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Highlights So What? U.S. policy uncertainty adds to a slew of geopolitical reasons to remain tactically cautious on risk assets. Why? U.S. fiscal policy should ultimately bring market-positive developments – though the budget negotiation process could induce volatility in the near-term. We expect spending to go up and do not expect a default due to the debt ceiling or another prolonged government shutdown. Former Vice President Joe Biden remains the frontrunner for the Democratic Party’s presidential nomination in 2020. But left-wing progressive candidates are gaining on him and their success will trouble financial markets. With Persian Gulf tensions still elevated, go long Q1 2020 Brent crude relative to Q1 2021. Feature Chart 1U.S. Politics Poses Risks Through Next November Economic policy uncertainty is rising in the United States even as it falls around the world (Chart 1). Ongoing budget negotiations and the Democratic primary election give equity investors another reason to remain cautious in the near term. We expect more volatility. There also remain several persistent global threats to markets posed by unresolved geopolitical risks – rising Brexit risks with Boris Johnson likely to take the helm in the United Kingdom; oil supply threats amid Iran’s latest rejection of U.S. offers to negotiate its missile program; and a major confirmation of our theme of geopolitical risk rotation to East Asia, with Japan, South Korea, Hong Kong, Taiwan, and the South China Sea all heating up at once. In sum, political and geopolitical risks are showing investors a yellow light, even though the macroeconomic outlook still supports BCA’s cyclical (12-month) equity overweight. U.S. Fiscal Policy Will Remain Accommodative While U.S. monetary policy has taken a dovish turn – supported by other central banks – fiscal spending is now coming into focus for investors. We expect the budget battle to be market-relevant this year, injecting greater economic policy uncertainty, but the end-game should be market-positive. Brinkmanship will not get as bad as during the debt ceiling crises of 2011 and 2013, though market jitters will be frontloaded if Pelosi and the White House fail to conclude a deal immediately. Chart 2The 'Stimulus Cliff' Awaits President Trump The U.S. budget process is always rocky and is usually concluded well into the fiscal year under discussion. This year the fight will be more important than over the past few years because, as the two-year bipartisan agreement of 2018 lapses, the so-called “stimulus cliff” looms over the U.S. economy and will get caught up in the epic battle over the 2020 election. The stimulus cliff is the automatic imposition of fiscal spending cuts (“sequestration”) in FY2020 that would take effect as a result of the Budget Control Act of 2011. Standard estimates of the U.S. budget deficit expect that the deficit will shrink in 2020 if the spending caps are not raised, resulting in a negative fiscal thrust (Chart 2). The result would be to decrease aggregate demand at a time when the risk of recession is relatively high (Chart 3). Chart 3Recession Odds Still High Over Next 12 Months This is clearly not in President Trump’s interest, since a recession would devastate his reelection odds. Hence, Treasury Secretary Steve Mnuchin and other White House officials are pushing for a budget deal before the House of Representatives goes on recess on July 26 and the Senate on August 2. Ideally, an agreement would raise the spending caps, appropriate funds for the rest of the budget, and lift the “debt ceiling,” the statutory limit on U.S. debt. But it would be surprising if a deal came together as early as next week. A failure to agree on a budget deal before Congress goes on recess will make the market increasingly jittery. Congress can cancel the August recess, or wait until September 9 when they reconvene, but a failure to agree on something between now and then will make the market increasingly jittery. The U.S. has already surpassed the current debt limit and the latest estimates suggest that the Treasury Department’s “extraordinary measures” to meet U.S. debt payments could be exhausted by early-to-mid September.1 This would give Congress only a week in September to raise the debt limit. There are three main reasons to expect that the debt ceiling fight will not get out of hand: Chart 4Americans Stopped Worrying And Love Debt First, a technical default on U.S. debt could result in a failure to meet politically explosive obligations, such as sending social security checks to seniors. No one in Washington would benefit from such a failure and President Trump would suffer the most. Second, the public is not as worried about national deficits and debt today as it was in the aftermath of the financial crisis (Chart 