What is the Fed trying to do?
Analysts, pundits, and Central Bankers are mostly right when it comes to economic issues, growth, and inflation. However, their models do not include a pandemic or war. As such, most estimates and projections during the past several months may be treated with skepticism. In fact, market participants have for the most part been positively surprised by most economies, as opposed to the doom and gloom that was forecasted at the start of the pandemic.
But in order to avert a depression, central banks and governments came to the rescue. Central Banks intervened with liquidity and loose economic conditions (lower interest rates and ample liquidity), and governments gave cash handouts to make up for the loss of income.
Now the Fed wants to take everything back. At least that’s what they mean when they want to reduce the Fed’s balance sheet. But there is a small problem. As a general rule of thumb when liquidity is created, it eventually gets backed in the system, and any attempt to take it out again (shrink the balance sheet) causes a lot of harm to the economy and markets.
Will higher rates reduce inflation?
As you all know, there have been many supply-side disturbances because of the COVID pandemic. These supply issues and bottlenecks have in many instances raised prices, caused delays in procurement, or simply made products unavailable. As a result, prices for many products and services have gone up. In fact, higher than originally thought, and longer in duration..
However, COVID price rises were not the end of the world and didn’t bite into consumer purchasing power all that much. The main problem with current inflation dynamics relates to energy costs and commodities. The current rise in energy costs is responsible for a much broader rise in goods and services, as opposed to a rise in computer chips.
As an example, a price-rise in a particular computer chip because of a supply side disturbance, only raises the cost in the specific product in which it is used. A rise in oil and gas prices, raise the price of gas that affects consumers, the cost of transportation, the cost of international shipping, air-travel, and even commodities because of all the reasons mentioned. However, let me make two observations.
First, the higher cost of energy is not so much because of an increase in demand, but of lack of supply. The lack of supply however is mostly because of geopolitical turmoil (Russian – Ukraine war). In fact, in many cases these price increases are self-afflicted, because many governments have decided to limit or prohibit Russian energy imports in their countries. Energy prices will eventually come down, but only after Russian oil returns to the market, or an increase in supply comes from another source, or if current producers produce more oil and gas.
In other words, there is not much the Fed can do to lower energy prices, outside of technically crashing the US economy with very high rates. As such, is doubtful if the monetary policy is an answer to current inflation dynamics.
The Fed does not have any easy options.
As you can see from the chart below, consumer sentiment is approaching the lows of the 2008 financial crisis, and only 3 times during the past 40 years has sentiment been so low.
Obviously, the main culprit for such a low sentiment reading is inflation, eating into consumer disposal income. However, what would happen if consumers had even less disposal income because of higher mortgage rates, higher credit costs to buy a car, higher credit card rates, and a many other costs that have to do with higher interest rates?
The answer is probably an even lower consumer sentiment reading, and lower demand. However, lower aggregate demand is what the Fed wants to achieve to lower inflation. By elevating interest rates the Fed can eventually achieve such a goal. Some market participants, however, are skeptical if the price of energy will fall in the absence of an increase in supply.
The Fed aims to achieve lower inflation but without inducing a recession. With consumer sentiment being so low, a soft landing is a very speculative bet. And while nobody knows what the outcome of the Fed’s policies will be, the most probable result will be recession, if it raises rates by 50 basis points several times in a row and shrinks its balance sheet as it has said it will. Obviously, another sector of the US economy that will be affected is housing.
As illustrated on the chart above, the average 30-year fixed mortgage rate is already approaching 5%. There’s an increased probability, when mortgage rates stay elevated long enough, the US housing may break. Is monetary policy the answer?
On the other hand, politicians on both side of the Atlantic are calling for Central Banks to do something about higher prices. Central Banks have been pressured for a while, with many accusing them of being behind the curve.
The problem however is that higher rates might not be the answer. In the absence of a pandemic and war, it is true that monetary policy would have been the answer to an economy that is overheating. However how can monetary policy lower higher energy prices, when there is a lack of supply, or supply side shortages because of the COVID pandemic, something that is still ongoing? This is something that many analysts and economists are trying to figure out. And the truth is that there are no easy answers.
