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Why Trump May Be Right About the Fed

A growing number of economists and investment professionals are beginning to agree with [the President]. To be sure, they are still in the minority, but their voices are increasingly being heard as the U.S. stock market surrenders all of its 2018 gains.

“Conveniently, there is a long list of usual suspects to explain the recent market turmoil,” writes Michael Arone, chief investment strategist for the U.S. SPDR exchange-traded-fund business of State Street Global Advisors. “Our deteriorating trade relations with China, the coming U.S. midterm elections, rising U.S. interest rates, free-spending Italians, and potential Saudi Arabian cover-ups top most investors’ lists for market-moving action. Not to mention that October is quite often a volatile month for the market.”

However, Arone contends, what’s really roiling markets is that the Federal Reserve doesn’t know what the “neutral” federal-funds rate is. That means the central bank won’t know when or where to stop raising rates. “As a result, investors are re-pricing financial assets to reflect the increasing probability of a monetary policy mishap,” he charges.

Despite a robust initial reading on third-quarter gross domestic product growth (a 3.5% seasonally adjusted annual rate, after inflation), the U.S. already is in a stealth slowdown with inflation turning lower, according to Lakshman Acuthan, co-founder of the Economic Cycle Research Institute.

That view clashes with the consensus among investors and economists, as well as Fed Chairman Jerome Powell. He helped touch off the global markets’ retreat this month by suggesting in a PBS interview that the monetary authorities had a way to go before reaching a neutral fed-funds rate from the “extremely accommodative” current target range of 2% to 2.25%. The Federal Open Market Committee’s projection at its meeting last month envisioned four more 25 basis-point (one-quarter of a percentage point) boosts by the end of 2019.

The ECRI’s Future Inflation Gauge began pointing to a deceleration in price pressures in July, Acuthan writes in an email. “That downturn is now a fact, not a forecast, with [year-over-year] headline [consumer-price-index] growth falling to a seven-month low and [year-over-year] core CPI growth falling to a five-month low in September.”

He further points out that his firm’s leading inflation indicator accurately forecast the 2017 dip in inflation that the Fed blamed on “idiosyncratic” factors and former Fed Chair Janet Yellen called that year’s biggest surprise. Now the ECRI gauge “is in a full-blown downturn, pointing to a further decline in inflation in the months ahead,” he says.

“There is no good reason for the Fed to raise rates, with inflation low and not accelerating,” concurs David Ranson, president and director of research of HCWE, formerly H.C. Wainwright & Co. Economics. Ranson relies on market indicators to derive his forecast, in this case the oldest inflation indicator of all, gold. Only in the past two months has the barbarous relic’s price begun to lift slightly. Still, it’s basically unchanged over the past year, which he sees as a more accurate market indicator than measures such as the CPI, which is dominated by difficult-to-measure service prices.

In addition, Minneapolis Fed President Neel Kashkari argues, the Fed should pause hiking its fed-funds target. In a Wall Street Journal op-ed article Friday, he says the central bank’s 2% inflation goal is “symmetric,” meaning that after years of undershooting that mark, it should permit a mild overshoot. That would let the Fed test how far unemployment could fall before stoking inflation. He notes that, in 2015, the central bank estimated a 5.1% jobless rate was the trigger point; its current estimate is 4.5%. But joblessness is down to 3.7%, and inflation remains muted, he adds.

Nevertheless, while no rate hike is expected at the next FOMC meeting on Nov. 8, odds heavily favor a move at the Dec. 19 confab. According to Bloomberg data on Friday, there is a 69.4% probability of a hike of at least 25 basis points then, although that’s down from more than 80% a week earlier.

Even if the Fed does increase short-term rates in December, HCWE’s Ranson doubts that it would have a big impact. He points to continued accommodative conditions in the corporate credit market. Both investment- and speculative-grade spreads remain narrow, indicating that investors aren’t yet demanding substantial yield premiums to compensate for the extra risk of holding corporate bonds rather than government securities.

In contrast, other market measures of financial conditions tracked by Goldman Sachs show significantly greater restraint. Its Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets.

