Damned if they Raise; Damned if they Don’t. The Dilemma Facing the US Central Bank
Stewart Richardson
Renowned investors are becoming worried and credible institutions are becoming increasingly nervous about what impact interest rate rises could have the US equity market. From where we sit, we think that a phrase used by Marc Faber some months ago sums it up quite nicely (and we paraphrase here)…equity markets are going to fall a long way but it could be from a higher diving board.
Before the financial crisis, the Bank for International Settlements (BIS – the bank for central banks) warned about financial instability, and remains one of the few institutions to have any real credibility. This past week, the BIS warned about the potentially extreme risks that come with zero or negative policy rates in most of the developed world. With more than 20 central banks easing policy further in recent weeks, the BIS warned… “In such a world, easing begets easing…If this unprecedented journey continues, technical, economic, legal and even political boundaries may well be tested.”(Please see the attached link to a Telegraph article about the BIS report). Clearly, the BIS thinks that interest rates have to rise at some point otherwise nasty and unexpected events may well occur.
Within hours of the BIS report, Ray Dalio founder of Bridgewater (a US$165 billion hedge fund, so clearly a credible commentator) warned that the Fed risks causing a 1937 style market slump when it finally moves to raise interest rates. With the Dow Jones Industrials falling nearly 50% between March 1937 and March 1938, it seems like this warning should be taken seriously. Dalio went onto say that…“We don’t know — nor does the Fed know — exactly how much tightening will knock over the apple cart,…What we do hope the Fed knows, which we don’t know, is how exactly it will fix things if it knocks it over. We hope that they know that before they make a move that could knock over the apple cart.” See the link to an FT article for more colour on this.
So, it appears that there is trouble ahead if central banks don’t raise rates, and there could be a whole lot of trouble if the Fed raises rates too much…and who knows (nobody including the Fed) what too much is. Furthermore, it is difficult to know what the Fed can do in the event of another bear market; except perhaps print more money – which an increasing number of commentators believe actually increases the risks of financial instability with very little real economic benefit.
Where does this leave US equities? One of the simplest ways to illustrate current valuations is to revisit a metric that Warren Buffet explained in 2001 was his shorthand for valuing the market, namely the market value to GDP, illustrated in the chart below.
As can be seen, aside from just a couple of quarters at the turn of the millennium (current comparison would place us somewhere in 2Q 1999), markets have not been this expensive since this particular data set started in 1951. Other analysts, splicing together this data with historic pre war data, can illustrate that the current market is the second most overvalued ever. The conclusion from this current level of valuation is that there is a bear market waiting out there somewhere (unless the Fed has abolished market cycles). The simple question is will the next bear market start in the next few weeks/months or perhaps 2016. Nobody knows, but the fundamental situation as highlighted by the views from the BIS and Ray Dalio is both unsustainable and increasingly fragile.
We would add that a US equity bear market would most likely coincide with a global bear market with very few left unscathed. This is why we spend so much time analysing the US. Perhaps QE in some countries will make the bear market for them look a bit different, but we fully expect the upcoming bear market to be global in nature.
From where we sit, the risk of an US economic growth shock continues to rise. Bloomberg has consensus expectations looking for 1Q growth of 2.4% and rising to basically 3% for the rest of the year. The Atlanta Fed GDPNow model we looked at last week is tracking 1Q growth of just 0.3% after last week’s updates. A recent BIS report claims that annual capex in the oil and gas sector doubled in real terms between 2000 and 2013 to US$900 billion. Estimates for reductions in capex for this sector are approaching 40% or approximately US$360 billion. This is about 2% of GDP alone and with oil reaching new lows this week, capex and jobs may well be cut further, with a reasonably high negative multiplier raising risk further.
What is strange about the FOMC statement and Yellen’s press conference this week was that the bust in the energy sector was not even mentioned. The fallout from the collapse in energy prices is a positive for consumers of energy that may or may not spend their savings, but it is a macro disaster for capex and corporate profits which are leading indicators for the economy as we explained at the end of January.
How can the Fed ignore such a massive macro event? Unemployment has fallen a lot but perhaps they also realise (just like the BIS) that holding rates at zero for 6 years and counting, and printing over US$3 trillion of new money, has massive unintended consequences. They realise that they need to try and raise rates sooner rather than later, and to be able to do so, they have to spin a narrative to the market that the economy is doing just fine. If this is the case, they have to paper over any obvious sign of weakness in the first quarter and continue to predict a solid pace of growth further out.
Both the equity and bond markets have bought into this narrative, with equities up a lot in February and bonds down a lot. However, we think the odds of economic weakness from 1Q extending into 2Q are high, and the Fed may well not be able to raise rates at all. If this occurs, and the Fed has to further downgrade their forecasts and admit they cannot raise rates, bond and equity investors will question the Fed’s credibility and will have to adjust their own forecasts for growth and earnings. This loss in the Fed’s credibility will be obviously bullish for high quality bonds, and may prove enough to pop the equity bubble.
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