4). Democrats, as the pro-government party, do not have an incentive to stage a showdown over the debt like Tea Party Republicans did under the previous administration. To be fair, they did do so in January 2018, but backed off after merely two days due to high political costs. Third, the one budget conflict that could create a catastrophic impasse – funding for Trump’s border wall – can be assuaged by Trump’s use of executive action, as he demonstrated by declaring a national emergency and appropriating military funds for fencing. Trump is fighting a general election in 2020 and is unlikely to use the debt ceiling as leverage to the point that the U.S. defaults on its obligations. The risk to investors, however, is that he goes back to threatening a 25% tariff on Mexico if it fails to staunch the flow of immigrants from Central America. What if the Republicans and Democrats cannot agree on the budget and spending caps? Democrats say they will not raise the debt limit unless they get non-defense spending increases. House Democrats need to reward their constituents for voting for them in 2018 and want to increase non-defense spending at “parity” with increases to defense spending. They also want to reduce the defense increases that Republicans seek in order to pay for non-defense increases. President Trump and the Republicans have a higher defense target and a lower non-defense target. The truth is that the Republicans and Democrats have agreed three times to increase spending caps beyond the levels required under the 2011 law – and they have done so most emphatically under President Trump with the FY2018-19 agreement (Chart 5). This year the two parties stand about $17 billion apart on defense and $30 billion apart on non-defense spending.2 We would expect both sides to splurge on spending and get what they want, but they could also split the difference: the amounts are small but the acrimony between the two parties could extend the talks. Congress may have to pass one or more “continuing resolutions” (stopgap measures keeping spending levels constant) to negotiate further. A continuing resolution could at least raise the debt ceiling and leave the rest of the budget negotiation until later, removing the majority of the political risk under discussion. Is another government shutdown possible? Yes, but not to the extent of early 2019. Trump saw a sharp drop in his approval ratings during the longest-ever government shutdown last year (Chart 6). Brinkmanship could lead to another shutdown, but he is likely to capitulate before it becomes prolonged. In early 2020, he wants to be lobbing grenades into the Democratic primary election rather than giving all of the Democrats an easy chance to criticize him for dysfunction in Washington. Ultimately, Trump can simply refrain from vetoing whatever the House and Senate agree – it is not in his interest to shrink the budget deficit in an election year. The Democrats’ spending increases would boost aggregate demand and are thus in President Trump’s personal interest. Trump is the self-professed “king of debt” – he is not afraid to agree to a deal that will be criticized by fiscal hawks. The latter have far less influence in Congress anyway since the 2018 midterm election. Why should House Democrats extend the economic expansion knowing that it would likely improve President Trump’s reelection chances? Because Trump will capitulate to most of their spending demands; voters would punish them if they are seen deliberately engineering “austerity”; and they need to show voters that they can govern. As for the 2020 race, they will focus on other issues: they will attack Trump on trade and immigration and focus on social policy: health care, the minimum wage, taxes and inequality, climate change, and student debt. What will be the fiscal and economic impact of a budget deal? The budget deal under negotiation ($750 billion in defense discretionary spending, $639 billion in non-defense discretionary spending) would raise the spending cap by about $145 billion – this is slightly above the $112 billion negative fiscal thrust expected in 2020.3 The result is that the U.S. fiscal drag expected in 2020 will at least be eliminated (if not turned into a fiscal boost), helping to prolong the cycle. The removal of fiscal drag will coincide with monetary easing, which is positive for markets since inflation is subdued. The Federal Reserve abandoned rate hikes this year (after four last year) because of the asymmetric risk of deflation relative to inflation (Chart 7). The FOMC believes that they can always jack up interest rates to combat an inflation overshoot, as their predecessors did in the 1980s, but that they are constrained by the zero lower-bound in interest rates. They may never recover from a loss of credibility and collapse of inflation expectations, so an