‘So we thought carefully about this, on how to normalize policy, and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy, to adjust to incoming data.”
Markets remain strong with many of the major indexes at or near all-time highs. Economic growth is robust, monetary conditions remain extremely easy and consumers are flush with cash from stimulus as virus cases fall and the economy reopens. What could possibly go wrong? This month we highlight risks into the second half of the year including: Fed tapering, lofty asset valuations, and “peak” GDP growth. The most likely timing of a Taper announcement may coincide with the market realization of a negative Quad 4 environment in late-summer. We believe it’s now prudent to use strength to reduce risk.
Ah, the (in)famous ‘auto-pilot’ quote! I remember it like it was yesterday. The Fed had just concluded its December meeting and jammed through the fourth rate hike of the year, taking the Fed funds rate, the foundation of all other interest rates in our economy, up to 2.5%. (The average 30-year mortgage rate at the time was nearly 5%, could you imagine that today?!?) In addition, the Committee also signaled that two additional rate hikes were on the table for the coming year 2019. Federal Reserve Chairman, Jay Powell, was addressing the media as is customary after each Fed meeting when he dropped this gem of a quote regarding the reduction of the Federal Reserve bond-buying program also known as Quantitative Easing or QE. Markets were already jittery in the fall of 2018 due to the slowing of the economy, and former President Trump’s portentous trade war with China, but the combination of the rate hike and the Chairmen’s comments sent the market into a tailspin. I vividly remember watching the press conference in Brian’s office (Brian Needleman, Cornerstone co-founder now retired), while we both took turns yelling at the television screen for him to stop talking, in the hopes that silence would halt the market’s slide! The S&P 500 went on to drop 8% over the following week to officially enter a bear market by registering a 20% decline from the peak in September.– Jerome Powell, Chairman of the Federal Reserve. December 19, 2018
The “auto-pilot” gaffe as it is now known, was reversed in just 16 short days, when at an event on January 4, 2019, Powell walked back his comments stating, “If we came to the view that the balance sheet normalization plan — or any other aspect of normalization — was part of the problem, we wouldn’t hesitate to make a change.” The “Powell Pause” signified to investors that the Federal Reserve was willing to support the market by any means necessary, allowing investors to, in the immortal words of Wayne Campbell and Garth Algar:
“Party on, Wayne! Party on, Garth!”
PS – Those 2019 rate hikes never came to fruition either, just as we predicted in our 2019 Kick Off call. (Celebrate the W’s!)
A shot across the bow
By now you’re probably thinking, “Thanks for the history lesson, Cliff, but what does any of that have to do with today?” Well, I’m glad you asked because the recently released minutes from the April Fed meeting just fired the first warning shot on tightening financial conditions:
“A number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”
IE Tapering is back on the table! The significance of timing here is extremely important. The Fed knows that (1) the market has gotten very used to extremely easy monetary conditions and (2) hates surprises. We think the ‘taper-talk’ will get louder over the coming weeks to give investors ample opportunity to prepare before the official announcement. The most probable timeline for a taper announcement is at the annual meeting in Jackson Hole, WY in August. In the past, the Fed has used this venue for other major policy announcements, and by then we’ll have had some 4-5 months of the strongest economic data releases in our lifetimes. In our view, this stance is completely appropriate given the unprecedented amounts of fiscal and monetary stimulus in the system. However, the timing of these comments, in combination with extreme valuations in the equity market, and an economy moving past the peak rate-of-change from a growth perspective increase the risk of volatility (aka a market selloff) going into the summer months and second half of 2021. Let’s first take a look at valuation.
On any given metric, the stock market is indicated to be over-valued at its current levels. One, which we’ve highlighted recently is the market’s price relative to earnings estimates for the next 12 months (NTM). As you can see, we’re just off of levels not seen since the Dotcom Bubble in what can still be considered extreme territory.
Source: Goldman Sachs
When investigating the link between valuation, such as the PE ratio, and the size of the Fed’s balance sheet it becomes evident that Fed tapering could become problematic for equity markets as the chart below highlights.
While valuation is never a catalyst and markets can remain overvalued longer than logic may dictate, what are catalysts are the rates-of-change of economic growth and inflation. As readers are aware, Cornerstone’s Macro Risk Management process is founded on these rates of change via a framework called the Quads. Our Quad models indicate that the most likely scenario going into the second half of 2021 is for both GDP growth and inflation to decelerate during the Third Quarter, also known as Quad 4.
2021 Quad Map
This is important because Quad 4 is the one economic regime where historically the market has a negative return expectation, and investors have about a 50/50 chance of losing money.
So to recap:
We have the market at all-time highs and at frothy valuations, the potential for negative news from the Fed right smack in the middle of the Third Quarter, which also happens to coincide with the worst macroeconomic regime for risk assets. Got it. In an of itself this does not appear to be a great setup, but we’re not done yet friends, oh no!!! We’ll add to this concoction a dose of leverage via all-time highs in margin debt after a 50% year-over-year increase.
Source: Advisor Perspectives
What could possibly go wrong???
We’ve tried our best to highlight the case for reducing risk in our clients’ portfolios. While we’ve been bullish on the markets and the economy since fall 2020, in our view the time has come to take down some risk. This does not mean sell everything and go to cash! Our crystal ball is out for repair, and the timing will no doubt be tricky. What it does mean is that we recognize that risk has indeed increased significantly. We strongly believe in risk budgeting, not to be confused with market timing, and maneuvering our allocations to reflect the increased risk. In practice, that means lightening up on some higher-beta holdings and keeping higher-than-normal levels of cash on hand to take advantage of any market weakness. We do not believe that the next correction will be “the Big One” but perhaps a more run-of-the-mill pullback of 10-20% (still scary in real-time) which we’d use as an opportunity to leg back in. Risk management is core to what we do; we will always put a premium on protecting our client’s hard-earned wealth. If this means missing out on the last few potential points to the upside, so be it. By the same token, when the context is more attractive from a valuation standpoint or otherwise, we will shift to take advantage of those opportunities as well. The goal is not only to mitigate pitfalls but also to uncover new opportunities.
Sounds simple. Simple but far from easy! Thanks for reading my note.
*Based on the frequency of positive or negative quarterly historical return data from 20 year rolling returns of the S&P 500, classified by quadrant.
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