Why does the Fed want to reduce its balance sheet?
First of all, for all the concern pertaining to the Fed’s balance sheet, very few mentions are made about the balance sheet of the ECB or the BoJ. As the chart above shows, as a percentage of GDP, the ECB has more than double the Fed’s balance sheet, and the BoJ almost 4 times the balance sheet of the Fed. So, my question is, why does the Fed think its balance sheet must shrink? Furthermore, how is this connected with its goal to reduce inflation?
This is not an easy question to answer, because nobody knows what is in the Fed’s mind. However, everybody knows that inflation as presented in the article found on the company’s internet side here in both Europe and Japan has not been a function of their balance sheets all these years. As such, there are reservations if the Fed’s balance sheet has anything to do with inflation.
As mentioned above, once liquidity is created it gets backed into the system, it is very difficult to unwind, and it might cause a lot more damage than the benefit of lower inflation. Also, the unwinding of the balance sheet acts like using leverage trade in reverse. In other words, the damage could be much more painful than we could imagine, if the Fed allows its balance sheet to unwind to the tune of about $1 trillion per year.
Bond market shakeout
It does not take much to figure out the kind of carnage bonds might face if the Fed raises rates as advertised with yields so low. According to a recent Financial Times article, “Treasuries set to post worst quarter of returns since at least 1973 on inflation and rate rise fears”.
Indicative of the carnage is the chart below (from Bloomberg).
The price of Austria’s 100-year bond has more than halved in price. After starting at around 110 in 2020, investors holding these bonds have lost around 40%. Not from the highs, but from their initial investment.
The Fed has reiterated via proxy (ex-Fed officials) that it wants to take the market down, to take away the wealth effect created by the market. The logic being, if everyone feels poor, they will curtail spending. Well, insofar as bonds are concerned, the Fed is doing a great job.
But how much fixed income carnage is the Fed willing to tolerate in the name of lower inflation? Impossible to know, but please keep in mind that many have characterized the current Fed as the most hawkish since Paul Volker.
Chairman Powell has suggested that QT (quantitative tightening) will proceed at about $1 trillion per year. Taking into account the addition to the QT of the expected net issuance by the US Treasury at around $1,5 trillion per year, market forces (or non-Fed buyers) are expected to purchase about $2 trillion on average for the next 3 years. It is not sure where this money will come from neither the yield that this debt will maintain.
So, as bad as the bond market seems at the moment, if the Fed’s playbook materializes, we might just be in the beginning of a lot more pain for bonds.
The bottom line
Be it stocks or bonds, if the Fed delivers on its threat to increase interest rates as it has hinted ( 2.25% – 2.50%), investors have no place to hide. There are no safe havens at the moment, not to mention that sentiment is limit down.
Also, this is still a very expensive market. Not so much at the average stock level, but at the mega cap and index level. I would be a lot calmer if the S&P 500 Index had a 15 multiple, but instead its trailing multiple is around 24, with the forward multiple at around 20.
Now having said all this, I do not believe that the Fed will be able to raise rates past 1.5%. The reason is that it will probably cause a lot more damage than the benefit. Also, one thing that seems wrong about current Fed policy is that it is aiming at inflation instead of growth.
Hawkish monetary policy usually aims at cooling down the economy. This colling down is expected to lower inflation and inflation expectations. This time around the Fed is aiming at inflation with a disrespect for growth. Furthermore, the Fed has a total disrespect for the market and the wealth effect.
At some point, I think the Fed will notice the damage being done and do an about face. But the question is how much damage will be done until then, and how long will it take for the Fed realize this. I do not have an answer, but my target as I said is the 1.5% mark.
Finally, remember that the market is forward looking. At some point, even as monetary policy continues its path, markets will bottom out. But trying to time the market at the moment, while the covid pandemic is still in play, with geopolitical turmoil in full blown mode, and with perhaps the most hawkish Fed sine Paul Volker, is an impossible task.
Just 1 week into 2022 and something interesting is happening. The rotation we have been witnessing for some time now has accelerated. While financial sites report a rotation from growth to value, I see it as an exodos from ultra-high valuation stocks to something else.