insurance policy is necessary. The result is likely to be one or two rate cuts this year, which has already improved financial conditions. Chart 7The Fed Fears The Asymmetric Threat Of Deflation Bottom Line: Budget brinkmanship could become a near-term source of volatility but it is ultimately likely to be resolved with the pro-market outcome of less fiscal drag in 2020. The debt ceiling debate is unlikely to result in a U.S. default and any government shutdown is likely to resemble the short one of 2018 more than the long one of 2019. We expect U.S. equities to grind higher over the 12-month cyclical horizon, but we remain exceedingly cautious on a three-month tactical horizon. The price of Trump’s capitulation on border funding could be a renewed threat of tariffs against Mexico. The Budget Deal, Geopolitics, And The Dollar Chart 8China Shifts From Reform To Stimulus What does this fiscal outlook imply for the U.S. dollar? Near-term moves will probably be negative, since the fiscal boost outlined above will not be comparable to 2018-19, and meanwhile our view on China’s stimulus is bearing out reasonably well (Chart 8). Improvements in global growth, Fed cuts, and rising oil prices will weigh on the greenback even though later we expect the dollar to recover on the back of renewed U.S.-China conflict and global recession in 2021 or thereafter. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity, or geopolitical competition among the world’s great powers. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity. Populism and the Fed: Domestically, the United States is seeing a rise in populism that is continuing across administrations and political parties. This is conducive to easier monetary policy. Left-wing firebrand Alexandria Ocasio-Cortez’s (AOC) recent exchange with Fed Chairman Jay Powell highlights the trend. AOC asked one of the most frequent questions that BCA’s clients ask: Does the Phillips Curve still work? Powell answered that in recent years it has not. President Trump’s Economic Director Larry Kudlow applauded AOC, saying “she kind of nailed that” (obviously the administration is pushing for lower rates). If inflation is not a risk, monetary policy need not guard against it. This interchange should be taken in the context of President Trump’s attempts to jawbone Powell into rate cuts and the notable monetary promiscuousness of his ostensibly “hard money” Federal Reserve nominees. The extremely different ideological and institutional profiles of these various policymakers suggests that a new consensus is forming that is conducive to more dovish monetary policy than otherwise expected over the long run. Populists of any stripe, from Trump to AOC, would like to see lower interest rates, higher nominal GDP growth, and a lower real debt burden on households. We are reminded of an oft-overlooked point about the stagflation of the 1970s. Fed Chair Arthur Burns is usually depicted as a lackey of President Richard Nixon who succumbed to political influence and failed to raise interest rates adequately to fight inflation. But this is only part of the story. Leaving aside that the Fed only had a single mandate of minimizing unemployment at that time, Burns was conflicted. He saw the need to fight inflation, but he had more than Nixon’s wrath to fear. He also dreaded the impact on the Fed’s credibility and popular support as an institution if he hiked rates too aggressively and stoked unemployment (Chart 9).4 Chart 9Rate Hikes Are Hard To Defend Amid High Unemployment In other words, populism can constrain the Fed from the bottom up as well as from the top down in a context of rising unemployment.5 Multipolarity and Currency War: Since President Trump’s election we have highlighted that dollar depreciation is likely to be the administration’s ultimate aim if President Trump’s overall economic strategy is truly to stimulate growth, reduce the trade deficit, and repatriate manufacturing. Jacking up growth rates relative to the rest of the world while disrupting global trade via tariffs is a recipe for a strong dollar that undermines the attempt to bring jobs back from overseas. We have always argued that China would not grant the U.S. “shock therapy” liberalization and market opening – and that neither China, nor Europe, nor Japan would or could engage in currency appreciation along the lines of a new Smithsonian or Plaza Accord. The U.S. does not have as much geopolitical clout as it had in the 1970s-80s when it forced major currency deals on its allies and partners. The remaining option is for the U.S. to attempt unilateral depreciation. The combination of profligate spending, easy monetary policy, and populism may do the trick. But it is also possible that President Trump will attempt to engineer depreciation through Treasury Department intervention. If a slide toward