Advisory Letter: 1st August, 2019
The highly anticipated Fed meeting is over, and the proverbial cat is out of the bag with a 25bp lower sneak. Many had expected more (ca. 25% of the investor audience + Donald Trump), but the majority is happy with the cut. Or are they?
I have been trying to figure out for a long time, what makes the Fed tick (no success there) and how would a central bank whose statuary mandate is to foster maximum employment and stable inflation be inclined to cut rates at a point in time where unemployment is at record numbers, and inflation steady; albeit a bit below the targeted 2% rate?
The short of it is the conclusion that the Fed simply over-tightened in the last cycle, raising rates too fast too high when they increased in late 2018 to the 2.25-2.50% range, and now we are in reverse mode.
Last night’s second major event that has gotten much less attention was the release of the Chicago PMI (Purchasing Manager Index – survey of senior executives in major corporations about their outlook for economic activity). As the next chart shows, this index tanked to levels we have seen only a few times in the past 20 years.
Ahead of the 2000/01 recession, 2007/08, 2015, and it indicates increased risk of a recession coming. I agree with that notion, because we have entered a new paradigm of uncertainty from unpredictable politics (China, Iran, de-globalisation and pull back on free trade) that has fostered an environment in which business owners are not willing to take measured risks given that there is no clear path ahead for your investments in capital goods and/or people.
My two take-aways from last night’s Fed meeting are:
- the 25bp cut in the policy rate to 2.00-2.25% range; and
- bringing forward the end of quantitative tightening to September, which can be seen as a mini-cut
But the language in the statement by Powell – “mid-cycle adjustment<sic>” and “not the beginning of a long series of rate cuts<sic>” – are poor attempts to leave some bullets in the chamber for the Fed. I do think he dropped the ball here a little bit…
I am inclined to think that the Fed is left with little choice but to continue cutting rates as the year progresses. A few reasons:
1. USD is (rightly) going stronger in the initial reaction and will possible continue to do so.
We have entered the upper right hand corner of the “$ Smile” and the fact that this is the last developed country in the world with positive rates will keep inflows intact, while the rest of the world is racing more and more into negative yield territory.
But what the U.S. needs now is a weaker USD to stimulate the economy and make this their neighbours problem, which will not happen unless rate cuts exceed the expectations.
The real trouble with a strong dollar, however, is the highly indebted borrowers from overseas, who need to keep buying USD to service their debt, and against the backdrop of low domestic growth across the globe, another 5% increase in your USD denominated obligations can cause trouble for some of the weaker EM and HY borrowers.
At the same time, every dollar rise in the exchange rate increases the probability of some sort of verbal or actual intervention by policy makers, causing a sharp reversal. So, stay nimble on that trade.
2. Increased likelihood of a stock market correction will put the ‘stimulus cut’ back into play at some point in time.
Funding for corporates to raise debt to buy back their own stock (the game of the last decade) needs to be lower to support these dynamics, at the same time PMI and other leading indicators, clouded outlook, etc. will keep any upside limited.
As always, time will tell who’s right and who’s wrong, but here’s what I like for the coming weeks – to play it safe and keep things close to home.
A set back in equities can be a good near term buy opportunity once it arises, but needs to be at least 5-10% lower from here. The higher $ move somehow puts the conviction about long gold and silver into doubt, but even there I think that a correction in gold to the 1350 level is again a good long term buying opportunity (2-5yrs).
As for rates, likely that we will see a continuation of this years trend, albeit at a somehow slower pace, that will persist until the Fed stops pushing a half-hearted monetary policy across on a shoe-string.