So far the S&P 500 has retreated by about 2.5%, the Wilshire 4500 index 4%, The Nasdaq 100 5.5%, but the ARKK innovation ETF has corrected by 13%. And that’s on top of the 25% slide in 2021.
Again, while the headlines point to the fact that this correction in growth stocks is the result of monetary policy, the truth is that it is probably more of a return to reality and investors becoming less complacent. Investors have been complacent for the past several years now, but at the end of the day valuation gravity always comes into play. And that is what I think is happening.
And the question is, what might happen if the mega-cap stocks start to fall also? Will that take down the entire market down or will the money flow to other names thus acting as a cushion at the index level?
Because if the rotation becomes a self-fulfilling prophecy, then eventually even mega caps will also correct, for no other reason than sentiment as opposed to anything wrong with their business. Remember we said Fed policy is probably a headwind in 2022. And while the mega cap stocks are not in bubble territory as many of the stocks that have correct by 80% recently, they are not cheap. Yes, there is the possibility that they could correct by 20% or more, and yes that will probably bring down the major indexes. But also keep in mind that just as many stocks corrected in 2021 with the major indexes up, many stocks can go up even as the major indexes go down.
As we ended 2021, the talk of the town was inflation. While Central Banks, especially in the US, think inflation will eventually come down, the new language in “Fed-speak” does not encompass the term “transitory” anymore. The Fed is now a headwind for markets.
I must admit that I never prescribed to the narrative that growth stocks can expand their multiple to infinity just because we were in a low inflationary environment. In fact, many of the high-flying names over the past 2 years have given up most of their gains and in many cases are below where they were pre-covid. The ARK family of ETFs is just a small example, where the ARKK ETF is down by 25% for the year. Is the growth-stock model busted?
On the other hand, we have the mega-cap names that have not given up anything and are the primary the reason for the record highs at the Index level. Five companies alone (Apple, Microsoft, Alphabet, Amazon, and Facebook) are responsible for about 30% of the gains of the S&P 500 and nearly 50% for the Nasdaq 100. Is there a risk of high concentration, and might a different strategy be needed in 2022?
Possible Fed policy mistake
I think we can mostly agree that the biggest driver of market returns over the past 2 years has been Fed policy. If we agree on that, it also means a reverse of Fed policy might be the reason for a market correction.
According to the average consensus, the Fed will raise rates 2-3 times in 2022, 2023, 2024 and even once in 2025, bringing the Fed Funds rate to 2.5% – 2.75%. All this to “fight inflation”. While I am very doubtful the Fed will tighten as many think, let’s assume it does.
If the Fed does what the consensus believes, it is possible the US economy will enter recession. But even if we don’t get a recession, a slowdown of economic activity is most likely. Insofar as the market is concerned, it will probably react the same in both cases. In other words, the perception that the economy will weaken will probably be bad for equities even in the absence of a recession. Second, for the Fed to tighten as many believe, everything must go according to plan over the next 2-3 years including the absence of an exogenous event like COVID.
But the problem with higher US rates is not only the effect it might have on the US economy, but the effect on other currencies and other economies. While Turkey’s currency problems mostly have to do with politics, the same does not apply to other emerging markets.
Usually, the value of the dollar has nothing to do with traditional metrics by which other currencies are valued. This is why the US twin deficits (trade and current account) have never really affected its value. Also note that when the dollar is rising it usually means risk-off, and vice-versa when it weakens.
When the dollar goes up or down it is usually a function of the availability of dollars in the global economy. Because about 80% of global trade is conducted in dollars, a lack of dollars usually bids up its value, and an abundance of dollars the opposite. The point being is that the dollar does not adhere to the normal metrics used in other currencies.
Now by default, repo open market operations increase liquidity (temporarily increase the supply of reserve balances in the banking system), and reverse repo operations decrease liquidity.
The above chart depicts the value of the Fed’s reverse repo facility. Please note that as of the day of this writing there are about $1.7 trillion parked in this facility. Please also note $1.7 trillion is no small amount, it is the equivalent of about 2% of global GDP.