recession threatens his reelection – or he is reelected and hence gets rid of the first-term reelection constraint – his unorthodox policies pose a significant risk to the dollar. Bottom Line: The U.S. dollar faces near-term risks as growth rebalances towards rest of the world, but will probably resume its rise in the impending recessionary environment and expected re-escalation of tensions with China. Over the long run, it faces severe risks due to fiscal mismanagement, domestic populism, and geopolitical struggle. A Progressive Overshoot Will Hurt Democrats … And Equities Chart 10A Democratic Win Will Weigh On Animal Spirits The Democratic Party’s primary election is also a risk to the equity rally. We see a 45% risk that President Trump will be unseated in November 2020 and hence that the U.S. will once again experience a dramatic policy reversal (as in 2000, 2008, and 2016). The risks are to the downside because the market is at all-time highs and Democratic proposals include raising taxes on corporations and re-regulating the economy (Chart 10). Whether you accept our 55% odds of Trump reelection, the race will be a continual source of uncertainty for investors going forward. How extreme is the uncertainty? Former Vice President Joe Biden remains the frontrunner in the race, though he has lost his initial bump in opinion polls (Chart 11). Biden’s success is market-positive relative to the other Democratic candidates since he is an establishment politician and a known quantity. Given his age, a Biden presidency would likely last for one term and focus on repudiating Trumpism and consolidating the Obama administration’s signature achievements (the Affordable Care Act, Dodd-Frank, the Joint Comprehensive Plan of Action, environmental regulation, etc). Greater predictability in the health care sector and a return to lower-level tensions with Iran would be market-positive. The financial sector would be consoled by the fact that nothing worse than Dodd-Frank would be in the offing. A Biden victory would be more likely to yield Democratic control of the senate than a progressive candidate’s victory.6 This means that the risk of Democrats taking full control of government and passing more than one major piece of legislation after 2020 increases with Biden. Yet any candidate capable of defeating Trump is likely to take the senate in our view; and Biden’s legislative initiatives are likely to be more centrist.7 So as long as Biden remains in the lead in primary polling, he increases his chances of winning the nomination, maximizes the 45% chance of Democrats winning the White House, and decreases the intensity of the relative policy uncertainty facing markets. The risk to the Democrats is … a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election. The risk to the Democrats is that the leftward policy shift within the party (Chart 12) may lead to a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election. This would give President Trump the ability to capitalize on his advantage as the incumbent by inveighing against socialism. Most of the major progressive candidates are electable – they have a popular and electoral path to the White House – as revealed by their successful head-to-head polling against Trump in battleground state opinion polling (Chart 13). But these pathways are narrower than Biden’s. Biden is the only candidate whose name has been on the ballot in two presidential elections carrying the critical Rust Belt swing states Michigan, Pennsylvania, and Wisconsin (not to mention Ohio and Florida). He is from Pennsylvania. And he is more competitive than most of his rivals in the American south and southwest, giving him the potential to pick up Florida or Arizona in the general election. But none of this matters if Biden cannot win the Democratic nomination first. The risk of a progressive overshoot is growing at present. Biden is losing his lead in the primary polling, as mentioned. Progressive candidates taken together are polling better than centrists, contrary to previous Democratic primaries (Chart 14). This is true even if we define centrists broadly, for instance to include Buttigieg (Chart 15). Biden is in a weaker position than Hillary Clinton in 2007 – and the more progressive candidate Obama ultimately defeated her (Chart 16). Biden has now slipped to second place in one national poll and some state polls. The second round of Democratic debates on July 30-31 will be a critical testing period for whether Biden can maintain frontrunner status. The first round fulfilled our expectation of boosting the progressives at his expense, especially Elizabeth Warren. It surprised us in dealing a blow to the campaign of Bernie Sanders, the independent Senator from Vermont who initiated the progressive left’s surge with his hard-fought race against Hillary Clinton in 