The Fed Remains in the Driver’s Seat

Perhaps the most lasting legacy of the Great Recession is that the short-term direction of the stock market has almost completely decoupled from the real economy. We’re not suggesting that this change is unprecedented or permanent. But for the better part of a decade, there has been a negative correlation between the economic data and stock prices. Stocks have generally responded positively to weak economic data – and vice versa – on a pretty consistent basis. On Wall Street they sometimes call this “climbing a wall of worry.” You may also have heard us refer to this cause-effect relationship as “bad news is good news.”

Nobody can doubt that the economic data in recent years have been overwhelmingly disappointing given the depth of the recession. In response, the Fed felt compelled to keep the target Fed Funds rate at zero for an unprecedented seven years. Each time it looked as if the Fed could safely disengage, stock prices swooned, the Fed came riding to the rescue (through rhetoric or action), and the bull market resumed. As long as the Fed keeps interest rates low, the narrative went, money will flow into “risky assets” in search of more acceptable returns. And so to suggest that the 200%+ upward move in stocks since 2009 (trough to peak) was either reflective of economic vitality or independent of Fed influence is simply naïve.

We do agree, however, that over the long term stocks should be positively correlated to the health of the economy. Why? Because a positive economic backdrop is supportive of the single-biggest driver of stock prices: corporate earnings. Which brings us to the “correction” in stock prices we are now experiencing. What is causing all the selling, why hasn’t it definitively stopped, and what will the Fed do now? According to a JP Morgan research note out yesterday (by head of equity strategy Dubravko Lakos-Bujas), the pull-back in stocks reflects a number of factors, including:

  • rising risk of US earnings recession;
  • diverging central bank policies and a Fed that is trying to tighten, causing the USD to strengthen;
  • US manufacturing sector already in recession territory and non-manufacturing sector continuing to decelerate;
  • deteriorating macroeconomic backdrop with China posing a significant risk to global markets;
  • credit spreads widening and high yield approaching recession levels;
  • late cycle dynamics;
  • continued elevated volatility likely to impact sentiment.

Lakos-Bujas went on to say that all of these factors make for an unattractive equity backdrop, and “if equities get progressively worse with sentiment spilling over into the real economy, the Fed may be forced to pause for a while.”

My first thought is WOW! That’s a lot of risk factors that the Fed will have to ignore in order to maintain its current forecast of four interest-rate hikes this year. But there is also a subtle sea of change going on here. While Lakos-Bujas does make reference to the Fed’s divergent monetary policy, all the other risk factors cited concern the real economy. Are we perhaps reverting back to some modicum of normalcy, whereby the outlook for the economy and corporate earnings actually determines the level of stock prices rather than some central authority? Is bad news bad news again, and if so, what are the implications for investors? Also, is it possible that a bear market in stocks can actually trigger an economic recession (as Lakos-Bujas seems to suggest), or does the downturn in stock prices always have to follow in response to a downturn in the economy?

In my opinion, the market is clearly beginning to price in some probability of a recession. During the typical recession stocks fall an average of 30%+. During the current pullback we’ve seen declines like this across many companies and sectors (the average S&P 500 stock is down over 20%+ from its 52-week high), but the decrease in the major market averages is much smaller. It seems that the difference this time (relative to recent market corrections) is that investors seem to be betting that either the Fed won’t come to the rescue this time or that the Fed has become impotent. This is the problem with what the Fed has done over the past seven years. Without even considering valuation levels or the froth in the markets, the Fed has created a dangerous moral hazard, whereby investors are conditioned to expect a Fed response to each and every stock-market correction.

The problem is, the Fed cannot keep the training wheels on forever. And each time they reinforce the reckless behavior, the markets climb higher and make the Fed’s extrication infinitely more difficult. If you think the Fed was responsible for a good deal of the stock-market appreciation since the March, 2009 lows (and we do), then why would it be unreasonable to expect the markets to give back some of these gains now that the Fed is retreating? More importantly, if the wealth effect (ie, higher stock and houses prices lead to greater consumption and economic activity) was highly supportive of the economy all the way up, is it possible that a negative wealth effect can be enough to cast us into recession again?

So, the $25,000 question is, will the Fed respond to the market swoon today by “guiding” us to a lower number of rate hikes in 2016? According to Drew Matus at UBS, “The Fed could likely tolerate a low GDP print, soft headline inflation resulting from energy prices and financial market volatility, but all three at the time of the March FOMC meeting may prompt a rethink on the speed of tightening being forecast by the FOMC.” Great. So either the economy is faltering and we get more Fed help (compounding the problem), or the Fed determines all is well, it continues to telegraph the cadence it has outlined for rate hikes, and stocks sell off in response. Neither outcome is especially encouraging.

Our conclusion is that there is undoubtedly some degree of “Fed put” still in the market. We continue to believe this is unhealthy, but the problem wasn’t solely created by the Federal Reserve. In recent years, the market has become increasingly short-term focused, which is in part the result of the wide proliferation of hedge funds and high-frequency trading. As a consequence of this short-term focus, investors have become increasingly impatient with regard to the resolution of risk and uncertainty. A “shoot-first-and-ask-questions-later” mentality has developed, and we think this is inherently destabilizing. Even more troubling, much of the risk and uncertainty in recent years has revolved around Fed monetary policy, increasing the stakes for the Fed in the execution of said monetary policy.

The good news is that the market’s fickleness and Attention Deficit Disorder create opportunities for those of us who covet strong fundamentals and invest for the long term. Opportunities are being created every day for those willing to look through the short-term turbulence and buy stakes in companies that are well positioned to grow and thrive, as well as withstand short-term volatility in the markets and economy.