The Fed is in the news this week again as the minutes of the January meeting were released yesterday. The minutes indicate much of what the markets have deduced – the Fed has entered a pause, and the status-quo duo of shrinking the balance sheet and raising interest rates is coming to a close. And while it does not necessarily mark the end of Quantitative Tightening, it certainly could be. This is especially true given the economic weakness so prevalent outside the US, the fading effects of fiscal stimulus, and the weakness in business investment (driven in part by policy uncertainty).
I had the great pleasure on Tuesday of appearing at the Lyons Companies/ University of Delaware 2019 Economic Forecast Conference alongside Cleveland Fed President and FOMC member, Loretta Mester. I’m always impressed by Dr. Mester’s thoughtfulness, pragmatism, and insight. I bring this up because for quite some time now, I’ve been telling you that a policy mistake by the Fed is the biggest danger to the economy. I’ve written about the lessons of 1937 when, recovering from the Great Depression, an abrupt change in monetary policy threw the country into one of the sharpest recessions in history. The scale of the change was small – less than half a point in interest rates – yet the results were catastrophic. One of the lessons of 1937 is that even seemingly small miscalculations can have large consequences.
During the panel discussion this week in Delaware, we were asked about our economic outlooks, the likelihood of a coming recession, and other questions one might expect following our respective presentations. In response to one question from the audience, I asked the question “what if the Fed is getting it right?”
Although I asked it as a rhetorical question to address skepticism, it struck me, on reflection, that the question is a very important one. We have warned of the possibility, if not likelihood, of a policy mistake. But what if the Fed is skillfully navigating the fine line that’s needed for a soft landing? Just as it would be wrong to fully discount the possibility of a Fed mistake, it would also be unwise to completely rule out the (perhaps unlikely) outcome that Fed makes all the right moves at the right time in the face of numerous obstacles and variables.
Before we look at that question, it’s important to touch on why interest rates are the grease for the economy’s wheel. On the face of it, everyone loves free money. If I can borrow at 0% for 5 years, I’m more inclined to buy a new car or new appliances. If my mortgage rate is 4% instead of 6%, I’m more willing to pay more for a bigger house or make major home renovations. Stock investors like free money because low interest rates make stocks a better investment alternative compared to bonds. As well, risk-tolerant investors will often use borrowed money to buy more stocks, further driving up stock prices. Lastly, bond investors are happy when rates fall because the value of their bonds increases (although new bond purchases will carry at lower yields).
Reflecting on all of the above, markets seem to throw a tantrum every time interest rates go up. So why raise rates at all? The answer is complex, but it begins with the notion that the markets are not the economy – they are intertwined and interdependent, but not the same thing. Markets love free money because lower borrowing costs drive economic activity and higher asset prices. But there comes a point in the economic cycle whereby free money leads to reckless investment decisions – decisions that would not be made unless money were so cheap to borrow. In an effort to keep the good times rolling, lending standards are relaxed, low-return investments are green-lighted, and caution is thrown to the wind. Markets, for their part, are generally slow to recognize the late-cycle excesses. Chuck Prince famously said that, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,”
But markets and the underlying economy can’t decouple forever. Eventually, as the bubbles of 2001 and 2008 showed, poor investment decisions will come home to roost. I liken low interest rates and the markets to kids with candy. Kids will eat cotton candy until they are sick – but they still need nutrition.
In recent decades, the arrival of the latter part of an economic cycle has usually manifested in asset bubbles and/or more widespread inflation. The dot-com crash and the financial crisis are in recent (enough) memory that the dangers of asset bubbles can be relatively well understood. It has been a long time since inflation took off as it did in the 70’s, but that inflation was a direct result of the Burns Fed in 1972 keeping rates artificially low. Ultimately, the Volcker Fed was only able to tame inflation by raising the Fed Funds rate over 15%, causing great pain throughout the economy.
Back to the current day, 2018 was a turbulent year for the markets to say the least. As the Fed reeled in accommodative monetary policy, we saw two sharp corrections. In December, we technically entered a bear market, falling 20% off the highs. However, we only spent the night in the bear’s cave and since those lows we’ve climbed 16%. The Fed has hiked nine times in this cycle, and while mortgage rates have risen significantly, they have backed down from the highs of last fall. The housing market is far from robust, but it is far from dead as well (and certainly there are forces beyond interest rates at work in housing.) Growth is slowing, but the US economy still seems far removed from a recession. The yield curve is close to flat, but it isn’t inverted.
So, has the Fed gotten it right? Thus far, the answer has to be yes. The economy is chugging along, and while there are plenty of concerns, there aren’t any obvious bubbles or imbalances large enough to send the economy into a tailspin. The markets have adjusted to the new rate regime, albeit with much sound and fury, but still without a crash that could drag the greater economy down. This was not a foregone conclusion, especially if the Fed had decided to cling stubbornly to its previous tightening path.
Does this mean all is clear sailing, sunshine and rainbows? We certainly don’t think so, and in past commentaries we have shared some of those concerns that investors need to be aware of as they move forward. We don’t see a return to the soaring market of 2017 anytime soon, but we remain fully invested. By focusing on companies with proven quality management, strong balance sheets, and reasonable prospects for future growth, we look to be in a position to navigate the risks in the marketplace, and take advantage of opportunities to come.