2016. Sanders is more competitive than the other progressives in the Rust Belt, and in the general election, based on his head-to-head polling against Trump. Yet he has fallen behind in recent Democratic primary polling, ceding ground to Warren, Harris, and Buttigieg, who are all his followers in some sense. The second debate is a critical opportunity for him to arrest the loss of momentum. Otherwise he is likely to be fatally wounded: a collapse in polling beneath his floor of about 15%, and relative to other progressives, despite extensive name recognition, will make it very difficult for him to recover in the third round of debates in September. His votes will go toward other progressives, particularly Buttigieg – the other white male progressive-leaning candidate who is competitive in the Midwest.8 Our 55% base case that Trump is reelected rests on the high historical reelection rate for incumbents, particularly in the event of no recession during the first term – yet discounted due to Trump’s relatively low nationwide popularity, as it is reminiscent of a president in a recessionary environment (Chart 17). Trump has his ideological base more fired up than Obama did (Chart 18), which helps drive voter turnout, although as a result he risks losing support from the rest of the population. Still, Trump’s approval rating is in line with Obama’s at this stage in his first term. As long as the economy holds up and Trump does not suffer a foreign policy humiliation, he should be seen as a slight favorite. A Trump victory is not positive for risk assets, aside from a relief rally on policy continuity. This is because in a second term he cannot reproduce the same magnitude of pro-market effects (huge tax cuts and deregulation) yet, freed from the need for reelection, he has fewer political constraints in producing higher magnitude anti-market effects (tariffs and/or sanctions on China, Iran, Russia, and possibly the EU and Mexico). This view dovetails with the BCA House View which remains overweight equities relative to bonds and cash over a cyclical (12 month) horizon but underweight over the longer run with the expectation that a recession will loom. Bottom Line: The Democratic Primary election should start having an impact on markets – the general election is likely to be too close for market participants to have a high conviction, driving up uncertainty. Uncertainty will be especially pronounced if, and as, leftwing or progressive candidates outperform in the primary races and poll well against Trump in the general election. This dynamic is negative for business sentiment and the profit outlook, especially if Biden’s polling falls further in the wake of the second debate. Investment Conclusions We recommend staying long JPY-USD, long gold, and short CNY-USD. We remain overweight Thai equities within emerging markets, a defensive play. And we would not close our tactical overweight in health care sector and health care equipment sub-sector relative to the S&P 500. The rally in Chinese equities – despite China’s Q2 GDP growth rate of 6.2%, the worst in 27 years – brings full circle the view we initiated in April 2017 that Chinese President Xi Jinping’s consolidation of power would result in a major deleveraging drive that would drag on the global economy. Since February we have argued that the U.S. trade war has pushed Chinese policymakers to favor stimulus over reform – but we have also maintained that the effectiveness of stimulus is declining, especially as a result of the trade war hit to sentiment. Nevertheless, as a result of this turn in Chinese policy – along with the turn in U.S. monetary and fiscal policy – we see the global macroeconomic outlook improving. Combining this view with ongoing tensions in the Persian Gulf and the expectation that oil markets will tighten, we recommend our Commodity & Energy Strategy’s trade of going long Brent crude Q1 2020 versus Q1 2021. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See U.S. Department of Treasury, “Secretary Mnuchin Sends Debt Limit Letter to Congress,” July 12, 2019, home.treasury.gov. Jordan LaPier, “New Projection: Debt Limit “X Date” Could Arrive in September,” July 8, 2019, bipartisanpolicy.org. 2 See Jordain Carney and Niv Elis, White House, Congress inch toward debt, budget deal,” July 17, 2019, thehill.com. 3 See the Congressional Budget Office, “The Budget and Economic Outlook: 2019 to 2029,” January 2019; “Final Sequestration Report for Fiscal Year 2019,” February 2019; and Theresa Gullo, “Discretionary Appropriations Under the Budget Control Act,” Testimony before the Committee on the Budget, United States Senate, February 27, 2019, www.cbo.gov. 4 See James L. Pierce, “The Political Economy of Arthur Burns,” The Journal of Finance 34: 2 (1979), pp. 485-96, esp p. 489 regarding a congressional testimony: “Interestingly, no