps the “true” nature of US economic activity is actually deflationary in substance, the arguments supporting the feared “downward spiral” in prices ever mounting.
We posit, however, that “inflation” is evident, but not in the traditional areas. The S&P 500 (SPY) has nearly tripled since the March 2009 panic bottom as excess reserves have found a home in stocks, and market participants have become so accustomed to an upward sloping equity market that the mere 5-10% correction we are currently experiencing has shaken them to the core. Market veterans will tell you that even a 20%-30% drop from all-time highs in a market that has tripled in just six short years could be expected. After all, the “bulls” keep saying that the 40% market collapse in the Shanghai Composite should have been expected because the market had rallied considerably in advance. Does that mean that another “crash” in the US market should be expected given the similar meteoric rise during the past several years? This is what happens when we extrapolate the reasoning of the bulls—a balanced view is so important.
It is our view that, “inflation,” while not evident in traditional Fed measures, is perhaps no more apparent than in the broader US equity markets themselves, which continue to be fueled by lax Fed policy that has only encouraged moral hazard in the form of overleveraged balance sheets supporting dividend policies that many deem unsustainable without ongoing assistance from the debt markets. Credit spreads in the high-yield markets have “exploded” across most commodity and energy end markets, and investors continue to place no differentiation between an organically-derived dividend and one that is fueled by financial engineering, as they price stocks on their “yields” instead of organically derived operating free cash flows. Whether a company pays its dividend out of organically-generated free cash flow is infinitely stronger than one whose dividend is fueled by external capital market issuance and credit ratings that ignore all implied cash-like debt-service obligations. Debt issuance ground to a halt at the end of August, but during the second quarter, “businesses racked up new debt at the fastest rate in seven years.” The debt binge is keeping equity prices afloat, and that’s an ominous situation in and of itself.
That the federal funds rate will remain low for some time, however, does not mean the Fed won’t eventually hike at the next meeting, and some are even now speculating that the Fed will raise rates at both its October (27-28) and December (15-16) gatherings, tallying two rate hikes in 2015. But that may not matter. The Fed may have waited too long to take its foot off the gas, and a rate-hike suspension into 2016 has become a distinct probability, not possibility. For one, it is our view that the makings of the next global crisis are already upon us in the form of either the “Asian Contagion” or a “Latin American Currency Crisis,” or both, and the Fed’s decision not to hike rates at the last meeting implies they know it, too, or at least understand the risks. Export-dependent countries levered to China’s pace of economic growth are in recession or nearing one, and a rate hike could very well have sent the US dollar to levels that would make US-dollar denominated debt of struggling nations ever-more burdensome to bear, setting the stage for this decade’s version of the next global currency crisis.
Not all is bad, however. Even though the Fed lowered its estimate of long-run potential GDP growth in the US to a range of 1.8%-2.2% from 2-2.3% previously, it is expecting growth nonetheless. Unemployment in the US is now expected to fall below 5% in both 2016 and 2017, and this should keep consumers happy and confidence from being completely shattered. The US housing markets aren’t performing poorly either, though there is some disagreement in this area—recent results from Home Depot (HD) and Lowe’s (LOW) suggest that secular demographic trends and pent-up demand from the Great Recession of late last decade have been resilient. And how can we forget about consumers’ seemingly insatiable demand for new Apple (AAPL) products? The iPhone maker, itself, has become a broad barometer of consumer confidence, and that appears healthy.
Concerns over the deteriorating health of China’s banks infecting the British banks, HSBC (HSBC) and Standard Chartered, remains a distinct possibility, and while Citigroup (C) and JP Morgan (JPM) have the largest direct lending exposure to China among the US investment banks, we have the Federal Reserve stress test to remind us that the US banking sector remains on solid footing. The London Whale incident of 2012, however, is also a reminder that, even with significantly more regulation post-Financial Crisis, trading losses can still be underestimated by a large margin, and the far-reaching operations of the largest banks may simply be too much for just one executive team to handle. Nonetheless, just because the US banks may be able to avoid the next global financial catastrophe in earnest, it doesn’t mean their equity values will perform well as world GDP deteriorates.
From our experience, the market tends to discount material macro events 6-9 months in advance of such an event suggesting that there still is a distinct possibility that the first hike in the federal funds rate won’t occur until 2016 on account of the US crash that occurred in late August. Savvy market observers understand that the Fed’s activity means much more than a tangible increase in a borrowing rate—in fact, the Fed’s moves also reveal its degree of confidence in the broader economy. As the sell-off in the equity markets ensues, counter-intuitively, it may become important for the Fed to reestablish confidence in the markets with an earlier-than-expected rate hike, meaning that a December, or even October, hike cannot be ruled out. A 25 basis point increase is rather immaterial if it ends up reigniting “animal spirits” and risk-taking, as a modest increase may be just small enough as to not attract enormous US dollar inflows that would be required to spark a currency-crisis in countries with substantial US-dollar denominated debt.
The crazy game of poker, or “psychological mind games,” between large participants in the broader US markets and the Federal Open Market Committee will continue for the foreseeable future, but the first rate hike in nearly a decade is coming, eventually. If it doesn’t happen soon, the market will assume that conditions are far worse than recent headlines make them out to be, and that outcome may result in more selling than that would be driven by the rate hike, itself. We’ve stated before that the Fed is in a pickle, and it still is. The implications on the capital positions of financially-engineered, high-yielding dividend-paying stocks held by retirees and near-retirees hang in the balance, as a “one and done scenario” as it relates to rate hikes is likely not going to happen given Chair Janet Yellen’s resolve to build credibility. Priced more like bonds with their dividends as “growing coupons,” entities that rely on financial engineering to pay their dividends face tremendous capital risk in the event of a prolonged period of contractionary monetary policy, in our view.
The Fed decision is only one factor that is adding uncertainty to the broader equity markets, and the global economic situation is far from healthy as valuations aren’t yet attractive enough to bring “new” buyers to market. We maintain our view that indexers continue to face some tough downward sledding ahead.