So, it might be the Fed has been tightening without realizing it. But even if it realizes it, paying 5 basis points of interest for reverse repos rather than having negative money market rates, might be the better of two evils.
While in theory repo operations have nothing to do with FX flows, and thus should not impact the value of the dollar, at the same time the fact that this dollar liquidity is trapped at the Fed might be a reason for dollar strength.
In any case, we will be following this facility in 2022 to see if our theories have any credence, and to see if we notice any change in the dollar (especially vs the EURUSD pair) as a result of the increase or decrease of this facility.
Now insofar as fighting inflation, the Fed must persuade markets and politicians that it knows what it is doing. The Fed can easily bring down inflation simply by crashing the economy with higher rates. The question is, is this the best policy? Is a recession worth bringing down inflation?
Personally, I doubt this is what the Fed wants. After all, why crash the economy only to lower interest rates again and increase asset purchases from the beginning? The Fed has a very difficult job ahead of it because markets are very sensitive to higher rates and conditioned to Central Bank liquidity.
Please recall that just 4 small hikes in 2018 were enough to crash markets and bring the US economy to a mini recession. This even before COVID. Today things are probably much worse, not to mention the fact that markets are conditioned to Central Bank liquidity and zero rates. Remember, we did not have monetary expansion in 2018, the Fed was shrinking its balance sheet, and rates were not at zero.
So, there is no playbook that the Fed can go by. This is why the current monetary situation is so difficult to navigate and prone to mistakes. Because if markets think they will not have Central Bank support, then there is the possibility of a sever correction that will most likely have a toll on the economy. Therefore, the Fed is skidding on thin ice; it’s a “dam if you do, dam if you don’t” type of situation.
My playbook of what the Fed might do is as follows. The Fed will continue to try to convince markets that it will tighten conditions to combat inflation, and it might raise rates 2-3 times, but no more than that. I honestly do not believe it will tighten conditions much more out of fear of what that might do to markets and the real economy. This despite having negative real rates for the foreseeable future. Between a recession and negative real rates, negative rates are the lesser of the two evils.
The risk of Extreme concentration in mega cap stocks
About 8 names are responsible for almost 30% of the market cap of the S&P 500, and the first 50 stocks are responsible for almost 50% of the market cap S&P 500 index. In other words, if the first 50 names go up 2% and the other 450 fall by 1%, the index will be up. This is exactly what has been happening for the past 12 months. And this is also the reason why active management has had such a hard time keeping up with index funds.
The question I have been asking myself over the past 12 months is what might happen if we see an exodos from mega cap stocks? Will money flow over to unloved sectors and deeply undervalued stocks, or will everything fall irrespective of the valuation of each individual name?
The risk, therefore, in 2022, is that we might see these mega-cap names being sold and bringing down the market at the index level. This is a real possibility, because it’s always the biggest and highest conviction stocks that fall last. While I am not making a call that the mega caps will correct in 2022, it is something to keep an eye on.
The above chart depicts the breath indicator for all stocks in the US above their 200-day moving average. As you can see, while the main indexes were going from record to record, breath indicators ,strong>were deteriorating the entire year. In fact, towards the end of the year in December, only about 1 out of 3 stocks were above their 200-day average. This is not indicative of a rising market.
It does not matter which breath indicator you look at; the common denominator is that most stocks in the US have been deteriorating all year while the main indexes were at new highs. Another example of how strange things have been this year can be found in a recent article in Blomberg (link here).
“Last week, when the S&P 500 closed at a 52-week high, 334 companies trading on the New York Stock Exchange hit a 52-week low, more than double the amount that marked new one-year highs. That’s happened only three other times in history — all of them in December 1999, according to Ramsey, who is chief investment officer for Leuthold Group.”
The so-called “stay at home stocks”, and many high-growth stocks have been dropping like a rock. High flying names like ROKU, DOCU, TDOC and many others too many to mention, are down as much as 80% from their February highs.
Will Mega-Cap stocks outperform in 2022, or will a different strategy be needed?