questions were raised or innuendo offered that monetary expansion would be excessive to support Richard Nixon’s reelection efforts. Instead, Burns was urged by the Democrats to follow an expansionary monetary policy in order to reduce the level of unemployment.” See also Athanasios Orphanides and John C. Williams, “Monetary Policy Mistakes and the Evolution of Inflation Expectations,” Federal Reserve Bank of San Francisco, Working Paper 2010-12 (2011), www.frbsf.org. 5 An analogy might be drawn with the Supreme Court, whose independence as one of three constitutional branches is much more firmly grounded in U.S. law than the Fed’s, but nevertheless cannot make decisions in an ivory tower. It must consider the effects of its judgments on popular opinion, since universally deplored decisions would reduce the court’s credibility and legitimacy in the eyes of the public over time and ultimately the other government branches’ adherence to those decisions. 6 This is both because Biden is more electable (thus more likely to bring a vice president who can break a tie vote in the senate) and because his candidacy can help Democrats in all of the senate swing races – for example, Arizona as well as Colorado and Maine. Harris is not as helpful in Maine while Warren and Sanders are not as helpful in Arizona. 7 Biden would return to the 39.6% top marginal individual tax rate and double the capital gains tax on those earning incomes of more than $1 million. See Biden For President, “Health Care,” joebiden.com. 8 Conversely, if Biden somehow collapses, Buttigieg unlike Sanders has the option of moving toward the political center to absorb Biden’s large reservoir of support.
We decompose the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction, as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate…
Highlights A lower fed funds rate will not necessarily boost equities, … : A chorus of Wall Street strategists has recently advised investors to curb their enthusiasm about looming rate cuts. … because stocks are more sensitive to the relative level of the fed funds rate than they are to its direction: The Street strategists’ advice is sound, even if they haven’t homed in on its true rationale. Monetary policy’s influence on equity returns is primarily a function of the fed funds rate’s relationship to the equilibrium rate, not the direction in which it’s moving. Monetary policy settings remain accommodative, in our view, … : We estimate that the equilibrium fed funds rate remains well above the target fed funds rate. One or two rate cuts will push monetary policy even further into accommodative territory. ... and investors should therefore remain at least equal weight equities: Over the last 60 years, investors would have done exceptionally well if they had simply owned stocks when monetary policy settings were easy, and avoided them when they were tight. Feature Dear Client, We are in the midst of collaborating with several of our colleagues on a roundtable Special Report outlining the view differences between BCA’s most bullish and bearish strategists, scheduled to be published on Friday, July 19th. In the absence of a major event between now and then, the July 19th roundtable report will replace the July 22nd U.S. Investment Strategy. We will return to our usual format on Monday, July 29th. Best regards, Doug Peta U.S. equities have rallied smartly since Fed officials began hinting at rate cuts in early June. The S&P 500 advanced nearly 7% last month on rate cut hopes, and tacked on close to another 2% by making new highs in each of July’s first three sessions. As the gains grew, however, so too did the admonitions from equity strategists at leading broker-dealers that they were getting out of hand. Over the last month, no less than four shops wrote reports warning that rate cuts will not necessarily boost equities. From the financial media’s summaries of the reports, the curb-your-enthusiasm conclusion stems from a straightforward analysis of rate-cut impacts over the last 35 years. According to Goldman Sachs by way of Barron’s, the S&P 500 posted double-digit returns in the year following the start of all five of the rate-cutting cycles that occurred from the mid-eighties to the end of the nineties, before performing terribly following the cuts that began in 2001 and 2007.1 The Street-wide takeaway was that rate cuts worked wonders for stocks when the Greenspan put was still a fresh concept, but the inverse relationship between interest rates and equity multiples that initially prevailed has since been supplanted by a direct relationship. It is surely true that rate cuts are not a magic bullet for equities, but we find the flipped-correlation hypothesis wanting. There is more to the question of how monetary policy impacts equities than just the direction of rates. The state of