6th May 2017
Due to last minute weekend travel plans, this week’s note is shorter than usual with fewer charts. This is somewhat unfortunate, as there are a number of little developments that when added together may be important for long term investors to appreciate as we head towards the second half of 2017. If these developments are as important as we think they are, we will no doubt cover them in more details in the weeks ahead. But let’s crack on with this week’s shortened note.
First off, the regular Federal Reserve FOMC meeting came and went without any major headlines. However, beneath the surface, we felt that it was interesting that they view the Q1 weakness in the US economy as “transitory”. These guys have one of the worst forecasting records out there, so why should we accept their view that economic weakness is transient. That said, the real issue is that the current Fed thinking is clearly very different from that a year or so ago.
At the beginning of 2016, the Fed (Stan Fischer in particular) was forecasting up to four rate rises. They managed to squeak one in December ‘15. This year, they have been forecasting three rate rises and are so far on track to deliver. For most of last year, the Fed was very sensitive to any signs of economic or financial weakness. This year, they view Q1 economic weakness as transitory. This, we believe, is a strong sign that the Fed is very keen to tighten policy this year so that they have some ammunition available to fight the next downturn (yes, there will be another recession at some point).
So, what does a Fed tightening cycle mean in the big picture? Historically the Fed tightens until something breaks. The chart below (courtesy of BofAML) illustrates this historical ‘track record’. The majority of Fed tightening cycles have ended with a US recession or to a financial event, either in the US and/or overseas. With the Fed seemingly keen to press ahead with tightening, we believe a policy error is highly likely to occur.
Chart 1 – What happens after the Fed tightens policy
Last week, we spoke about property, alluding to what we see as stresses rising in the real economy. We also noted that the auto sector was struggling (confirmed by another weak data point during the week), the retail property sector was struggling and delinquencies on consumer debt were rising. We offered up a parallel between the pre 2008 property and credit market dynamics and what is appearing now, and noted that these real economy problems arose months before the 2007 peak in equity markets. The point being that the problems were occurring whilst market participants either chose to ignore them, or felt (like Bernanke) that they would be contained.
We are looking at some of the action in the financial markets in recent days, and wondering whether we are seeing signs of stress building. For example, the price of oil fell by over 8% this week (as of Friday lunchtime London time). We wrote about oil two weeks ago, stating our view that “We view the recent failure at $54 as potentially very significant, and ushering in a more bearish phase for the oil price.” This was when WTI oil was at $49.62 compared to the current price of $45.33.
The trigger for the oil price decline is being laid at China’s doorstep. We need to take a little step back here. Last year, Q1 to be precise, China was wobbling and global financial markets joined in. Globally, the authorities took action with China throwing a huge amount at the problem via their trusted credit creation machine. We know the story here; once the China credit machine hits warp speed, the economy stabilises (even accelerates) and property prices rise a lot and then Beijing ultimately has to apply the brakes to prevent overheating, which then causes problems. Well, since the Lunar New Year, Beijing has been tapping on the brakes hoping to find the elixir for a never achieved (in China anyway) soft landing.
And it’s not only the oil price decline that is indicative of stresses emerging in China. Commodity prices are declining pretty much across the board, Chinese money market rates are rising and the Wealth Management Product market is stumbling as Beijing brings in new policies to prevent the most speculative of activities.
Our point here is that we have both the US and China, the main sources of stimulus in the past, both in the early stages of tightening policy. Stresses are already emerging, and we strongly suspect that the US Federal Reserve will continue to tighten policy until something breaks. Backing this up so far is the signal from the US bond market, where the yield curve remains on a steady flattening trend.
To add in one more twist as we head into the second half of this year. We are increasingly of the view that the Fed’s actions, along with potential tax and trade initiatives from Washington DC, will lead to a strong Dollar at some point. As we have seen several times in the last two plus years, a too strong Dollar is bad for the global economy and ultimately for the US too.
So to wrap up here. We are seeing signs of stress emerge in various types of property markets in several locations, not dissimilar to the 2007 period. We are seeing signs of stress emerge in “fringe” financial markets; China and commodities in particular. The Fed is ignoring the Q1 slowdown and remains on course for tightening policy. This, along with Chinese tightening, sets up real headwinds for the global economy and probably financial markets as well. These alone could be enough to trigger problems later this year, and then we add into the mix a potentially much stronger Dollar, and we absolutely have the recipe for financial market losses that have not been seen for a decade or so.
Are we sounding too alarmist? Depends on your time horizon. Long term investors should be reducing risk to underweight in our opinion, as making and executing big asset allocation changes when markets are falling and volatility rising is never easy. That said, we all know that timing bear markets is next to impossible, but we would offer the viewpoint that markets usually spend some time topping before the real losses occur.
With that market topping process in mind, and our view that the greatest risks lie a few months from here, we suggest that equity and credit markets are losing momentum and may be starting the topping process in the current time period. If correct, further portfolio gains will be hard earned in the months ahead and volatility should start increasing from a very low base. Despite a recent Bloomberg article trying to offer a timeline between the current US equity market and that in the late 1990s, and offering a view to readers that they should not worry as it is only 1997, we would offer something a little different on this basis. We believe we are either late 1999 or early 2000, a period when risk reduction may have looked ridiculous on a day by day basis, but in hindsight, was breathtakingly successful.
Stewart Richardson
RMG Wealth Management
