“It was also pointed out that a prompt start to normalization would likely convey the Committee’s confidence in prospects for the economy.”…..
…. was in the minutes of the July FOMC meeting, released Wednesday. We feel this is a most telling statement and seemed to be shared by many of the participants at the meeting. While it was immediately thought by the markets that the minutes showed a Fed that was still stubbornly “dovish”, ready to wait for – well whenever, before ending the adherence to Zero Interest Rate Policy (ZIRP), a growing group in the Federal Reserve is becoming impatient. The market is perceiving the Fed as enacting a very poor over-acted financial “Hamlet” with “to be or not to be” replaced by “to ZIRP or not to ZIRP”, except the phrase is heard only once in Hamlet, now being repeated over and over and over……..
So the Goldilocks trade, where the market perceives a long term period of ultimate liquidity as the US economy shows greater and greater strength, is coming off, and the market is not waiting for the above play to end but is arranging business as if rates were already normalized and ZIRP in the review mirror.
This could leave the Fed with a fierce tactical challenge for if the market has lost patience and gone on without the Fed leadership, once the Fed does normalize they will find they have to raise quicker and harsher than they are ponderously planning on now. This means the current game plan and stately controlled manner of the Fed is thrown out the window as the Fed scrambles to regain “leadership”. Not getting into what that means for rates but to note that rates will be higher than they are now, it does make it a fait accompli that the risk and drama of sudden lurching acts by the Fed to regain that leadership will end with greatly increased risk (volatility) in all assets.
We think this pricing of anticipated greatly increased volatility is what has been happening over the last week with the large drop in the SP500. While most stress only one or two factors (DIS earnings as content goes “over the top” bypassing the commercial channels of ESPN or other commercial TV, Walmart who showed they weren’t kidding when they said earlier this year that they were raising wages (wage inflation), China continually deteriorating authoritarian designed market and economic structure, and residual of Greece) which are valid but not focused on the main event. The Fed and what is starting to seem to be financial dithering, is at the heart of this down trade.
Economic data continued to show the very strong robust strength to the US economy with strong home sales, real earnings and especially unemployment claims data which is showing such strength it is off the grid in terms of comparison to any prior period. Yet all survey data which is based on opinion or very small samples to deduce very large populace continued to be lack luster such as the NY Federal Reserve “Empire State” survey of business conditions or the “Business Leaders” survey. The Fed’s dovish concern over the economy is almost solely based upon the survey based input, and now they are willfully ignoring the census based data.
SP500 was down 72 points from last Friday’s close of 2091 trading at 2018 at the time of this writing. While Consumer Discretionary was given as the leader, as in most large declines the losses were fairly evenly distributed with only high dividend or utilities not trading down as much. Unlike previous down trades in equities, US Treasurys did not trade up as much as other equity declines and the US Treasury 2 year is now at still recently high levels of .65%, down 5 basis points (.05%) from the .70% level. When the market traded down for Greece, the US Treasury 2 year traded down to a low of .50%. Our read is the US treasury 2 year is priced anticipating near immediate end of ZIRP.
BBBBBBB, after a brief drop in the weights immediately after Greece, has been maintaining our highest cash weights throughout this downslide. This was not so much in anticipating a drop in equity levels, but rather in anticipating the large increase in volatility that has been occurring and will increase as markets reorganize given the end of ZIRP. Our cash weights for our model portfolio have been 22%. We do not see value in fixed income and out fixed income is still short maturity corporates. Equity sector weights are still financials, consumer discretion, and some health and tech.
We are still waiting for the “fat lady to sing” which will be the Federal Reserve normalization of rates, but since we do not think this normalization will behave and act to the Fed’s script, we will carefully assess and not re-deploy fully weighted into equity until we think all the increased volatility has been priced. But it should be kept always in the forefront that the reason that will force or prompt the Federal Reserve rate rise is the ever increasing strong robust strength to the US economy. This makes us very constructive for the long run on US equity which will likely be the bell ringing asset for the next decade, barring any exogenous foreign shocks.