monetary policy – accommodative or restrictive – matters, too. Even though assessments of the state of policy are necessarily uncertain, they allow for a much more sophisticated analysis of policy impacts. Without estimating the equilibrium fed funds rate, an investor cannot go beyond simple observations of the correlation between policy rates and equity returns to the causal interactions that drive the observed correlations. Numerators And Denominators When an investor buys a stock, s/he is buying a pro rata claim on the future earnings of the company that issued it. The value of that claim is a function of the company’s estimated future earnings and the interest rate used to discount them. Expressed as an equation, the fundamental value of a share of stock is as follows, where r is the reference interest rate: Year 1 Earnings + Year 2 Earnings + Year 3 Earnings + … + Year n Earnings (1+r) (1+r)2 (1+r)3 (1+r)n That equation can be simplified and rewritten as: Fundamental Value = ∑nt=1(Year t Earnings) (1+r)t It’s a stretch to think that equities’ reaction to rate cuts reversed after the year 2000. The final form of the equation shows that the underlying value of a share of stock is directly related to its future earnings and inversely related to interest rates. When the broker-dealer analyses conclude that the ‘80s-‘90s inverse relationship between stock prices and rate cuts has flipped since the turn of the millennium, they’re asserting that the relative sensitivities of stock prices to changes in the numerator (earnings) and the denominator (interest rates) have changed. That’s a mouthful, but the effect can be seen clearly by holding the numerator constant: if earnings don’t change, stock prices are inversely related to changes in interest rates. Relaxing the constant earnings assumption, the inverse relationship between rate cuts and stock prices in the ‘80s and ‘90s could only have occurred if earnings rose when the Fed cut, or if earnings fell when the Fed cut rates, but not so much that they offset the beneficial impact of the reduction in the discount rate. An Empirical Curveball When investors think about the impact of changes in interest rates on stock prices, they tend to assume that earnings remain constant. They therefore conclude that lower rates are good for stocks and higher rates are bad for them. The underlying assumption is flawed, however, because it ignores the fact that earnings are themselves a function of the macro backdrop that influences interest rates. Rising real interest rates are most often a sign of gathering economic momentum; since the end of World War II, U.S. equities have performed markedly better when real long-term Treasury yields were rising than they have when they were falling (Chart 1). Chart 1Stocks Do Better When Real Rates Rise Investors’ appetite for equities reinforces the direct relationship between earnings and rates, as long as rates are not at extremes. Trailing P/E multiples have risen with real interest rates except when rates are negative or above 4% (Chart 2). When real rates are negative, deflation is a real possibility and fearful investors value future earnings streams conservatively. When they’re above zero, investors have been willing to let multiples rise with real rates, until rates get high enough to squeeze profitability. The key, then, is what is going to happen with real yields if the Fed does indeed cut rates. Will 50 basis points (“bps”) of incremental accommodation (we expect 25-bps cuts in July and September) help to extend the expansion, or will it be too little, too late to impede the course of a recession that’s already begun? In the former case, economic growth will get a boost, and real yields and corporate earnings will go along for the ride. In the latter, the economy will contract, drawing real yields and corporate earnings into its vortex. We believe monetary policy is still squarely accommodative, and therefore have both feet planted firmly in the bullish camp. The Fed Funds Rate Cycle Our fed funds rate cycle framework helps us to assess the line of demarcation between accommodative and restrictive policy settings and thereby project the direction of corporate earnings following rate cuts. To refresh, we decompose the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction (Diagram 1), as follows: Diagram 1The Fed Funds Rate Cycle Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above our estimate of the equilibrium rate. Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate falls from below its equilibrium level to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Plotting the course of the fed funds rate is a simple matter; the challenge in Diagram 1 comes in deciding where to draw the dashed line. That decision requires estimating the policy rate that neither encourages nor discourages economic activity. Our equilibrium estimate, which uses potential GDP growth to adjust a smoothed and filtered long-run series of the actual fed funds rate, can be viewed as a line in the sand separating the point where monetary policy goes from encouraging activity to discouraging it. When the funds rate is above our estimate of equilibrium, we consider policy to be tight; when it’s below our estimate of equilibrium, we consider policy to be easy. Since equilibrium is a concept, rather than an observable objective data point, we have to look at the broad sweep of economic activity to infer whether or not our equilibrium estimate is accurate. As we’ve repeatedly written, we interpret the economic data received so far this year as indicating that the U.S. economy is decelerating from its stimulus-fueled 2018 surge, but is on track to meet or exceed its long-term potential growth pace of 2 - 2.25%. We therefore do not believe that policy is tight, and that a recession has already begun, or is in the offing. Recession? What About Stock Prices? We didn’t forget about stock prices. Markets are always our primary focus, and we study the economy for insight into how it might impact their direction. The business cycle is a robust link connecting the state of monetary policy with equity performance. In the 60 years covered by our equilibrium fed funds rate estimate, recessions have only occurred when the funds rate has exceeded our estimate of equilibrium (Chart 3). Equity bear markets typically coincide with recessions – Black Monday in October 1987 is the only instance of a bear market occurring independently of a recession in the last half-century. Chart 3Recessions Only Occur When Policy Is Tight For 60 years, stocks have thrived when monetary policy is easy and staggered when it is tight. S&P 500 performance across the four phases of the fed funds rate cycle reveals that it has been the level of rates vis-à-vis the equilibrium rate that has mattered for equity returns, not the direction. Annualized nominal S&P 500 price returns have been nine percentage points higher when policy is easy than when it is tight (Table 1), and the disparity widens to ten-and-a-half percentage points after adjusting for inflation (Table 2). The disparity is even more pronounced when the Fed is cutting rates – annualized Phase IV price returns beat Phase III by eleven percentage points on a nominal basis, and by thirteen-and-a-half percentage points on a real basis. Table 1Stocks Love Easy Policy, ... Table 2… Especially After Adjusting For Inflation Our base case is that the FOMC will cut the fed funds rate by 25 bps at its July and September meetings. The investment strategy question arising from our base-case scenario is what will that mean for equities? With reference to the dot-com bust and the financial crisis, the broker-dealers say, “nothing much.” We posit that a more sophisticated answer would consider the monetary-policy climate in which the cuts occur. Reduce equity exposure if you believe the Fed went too far hiking rates last year, but maintain/increase it if you think monetary policy has always remained accommodative. 60 years of history say that incremental accommodation will boost equities if it occurs against a backdrop of already easy policy. The S&P 500 will decline, on the other hand, if the monetary policy starting point is restrictive.2 In terms of our fed funds rate cycle framework, the equity market outcome turns on whether the cuts occur in Phase III or Phase IV. We estimate that the equilibrium rate is currently in the neighborhood of 3¼%, so we have a high level of conviction that equities will spend the rest of the year in Phase IV, the rate cycle phase that has been most conducive to equity outperformance. Investment Implications From the perspective of our monetary policy cycle framework, positioning a balanced portfolio for impending rate cuts boils down to one’s take on current monetary policy settings. If one thinks the Fed’s already tightened policy enough to squeeze the economy, s/he should sell stocks. (Some of our BCA colleagues advocate that course, and we will share the stage with them in next week’s roundtable Special Report). If one thinks, like we and the overall BCA consensus do, that the Fed hasn’t yet crossed the easy/tight Rubicon and is on a course to push the date when it will out to 2021 or beyond, one should maintain his/her equity positions and consider adding to them. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Hough, Jack, “The ‘Fed Put’ Is Kaput and Interest Rate Cuts Might Hurt Stocks,” Barron’s, July 1, 2019. 2 Remember that monetary policy impacts the economy with a lag. Cuts ameliorating too-tight policy don’t have an effect until after the initial overtightening makes its way through the system.
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