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Is my Fed hawkish?

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The Days Ahead: Consumer confidence for September

Stocks reached an all time high this week. It’s been pretty much a straight line all year. The biggest correction was less than 2% in August. We've not had a correction of more than 10% in over five years. That's not great but all market cycles are different and any “exuberance” is taking place away from public our view it's in the VC, privates and Bitcoin…see below. The narrative was the Fed, renewed healthcare legislation and some stocks hit for missing earnings. We’ll discount the latter because it’s unusual for companies to report an end-August Q3 number.

1. The Fed, no change though you lie under:
The Fed held rates but left open the possibility of a December increase. The full release is here. They don't feel the hurricanes will leave much impact on the economy, which sounds right. Rebuilding and new auto purchases are likely to be balanced by wage loss, some price increases and supply disruption. They announced the start of the balance sheet “normalization” which means smaller but we’re not sure how much smaller. The way they'll do it was announced back in June but is basically:

i) Treasuries: stop reinvesting maturities at a rate of $6bn a month up to a cap of $30bn in 12 months

ii) Mortgages: stop reinvesting maturities at a rate of $4bn a month up to a cap of $20bn in 12 months

Given they hold $2.4 trillion of Treasuries and $1.8 trillion of mortgages, this could take a while. But we think it’s absolutely the right approach and the market regards it as a “nothing to see” event. The 10-Year Treasury rose from its 2017 low of two weeks ago to 2.25%, which was where it was in August. 

Here’s the Fed projections at the time they started the rate hikes in December 2015 and now. Back then, they expected rates to be 3.5% going into 2018. Now it's 2.1%. We realize estimating inflation and growth has become trickier lately. Productivity growth has stumbled and the core PCE inflation seems to have a series of one-offs depressing it but it has only broken the 2% target in 16 of the last 120 months and 13 of those were prior to 2009. 

The Fed’s inflation debate is around two camps.

One, those who believe there are temporary forces at work and that inflation will stabilize at around 2%. The Cleveland Fed Governor even said that it’s going to be 2% because that’s been the most accurate forecast for the last 30 years, which to us smacks of some very lazy thinking.

Two, that post-crisis trend inflation has fallen permanently and deflation is a constant threat. Governor Lael Brainard takes the lead on this view.

We'd side with the latter because wages (here, Europe and Japan) have absolutely failed to move and without wage inflation, there is slime chance of broad inflation. Also, we’re always paranoid about deflation, which tends to kill an economy dead in its tracks.

It could be taken that the Fed is overtly predicting more volatility to come with rates increasing 200bps in two years. But back in 2015 it was 275bps and it just didn't happen. You’ll read plenty of forecasts about increasing volatility (if you're a hedge fund or running a bank FICC desk, you dream nightly of higher volatility) but we believe it will be slow, gradual and ultimately all a bit disappointing on the rate front.

2. Bitcoin everywhere:
We don't pretend to be experts on Bitcoin but we think we know a thing or two about bubbles. There’s lots of information on it. Some of the better sites we've seen are with the BIS here,  here and here.  Here’s an interactive map showing the number of active nodes (nodes are people running Bitcoin software and actively trading) exploding and here’s some instructions on how to trade it you're in North Korea or New York. Apparently, the computing power needed to run Bitcoin takes up 90% of your computer’s processing power so you may want to get a burner phone if you want to explore (definitely not investment advice).

We lived through 1987, the Asian Crisis, the tech crash and of course 2008 so looked back to the Nasdaq boom in the late 1990s and overlaid it with the price of Bitcoin today. We know Bitcoin is just one of the group of crypto-currencies, but we’ll use Bitcoin for now. But anyway, guess what? They match.

So, if you’d bought Bitcoin two years ago, you’d have made 20 times your money and three times since May. At its heart, Bitcoin is a ledger system allowing transactions across multiple users. Its benefits include encryption, anonymity, fixed unit amounts and peer-to-peer management. Which suits well if you want to transact stuff anonymously and cheaply or you believe that having a fixed supply of a currency prevents devaluation (which is why gold bugs like it).

But…but, it's still a bit all wild west out there and we’re seeing multiple copycats and free riders. Here’s one for dentists using Bitcoin called, wait for it, Dentacoin, which, I don’t know, sounds like a solution in search of a problem. Anyway, we put together a mini checklist of what our concerns are here. But if you get approached with a deal that has a spanking new team with a lot of dodgy Phds, a spiffy big font website, a whitepaper attached, security system that you can't quite understand (what is “offline multisig wallet”??) and pitched by a B-list celeb (not this one, he’s A-list), just, you know, don't. The SEC says it best here.

3. How’s International doing?
Depends where you're sitting. If you're in the U.S., then very nicely, thank you. We looked at the returns of the S&P 500, Japanese and Eurozone markets for a U.S. investor and a local investor. Here’s the chart:

The top three lines are for the U.S. investor, with Europe up 20% and the U.S. and Japan tied at around 12%. But for European investors stocks are up around 6% and for their S&P 500 investment, it's negative.

Most of the story this year has been the decline in the dollar, down some 11% this year. Some stock markets are highly dependent on the exchange rate. A strong Yen has not typically done well for Japanese stocks and vice versa. With some markets, a strong currency has just done just fine for stocks. The Aussie dollar strengthened in 2001 and again in 2009 and stocks were up 143% and 46% (ignoring the 2008 crash). It has to do with exporting of U.S. dollar priced commodities and importing secondary goods (we’re over simplifying, we know).

In the U.S., it's a bit of a mix because a weaker dollar flatters many S&P 500 companies that collectively derive 37% of their sales from overseas. For some companies like PM, WLTW, and AVGO it’s well over 90% and they're on a tear this year. It’s one reason why we're quite optimistic about the upcoming earnings season, which we don't think has adequately compensated for the 12% depreciation against the Euro the last three months.

Bottom Line: Stocks remain within a whisper of their all time high. Rates have taken the Fed in their stride and essentially round tripped from the early September low. Watch for politics because if there’s a deal on healthcare, tax reform may come soon after.

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(Note I own PM personally)


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.