Policy Misstep Deja Vu?

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Summary

US stock and bond markets have been sending conflicting messages all year.

Futures market pricing in rate cuts while Fed remains neutral, hinting Fed is misjudging outlook.

Inversion of yield curve increases odds of a Fed cut and raises recession risk.

With outlook darkening, a defensive stance is warranted.

Last year’s fourth-quarter bear market went into overdrive due to several miscalculations by the Federal Reserve led by Jerome Powell, in which they underestimated the rapid decline in liquidity and the market’s ability to handle further planned tightening for 2019. More fuel was added to the fire by rising escalations between the US and China regarding trade policy between the world’s two largest economies.

After an official bear market in the S&P 500 of a greater-than-20% decline from the highs, the Fed adjusted its stance to a more neutral, market-friendly posture with Powell’s early January speech where he communicated no more rate hikes and an end to the Fed’s balance sheet reduction program many have dubbed quantitative tightening (QT).

While incoming economic data in the first quarter was softer than the fourth quarter of last year, the economy still showed decent growth; the US and China were working closer to a trade agreement, and the global economy was showing signs of stabilization. This provided ample fodder for a powerful market rally that took us and many by surprise, which we believe was largely due to stock buybacks as corporations took advantage of the market selloff.

We’ve explained how significant corporate buybacks have been to this bull market in past letters, but nothing illustrates it more than the figure below showing how S&P 500 buybacks have accounted for more than $4.5 trillion in demand for stocks! In other words, for every $100 of inflows into equities since the bull market began, $98.9 comes from S&P 500 buybacks.

Part of our suspicion towards the first-quarter market rally was in the conflicting messages from the stock and bond markets. Interest rates typically follow economic growth rates, as higher economic growth is typically associated with higher levels of inflation which pressure interest rates higher. The stock market also typically follows economic growth rates, as corporate earnings tend to move in sync with the economy. For this reason, the stock market and bond yields often move in the same direction.

From late 2017 through the third quarter of 2018, both the stock market and bond market were singing the same tune as stocks and long-term interest rates moved higher. Then, beginning in the fourth quarter of last year, both stocks and bond yield began to decline, particularly in December, but both were still moving in concert.

While stocks enjoyed a strong rally at the start of the year, the same can’t be said regarding interest rates. Through the first quarter and well into May, stocks rallied while bond yields continued to decline, which argues one of the markets likely has the wrong outlook as seen below.

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