Don’t Fight the Fed - December 2019
There is an investing adage that says, “Don’t fight the Fed,” and has that adage ever proven true this cycle, but especially so in both 2018 and 2019. It’s been well documented that various rounds of so-called “Quantitative Easing” coming out of the 2008-2009 financial crisis in which the benchmark Fed Funds rate was pushed to 0% and the Federal Reserve purchased tens of billions of dollars in Treasury assets on a monthly basis infused capital into our financial system for years to pull our reeling economy out of the soup. The impact of this monetary policy has led to an epic 11-year run for asset prices.
But normalizing the long-standing easy money policy has been a goal of current Fed Chairman Jerome Powell during his tenure. In 2018, the Fed hiked rates by 25 basis points on four occasions and ended its asset purchases as signs of synchronized global growth emerged. Slowly raising rates would serve to ensure the domestic economy would not overheat, but also allow the expansion phase could continue. The economic growth of 2018, spurred by corporate and personal tax cuts, led to a >20% increase in earnings for the S&P 500 companies. That sounds like a formula for fantastic stock performance, assuming that revenue and earnings performance are fundamental drivers of stock prices. So what was the reaction of the broad stock market in such a robust growth environment last year? A not-so-robust 4.5% drop for the year. What had been a solid start to the year – dovetailing with strong earnings performance – ended with a loud thud during a fourth-quarter meltdown. Investors and algorithm-based trading platforms quickly fled risk assets following commentary from Mr. Powell that that path for rates was still higher, even as signs of a global growth deceleration came to light late in the year. The stimulus that had aided the market was being removed; therefore, asset prices needed to adjust.
As the calendar flipped to 2019, Mr. Powell also flipped the messaging about interest rates early in the year after the market’s tantrum to end 2018. Policymakers noted a patient and data-dependent approach would be followed going forward. Ultimately, as data showed a continued slowdown on a global basis, the rate hiking cycle ended and was replaced by three rate cuts totaling 75 basis points. This policy pivot has clearly buoyed markets – the S&P has advanced 27% so far this year. The Fed and many other central banks also started purchasing Treasury assets again to provide more of a boost. But what about 2019 earnings performance, which should be a fundamental driver of the market? Earnings for S&P 500 companies are forecasted to be up only slightly year/year. So stocks have surged to record highs this year primarily due to the Fed’s apparent support coming back, significant multiple expansion, and hopes of a trade deal with China that may or may not materialize in some form.
While the past two years have confirmed the “Don’t fight the Fed” mantra, earnings performance and stock performance have not been correlated over that span. The question is what lies ahead for earnings growth and rate policy in an upcoming election year, and what factor will define the path for stocks? The market is currently betting that the Fed will remain on hold as current rates are believed to keep the expansion alive while inflation remains muted. We shall see if the market forecasters are correct or not as 2020 plays out.
