2018 was a bad year for risk assets – stocks were down, U.S. Treasurys were down, corporate bonds were down, and commodities were down. The fourth quarter was especially rough.
Blame the Fed.
Their continued trek on the path of the normalization of both interest rates and their balance sheet put the market on defense. Chairman Powell’s comments about the balance sheet reduction being on “autopilot” were particularly jarring.
About face! The minutes following the January Fed meeting told another tale entirely. Given the absence of any credible uptick in inflation and a readily observable growing weakness in the domestic economy (to say nothing of an accelerating global slowdown), the data dependent Fed said, in effect, “no mas.” Patience was the watchword on normalization and the autopilot balance sheet reduction program would be slowed to a stop by the end of 2019. Risk on!!
Source: Bloomberg
The market roared and that roar continued into February. Where we go from here, in my opinion, will be a function of what the Fed does next.
Economic data will clearly play a role in the Fed’s determinations. Whether or not the geopolitics associated with China trade talks, North Korean nuclear talks, or the impact of Brexit (or no Brexit) figures in to their calculus, only time will tell.
The economic data that we expect the Fed to be keenly focused on are those relating to employment and inflation. The chart below from the St. Louis Fed shows the four-week average of initial unemployment claims.
Source: FRED
This is not a rigorous statistical analysis, far from it, but it looks as though the series may have bottomed in January of this year and started to look up. If claims climb, that’s an argument for the Fed to stay on hold.
The Fed’s preferred measure of inflation is the Personal Consumption Expenditures (PCE) deflator. You can see from the following FRED chart that although it appears to be rising from its 2016 low, it is only now hitting the Fed’s self-proclaimed 2% target.
Source: FRED
It is worth noting that the Fed’s target is thought to be symmetric in nature, that is to say, they are equally as willing to let it drift about 2% as they were willing to let it linger below 2%. That’s a long way of saying that at current levels, this is another argument for remaining patiently on hold.
In the inflation target discussion, I’d be remiss if I didn’t mention “price-level targeting.” Here is the Investopedia take on the subject:
“Price level targeting is a monetary policy framework that can be used to achieve price stability. Like inflation targeting, price level targeting establishes targets for a price index like the consumer price index. But while inflation targeting is forward looking, price-level targeting commits to reversing any temporary deviations from the target rate of inflation. If inflation fell below 2% for a time, the central bank would compensate by aiming for inflation above 2% until average inflation over the whole period had returned to 2%.”
Source: Investopedia
Why is this significant?
Because the inflation has been well shy of the Fed’s stated 2% for quite some time. For the last ten years, CPI has averaged just 1.6%. To raise the average to the Fed’s 2% target would require tolerating inflation to run at an average of 2.4% for the next ten years. That has some pretty stark implications for interest rates.
Do they need any additional data to justify the current dovish stance? Not likely, but it is available, we think, if they need it.
Take new home starts, for example. This is another series that was undoubtedly hurt by the normalization that was still in effect in December 2018 and early 2018. It is too soon to tell if this pause will refresh, but if they needed an excuse to err on the side of additional patience, this could be what they are looking for.
Source: FRED
All is not negative.
Certainly the near 20% rally off the Christmas Eve lows has to be respected. Regardless of what catalyzed it, the market has resumed its uptrend (i.e. the SPX is trading above its twelve-month moving average).*
Nor is all negative with our Five Factor Framework.
Although our leading economic indicators growth rate is still showing as negative and red, the market trend is positive and green. The remaining three factors, monetary conditions, investor sentiment, and valuation, are all neutral at the end of February, showing yellow.
Five Factor Framework
We say it often because it bears repeating: This dashboard should never cause you to change your long-term asset allocation. Changes to your long-term asset allocation should be a function of changes in your circumstances, your goals and objectives, or your risk tolerance.
Disclosure:
* For the two-month period ending Feb. 28, 2019, the S&P 500 returned 11.48%, including dividends. The twelve-month moving average of the S&P 500 as of 2/28/2019 was 2734.31. Indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts. You cannot invest directly in an index. S&P 500 Index is regarded as a gauge of large cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of the available market capitalization.
