“Based on incoming data, … concerns about the strength of the global economy continue to weigh on the U.S. economic outlook. Inflation pressures remain muted.”
— Fed Chairman Jerome Powell, July
The last few weeks have coincided with a significant shift in U.S. monetary policy, with the Federal Reserve taking a significantly more dovish outlook. Pointing to increasing uncertainties about global growth, the Fed has telegraphed a rate cut is coming later this month. Markets have cheered.
The S&P 500 rallied past the 3,000 mark for the first time in history. Given that the index is weighted on the size of the company, the gains are most influenced by the largest high-flying technology stocks.
A recent analysis by investment consulting firm LCG Associates noted the divergence between “growth” and “value” stocks is the largest since the late 1990s. Starting to feel like the boy who cried wolf, this column has pointed to that divergence for several years.
But using the MSCI Inc. world growth and value funds as comparative proxies, growth stocks trade at a forward price to earnings ratio that is close to 20-to-1 versus less than 12-to-1 for their value alternatives.
Investors seem to believe low interest rates will be here forever, creating nearly “free money” for U.S. tech companies to fund their growth. Industrial companies or those with real assets are “so 1999” — read “out of favor.”
Perhaps some bargains do remain while the market hits new highs?
During testimony on Capitol Hill this month, several elected officials challenged the Fed’s more dovish tone.
Initial jobless claims remain at multiyear lows. The unemployment rate hovers around 3.7%, and while the May jobs report was a bit ugly, June bounced back strong, resulting in a six-month average of heady job creation. GDP growth for the first half of the year is likely to come in well north of 2% (a good clip).
Powell and his compatriots don’t seem convinced. Minutes of the last Fed meeting show nearly all participants revised down their assessment of where short-term interest rates should be and many indicated a preference for a more accommodative monetary policy.
Arbor Research, which analyzes Fed speeches, released measures showing these were the most dovish comments from the Fed since 2017.
Some might say the Fed is caving to jawboning by President Donald Trump, who clearly thinks lower rates will boost the economy and stock market ahead of the 2020 election.
The Fed seems to have danced around this criticism deftly. While many economic indicators are mixed, monetary leaders around the world are signaling that more monetary stimuli are coming. The Fed is skiing in their wake.
The European Central Bank is planning to cut rates and restart its quantitative easing program (printing money to buy bonds from companies and governments around Europe). This has lowered interest rate expectations across the pond.
The ECB has friends. Japan has its own QE program, where the Bank of Japan owns about half of all of the Japanese government bonds outstanding. The BOJ also purchases stocks in the form of exchange-traded funds.
The Swiss National Bank buys stocks directly, owning nearly a $100 billion in stocks like Apple, Microsoft and Amazon. Remember, they printed money out of thin air to buy these stocks.
Thanks to the world’s central banks, there is now a record $13 trillion in negative-yielding debt trading around the world. Like gravity, the massive amount of debt drags down growth and, with it, interest rate expectations.
The Fed is adeptly ignoring the political drama around interest rates and using this lack of global inflation as its cover to lower rates and stoke higher inflation.
One of the biggest questions the Fed is wrestling with is its framework for inflation expectations. The longstanding connection between lower unemployment resulting in higher wages and inflation has broken down over the last decade.
The Fed is looking for new tools and frameworks for thinking about interest rates in the future.
One of the prevailing proposals is to drive inflation above 2% for some time to make up for the long period of sub-2% inflation.
The Fed may get what it wants. Markets are pricing in a 100% chance of a quarter-point cut this month, with more to come later this year. Gold has begun to rally. Stocks are rallying. Inflation expectations have begun to rise.
Shortly after Powell’s testimony, the Consumer Price Inflation report was released and showed inflation measures were a bit stronger than expected. Core CPI rose to 2.1%, driven by goods inflation, where prices rose for the first time in five months.
This may prove transitory, or maybe not. In the meantime, enjoy the rally.
To take a contrarian view, building some exposure to higher rates, higher prices and higher inflation may be warranted. And, with markets really happy just six months after they were seriously depressed, some hedges seem to make sense.