While we do not know what will happen in 2022, it is interesting to make some observations.
The above charts come from Yardeni research and offer some fascinating incite insofar as the forward multiple of US indexes.
While we do not know what will happen in 2022, it is interesting to make some observations.
While Index investing (AKA passive ETF investing) has been the main investment theme for several years, if you buy in an index fund today, you are paying the highest forward multiple on record, except for the 2000 dot com bubble period. On the other hand, small caps are the cheapest on record, with the exception of the 2008 financial crisis.
This does not mean that mega cap stocks will not rise in 2022, but it does mean that buying smaller companies might offer better returns. The same can be said for emerging markets as well.
The S&P 500 finished for 2021 up 27%. This is the 3rd year of double-digit gains, the longest annual hot streak since 1999. This is a very difficult streak to beat even in the best of times. In addition, the Fed is officially a headwind for markets, and it is unknown if the dollar will strengthen in 2022 which might act as an additional headwind. On top of this COVID is still with us, and the major US indexes are the richest they have been in many years.
Yes, US markets could still rise in 2022, but it will not be easy, and everything must be smooth sailing, including the Fed not overdoing it by tightening too much.
On the plus side breath indicators in the US are starting from a low point, with small and mid-caps being a good value, which might indicate there is money to be made if the market does not repeat the extreme concentration into mega-caps of the past several years. In addition, emerging markets especially China might also be a good investment choice in 2022.
One of the main characteristics of the current investment environment is the extreme concentration of a meg-cap stocks in ETFs and funds as a result of ETF investing.
While the Nasdaq 100 has lost a fraction of percentage points from its all-time highs, more than 30 components are down 25% or more, with high flaying names like Peleton down by over 70%, Baidu, Zoom, and Biogen by about 50%, Paypal holdings by 40%, and even names like Intel down by about 30% from its highs. In fact, just 8 components comprise over 50% of the Nasdaq 100 index. And this data is prior to December 1, when the ARKK ETF fell by about 6.5% in one day, followed by another 6% last Friday.
This over concentration has elevated the valuation of the top components to extreme levels, but companies which are not represented enough in most ETFs have an extreme low valuation.
And the question is, how vulnerable is the US market if stocks like Tesla and many of the top components of the S&P 500 and Nasdaq 100 Indexes start to fall? Will the money roll over to other unloved sectors and stocks, or will everything collapse, and cheap stocks will become even cheaper?
We don’t really know what might happen, but the recent correction in high flying technology names might force fund managers to be more selective. Fund managers for years now have been buying companies with a total disregard for valuation metrics. No valuation was too high as long as a stock had marginal improvement in adjusted EPS and revenue growth. That is, until the multiple was so far stretched, that no matter how much a company beat expectations, its stock went down. The 42% one day correction of DocuSign last Friday is probably a small indication of what might happen over the next several months.
The bottom line is passive ETF investing has created huge valuation disparities because of the extreme high concentration of money into specific stocks. However, the recent correction in high flying multiple stocks might be an excuse for selective stock picking one again. If confirmed, fund managers might actually pay attention to the valuation from now on, instead of focusing on marginal adjusted EPS improvements and revenue growth, but with a total disregards for valuations.
If one looks at consumer sentiment vs the major US indices over a very long period of time, they will notice that they are correlated. That is until recently. The chart below depicts divergence unlike anything we have seen before.
As is clear from the chart, consumer sentiment has dropped like a rock while the Wilshire total market cap index is at a record high.
So, the question is, who is wrong? Are consumers wrong and sentiment will soon come back with a roar to coincide with the market? Or will US markets correct to come to terms with consumer sentiment?
Sentiment should be higher today if one takes into consideration the low unemployment rate, voluntary job quits, high savings and record consumer net worth. All these should have reflected a much rosier sentiment picture, but they haven’t.
The bottom line is that many strange things have happened during this economic cycle. The divergence we are seeing in consumer sentiment vs the market is one of them. Whether this divergence means anything insofar as markets are concerned is unclear. At least for now markets are shrugging it off. Nevertheless, it is an interesting revelation and something to keep an eye on.