- Strong economic data and a dovish Fed propelled equities higher in Q1
- Given the Fed’s dovish about face, it is now faced with a higher burden of positive data to rein in potential future excesses in the economy
- The Fed may be counting on a decelerating economy to mitigate any potential asset bubbles that could result from its currently loose monetary policy
- We remain mindful of data indicating we are late in the economic cycle
As we discussed in our last letter, the sudden plunge in equity markets in Q4 seemed to be at odds with the solid economic fundamentals in the US at the time. Since then, the soft patch in data we witnessed in January and February – data that seemed to confirm the recessionista’s worst fears – has turned out to be a passing phenomenon, largely attributable to severe winter weather and the prolonged government shutdown. The soft data have been replaced by robust economic numbers in retail sales, employment, industrial production, and wage growth, while inflation remains tame. Corporate earnings further support this direction with nearly 80% of S&P 500 earnings beating Wall Street forecasts in Q1. We would blame it on the low expectations coming out of Q4 were it not for the fact that coupled with these earnings reports is almost uniformly strong forward guidance from these same companies. As a result of all of this, equity markets spent the better part of Q1 recouping losses from last year and touched new highs by late April. Meanwhile, the newly dovish Fed is faced with how to manage interest rate expectations given this turn of events.
To recap, amid plunging equity markets late last year, the Fed took a decidedly dovish turn, positioning itself to sharply slow the pace of rate hikes in 2019 and beyond. Now markets do not expect any further rate hikes until early 2020. The sudden about face by the Fed put it in a difficult position; not only did it appear to be cowering to pressure from President Trump to keep rates low, but it could now face a higher burden of positive data to justify going a different direction with interest policy yet again. Remember, it was just last October that Fed Chairman Powell sounded a shockingly hawkish tone in his interview with Judy Woodruff. To go from hawkish to dovish and back to hawkish again in the course of a few short months would beg credulity without the support of overwhelming data.
Yet here we are. The market is running away with strong economic data and earnings while the Fed has pledged itself to holding down rates until it sees the whites of the eyes of inflation. This pledge was tacitly acknowledged in Fed meeting minutes – published early this week – with the observation that “the appropriate path for policy, insofar as it implied lower interest rates for longer periods of time, could lead to greater financial stability risks.” In typical fashion, the Fed has chosen to take the risk of creating an asset bubble at some point in the future over having to deal with a further and prolonged battle against deflation. Its obvious calculation is that it has more tools to deal with an amorphous risk of financial instability at some point in the future than it does to deal with the very clear and present danger of deflation so soon after closing in on its 2% inflation target. It may have been a rational choice at the time, but one that could look foolish should the soft spot in inflation that emerged in December turn out to be as fleeting as the rest of the weak economic data that came out of that same period.
Only time will tell if the Fed has sown the seeds of financial instability somewhere down the road. In the meantime, it has ushered in a period that will continue to favor risk assets like equities over safe-haven assets like bonds. At the same time, the Fed very well may succeed in extending one of the longest expansions in recorded history. During this period, however, we will continue to be mindful of the fact that credit and monetary conditions are tightening, economic growth is moderating, parts of the yield curve remain inverted and we are entrenched in protracted trade wars with most of our largest trading partners. The data seem to be telling us that we’re late in the economic cycle, a period that warrants caution about the future despite most lights flashing green in the present.