Bye, Bye Backstop

  • Trump’s agenda of regulatory rollback, infrastructure spending and tax cuts is all but stuck in Washington’s ideologically fractured environment
  • Strong earnings made up for stalled policy and a lack of improvement on the economic front, with reported earnings for the S&P 500 up nearly 14%
  • The Fed may be moving from a focus on financial stability to one of monetary stability, which has important implications for risk taking
  • In the meantime, valuations remain stretched across a number of different asset classes

In Q2, the economic and political situation in the US began to feel a bit stuck.  Tax reform remains stalled out behind the broken down bus of health-care reform.  The dream of easy policymaking under single-party control of government has given way to a nightmare of conflicting ideologies inside the Republican Party. And, investors continue to struggle with stretched valuations across a number of different asset classes, due in large part to ultra-low interest rates for an ultra-long time. The IMF recently downgraded US growth prospects - while upgrading those of Eurozone and Asian economies - on the premise that sweeping fiscal reform seems increasingly unlikely in the medium term.  The Fed, however, sees it differently.  Rather than looking for excuses to maintain loose monetary policy as it has done for the past decade, it suddenly appears to be looking for excuses to tighten.  This has a number of implications for the economy and capital markets.

When parsing the Fed’s words, it is clear that Janet Yellen has two primary concerns.  One is jobs.  At 4.3% unemployment, the Fed has expressed concerns that tightness in the labor market is unsustainable and will likely lead to inflation down the road.  (Data aren’t telling this story yet; in fact inflation remains remarkably subdued.  The Fed has excused the absence of inflation pressures on transitory issues like falling prescription drug prices and cheaper cell phone plans).  The other, ironically, is recession.  If the Fed tightens short-term rates to deal with the hot jobs market, it risks creating an inverted yield curve - a term used to describe higher short-term rates relative to longer-term interest rates – typically a harbinger of recession.  By selling some of the longer-term debt on its balance sheet as it recently promised to do, the Fed can manipulate the longer end of the yield curve upward, maintaining banks’ incentives to lend and helping bolster corporate profit margins, extending the economic expansion.  It’s entirely possible, in other words, that the Fed can raise rates to preempt inflation without derailing the economy (possible is the operative word here as the Fed admits that the exit from quantitative easing is unchartered territory).

Beneath the surface of the Fed’s newfound willingness to fight inflation, however, is a more important message.  Rather than focusing on financial stability, as has been the case under quantitative easing, the Fed is indicating it will be more focused on monetary stability going forward.  The so-called ‘backstop’ role the Fed has played in recent years - stepping in with rate cuts and various QE programs any time markets have come unhinged - may very well be in doubt if the central bank’s primary focus is on fighting inflation.  Inflation, the thinking goes, can itself be a huge source of financial instability should it get out of control.

It’s not hard to imagine what the world might look like without a Fed standing by to buffer every twist and turn in the market.  For one, it will mean (for better or worse) that market forces and economic fundamentals will play a greater role in determining prices in capital markets, rather than being so heavily influenced by central bank policy.  Investors should like that, as it will allow them to be rewarded for differentiating between fundamentally good and bad companies.  However, much like the period from 1994 through 1999, it will mean greater market volatility. No backstop (and more volatility) could also mean less risk taking by market participants; take away seatbelts and drivers should adjust their behavior accordingly the thinking goes.  Finally, without the Fed standing by to cut rates any time the market drops materially – a tool that has prevailed since Greenspan successfully used it to buffer the 1987 stock market crash – the typical inverse relationship between bonds and equities could break down.  Bonds go up when interest rates go down, so they’ve been a reliable portfolio offset to equity risk in a world where the Fed reliably intervenes.  Without the Fed backstop, it could mean a rethinking of traditional portfolio construction.

It’s still not crystal clear that this is where the Fed is going, but we will continue to monitor its behavior for this possibility given the signals we have seen so far.  Should falling prices prove to be transitory as Yellen asserts and we revert to the historic positive relationship between a tight job market and inflation pressures, we will begin to modify portfolios to include greater inflation protection.  This will mean potentially adding a small allocation to commodities and emerging markets equities.  Both remain relatively cheap from a valuation perspective when compared to large cap US equities and both have generally been good long-term inflation hedges in the past. 

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