Indeed, stocks will be a “modest negative for growth early next year,” even if the S&P 500 reaches its three-month target of 2850, more than 7% above Friday’s close. That had seemed an unambitious target when the benchmark index peaked at 2940.91 in late September.

While Trump may have a point, his strident complaints about the Fed might backfire. To maintain the central bank’s independence, Powell & Co. can’t appear to knuckle under to pressure from the president So odds still favor a 25-basis-point boost in December.

For 2019, the probability of multiple rate increases has been receding, with the futures market predicting only a single hike, to 2.5% to 2.75%. Away from the headlines, the Fed also is reducing its balance sheet at a quickening pace; it’s down by $271 billion over the past year and is shrinking by $50 billion a month. Market participants hope the monetary authorities know when to declare victory and end their tightening campaign.

Talk about an October surprise! It seems we read somewhere that Octobers in midterm election years were supposed to be winners. This month, however, is living up to the reputation of past October debacles; perhaps not as cataclysmic as the those of 2008 or 1987 or 1929, but bad enough. And the month’s not over.

In the week just ended, The Dow Jones Industrial Average shed 3%, while the S&P 500 lost 3.9% and the Nasdaq Composite dropped 3.8%. In terms of dollars, U.S. stocks suffered a loss of $1.2 trillion in the latest week, with some $3.3 trillion of equity values evaporating in the past five weeks, according to Wilshire Associates’ reckoning.

The selloff was global. Japan’s Nikkei 225 and South Korea’s Kospi both were down 6%. Europe suffered a bit less than the States, with the Stoxx Europe 600 index off 2.5%, and the FTSE 100 falling 1.6%.

A prominent exception to the doleful declines was the Shanghai Composite, which managed to rise 1.9%. To be sure, that pares the main China market measure’s loss from its Jan. 24 high to a still painful 27%. (See the cover story, “After a Slide in Chinese Stocks, Where to Look for Bargains,” for more about what still ails the Chinese economy and stock market.)

The current swoon, while similar in magnitude to the drop in early February, doesn’t seem to be helped by a generally good corporate earnings reporting season.

Expectations already were high for the current crop of profit reports. But the aggregate profits of S&P 500 companies have fallen short of the expectations at Evercore ISI, which estimates them to come in at a $160 a share annual rate for the third quarter, once the numbers are all in. That’s up a hefty 24% from the level a year earlier, but a bit short of $162, the company’s earlier forecast, which also happens to be the actual run rate achieved in the second quarter.

Evercore ISI estimates that, in the most recent three-month stretch, 13% of the gain resulted from tax cuts and the other 11% from “organic” growth.

The positive side of the market decline is that valuations have become less inflated. The forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, according to BCA Daily Insights.

The multiple compression has been global. The MSCI All-Country World Index P/E has slid to 13.8 times from 16.7. BCA advises getting “ready to buy on further dips,” given what it sees as a favorable backdrop of still-accommodative Fed policy and no recession in sight.

Whether there are buyers available to take advantage of further dips is another question. JPMorgan’s global markets strategy team, led by Nikolaos Panigirtzoglou, casts some doubt on that.

The bank’s monitoring of flows indicates that hedge funds continue to have elevated exposure to global equities and may yet still have to “capitulate” to the market’s slide. But the hedgies aren’t solely to blame. “Real money” investors also remain overweight stocks. That’s Street parlance for major institutional players (as opposed to traders), such as mutual funds, pension funds, insurance companies, endowments, and sovereign-wealth funds.

Looking at nonbank investors overall, JPM finds their equity allocations at the highest since the financial crisis of a decade ago, while their bond and cash allocations are near their postcrisis lows. All of which “poses further downside for equity markets from here if negative momentum and sentiment eventually induce real-money investors to capitulate also,” warns a research note from the JPM team.

The good news is that Halloween is on Wednesday, so this month of horrors is almost over. And by the following Tuesday, the midterm elections will be behind us. Best of all, at some point, the selling will end.


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