BY GUY CARSON
For financial markets the determining factor for 2019 actually came in December 2018. The “Fed Pivot”, which saw the Federal Reserve move from tightening to easing monetary policy, halted an aggressive equity market selldown in the 4th quarter of 2018 and led to a positive 2019. An inverted yield curve, often held up as a harbinger of recession, has been seen in addition to a squeeze within credit markets. However unlike previous times, the Fed took notice of what the markets were saying and started easing ahead of a downturn in the economy.
Historically, whenever the yield curve inverts, a recession follows six to 24 months later. The Fed, has typically ignored this signal because inversions happen well ahead of a downturn and they have often been more worried about inflation than recession. In fact, the Fed in the past has often continued to raise policy rates after an inversion. It is typically that tightening that tends to precede a recession.
With little worry around inflation this time around, the Fed was able to take a very different approach in this cycle. This is evident in that many of the Fed members seem to view an inverted curve as signaling economic weakness. From the minutes of the June Federal Open Market Committee meeting:
“Many participants noted that the spread between the 10 year and 3 month Treasury yields was now negative, and several noted that their assessment of the risk of a slowing in the economic expansion had increased based on either the shape of the yield curve or other financial and economic indicators.”
As further evidence, the Fed has already cut rates well ahead of broad based recessionary signals. Although, according to central officials, the economy is in a “good place,” they are not waiting until the data turns decisively toward weakness before easing policy.
With other Central banks joining in, the result has been the greatest pace of monetary easing since 2009.
Furthermore, unconventional policy is back in vogue and asset purchases are set to rise again next year. The Fed has resumed asset purchases to calm the overnight repo market which saw a spike in yields as liquidity disappeared. Despite expanding the balance sheet again the Fed has repeatedly told markets this is not QE4 despite its similarity in look and effect. This “non-QE” is set to continue into 2020.
The effect monetary policy on markets has had has been dramatic and the longest bull market in history has continued. This is despite the continued trade concerns and serves as a good reminder that Central Banks have become more influential in financial markets than the government.
Markets appear sanguine now on the risk of recession. The Federal Reserve has appeared to have done its job. The important underlying story is that yet again interest rates have peaked at a lower level than the previous hiking cycle. This is trend that is been in place since the mid 1980s.
The key reason behind this is debt. The world has seen a rapid growth in debt levels since the 1980s which ultimately led to the crisis in 2008. Central banks since then cut rates to zero and allowed more debt to enter the system. To paraphrase Homer Simpson, Central Banks appear to believe that the “cause of and solution to all of life’s problems” is debt.
Since 2008, the mix of debt has changed. US Households have deleveraged but overall debt has gone up on the back of the Government as well as Corporations. It is the corporate debt market that started to experience issues in late 2018 and caused the Fed to pivot. With so much debt outstanding, the ability for the Fed to raise rates is limited. In addition without the ability for debt levels to increase, economic growth is likely to remain anaemic.
The high level of corporate debt is also impacting earnings. With limited balance sheet capacity, corporate investment has started to fall and earnings have followed suit, down 2.7% year on year in the third quarter.
This means the rally that the rally this year in equity markets has been driven by multiple expansion and not profits. Multiples have expanded because interest rate expectations have fallen and discount rates have dropped.
Companies with stable or growing earnings have been bid up whilst cyclicals have fallen.
This is not just happening in the US, it is happening globally. In Europe, growth stocks now trade at their greatest ever premium to value stocks exceeding the peak of the dotcom boom.
So what do we expect moving forward in 2020 and beyond? The easiest prediction to make is that interest rates will remain low. Inflation remains in check largely due to high levels of debt as well as technology which reduces the cost of goods production as well as services.
Low interest rates continue to encourage speculative investment and similar to the last 30 years we will see boom and bust cycles in asset prices over the coming years. At present the asset classes that seem vulnerable are growth stocks as well as private equity and debt markets. The result of which is that we favour value stocks at this point.
With interest rates here to stay, it is near impossible to know what might break the bull market. It could be a breakdown in trade discussions or some other exogenous factor. The bull market could of course continue for some time, reminiscent of the saying that “markets can stay irrational longer than you can stay solvent”. However, as the rally continues the balance of risk shifts towards the downside and as a result investors should look to be more conservatively positioned at this point.
If you wish to review your investments heading into 2020, please contact Guy Carson at [email protected]
Disclaimer: The above contains the opinion of the author and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice