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If I Were the Federal Reserve

     The Federal Reserve is talking again, working hard to (re)convince the financial world that rate hikes are still possible and coming soon. If we believe the message, and we trust they are looking at good data, we need to be aware that we could be looking at a significant change in the character of the US economy and thereby our investment choices looking forward.

 

Dependent on Which Data?

 

     The Federal Reserve is steering the US economy with words alone. Guessing what they will say is not a good investment strategy as their message seems to change from one quarter to the next. Nevertheless, their words do have an impact on global currencies and credit markets leading to changes in leadership and preferences among stocks. Last week we heard the message that rate hikes are still very much a possibility in the coming months but decisions will be dependent on the data. Wouldn’t we all like to know which data they’re talking about? I looked for an hour and found nothing consistent suggesting there was a specific set of data they were looking at. We should all conclude that they are just looking at a lot of data and hoping to make the right decisions regarding the current trends in prices, costs and labor. Needless to say, they are driving an enormous ship in uncharted territory so even a slight wrong turn can have some rather serious consequences. You can imagine why they would want to consider everything (all data) and move very slowly. On the other hand, we could also see the Fed failing to act when they need to in the proverbial “paralysis by analysis”. If I were the Federal Reserve, these are some of the data points that might suggest rate hikes are still possible.

 

Rising Labor Costs – Still at full employment with SOME new signs of wage pressure. This is inflationary.

 

Cost of Materials – All things that hurt if you dropped them on your foot have been rising sharply since February (metals, wood, a barrel of oil). This is also inflationary.

 

Higher Global PMI Index – Purchasing Managers Index had its first rise in nearly four months. This is notable as this is often an early sign of an economic rebound. 

 

Earnings Guidance Higher - For the first time in 18 quarters (yes you read that right), corporations actually offered net positive future guidance for their earnings this quarter. This is big!

 

Global Risks Diminishing - The US Federal Reserve is now operating like the world economic police. They are factoring in the impacts of global trade including the health of our trading partners. This was their comment from recent minutes.

 

“A few participants judged it appropriate to increase the target range for the federal funds rate at this meeting, citing their assessments that downside risks associated with global economic and financial developments had diminished substantially since early this year.” 

 

Average House Prices Make a New High – Those who still own their homes are feeling some wealth effect again associated with their home prices. Homebuilders are busy, inventories still very low. Real Estate price trends are not done moving higher on basic supply and demand. Raising rates a bit won’t kill the trend.

 

Energy Crisis is Abating – It’s hard to get excited about energy anytime soon but the number of bankruptcies, mergers, drop in active drilling rigs, and some price stability indicate that the energy complex is beginning to heal. It will take years but the acute part of the POP in the energy bubble is now over.

 

     On the other side of the discussion, we have some variables that don’t inspire me (acting as the Federal Reserve) to raise rates. This is a slow and sluggish US economy that is starving for demand. Will raising rates help that situation? Probably not. On the other hand, supply side efforts called QE or keeping rates at zero have done zero to spark the engine beyond a little tailwind to real estate. China is an unknown but not in great shape. Furthermore, I have to worry what Wall Street will say about me if I raise rates. It is a popularity contest after all right?

 

     Just looking at the weight of evidence, I wouldn’t be in a hurry to increase rates again but the data does suggest that I have enough reasons to do so perhaps sooner than many expect.

 

Changes in Investment Choices

 

     If the Federal Reserve does move forward with raising rates, we can expect the US dollar to continue on with its uptrend that began nearly three years ago. Last week, may have marked a significant low point in that longer term uptrend. A rising US dollar environment for investors requires more work and selectivity for investors. Specifically, we need to get our money a lot more focused in companies with high free cash flow, low debt, and those that generate most of their revenue domestically. On the bond side, we become critical of all Treasury bond oriented income. Commodities can continue to do well as a late stage leader with the exception of gold and silver, which are simply inverse US dollar trades.

 

     Sector strength should favor banks and financials, tech and semiconductors, healthcare, industrials, materials and consumer staples. Losers can be consumer discretionary and utilities. Dividend payers become less attractive in a rising rate environment as well.

 

     Also, watch small caps in here as a rising US dollar is supportive of small and domestic areas of the market since they derive most of their revenue in the US and profits are not hurt by adverse exchange rates.

 

     We are beginning to follow these trends in our own strategies, leaning on our selection screens now more than our net exposure screens. Last week we sold ½ of our gold position for a very tidy gain and will sell the remainder today. We also bought small positions in financials and semiconductors via individual names as well as sector-oriented funds and ETFs. As a reminder, this is what we do for our clients. We do our homework; we understand how the market works and where we should be looking for new opportunities. We keep our clients’ money in the right places making adjustments only when needed.

 

     And to answer your question, yes the broad US stock market can move out to new highs even as interest rates are rising. In fact, rising interest rates are supportive and indicative of a stronger, expanding economy at least up to a point. A stronger economy leads to stronger earnings, which lead to stronger stock prices in very general terms. Ultimately, when short term rates push up past 4.5%, the historical patterns tell us that financial markets feel the headwind and run into trouble. But we’re a long long way from 4.5%. Today, we need to respect the market pattern, which has been troubled, toppy and flat since mid 2014 – see the chart below. At the same time, we still need to remain open to something unthinkable – an all time new high.

 


 

 

That’s it for this week. Get out and enjoy one of the best times of the year!

 

Cheers

 

Sam Jones