Policy Mistake

Fed logoBy David Nelson, CFA

Thanksgiving wasn’t enough to attract the bulls as the shortened holiday week saw additional selling setting up a retest of the October lows. There was no single catalyst but the continued selloff in oil was notable as crude touched the lowest levels in more than a year. Economists and portfolio managers are starting to come over to my side of the fence suggesting the Fed is on the cusp of a massive policy mistake. Stocks are a leading indicator and are screaming for the FOMC to slow down.

Everyone understands the need to normalize and the long term direction for the short end of the curve is up but it isn’t a race. We have nothing in history to compare to. Despite a Fed mandate to keep inflation at bay, oil’s fall of more than 30% suggests otherwise inflation expectations will stay within target. Energy costs touch pricing at both the producer and consumer level. The dramatic decline in costs will help dull the inflationary push from rising wages. Falling oil prices are a dual edged sword. While we appreciate the lower prices at the pump the U.S. is now the world’s largest producer. A price drop here points to both oversupply and a potential slowdown in demand. Add the fact that a lot of jobs are at stake in the energy complex not to mention that each dollar lower in crude adds to pressure in the credit markets as some companies on the lower edge of quality might have trouble servicing their debt.


Once again the FOMC and Fed policy does not exist in a vacuum. The carnage first showed up in the emerging markets where dollar denominated debt became problematic. Emerging Markets (EEM) were the first domino to fall and now it’s here right at our doorstep.

No one is suggesting that Fed Policy is the only challenge investors face. The fall from grace of some of the most popular companies added to the pain. The final straw had to be Apple (AAPL) as the law of large numbers finally caught up to Tim Cook & company. Apple certainly isn’t expensive but for the moment investors are reacting to a slowdown in their flagship product. The importance of AAPL can’t be overestimated as many NASDAQ tech companies are part of the AAPL food chain and in some cases owe their very existence to the Cupertino giant.

Two events that could set up a 1000 point rally

  • Any hint the Fed will slow down the path to normalization would force a violent reaction to the upside. Its duration would be suspect but the knee jerk reaction would force shorts to cover and investors to move to Risk On.
  • President Trump and Xi are set to meet later this month. Sentiment is poor as most now believe the U.S. and China are on a collision course for a cold war with neither side ready to blink. The key sticking point is of course intellectual property. Any signal from President Xi that China was ready to address what is perceived as a significant threat to world trade would likely be met with at least the basis of a trade deal. Again the market reaction would be violent acting as a coiled spring

Meanwhile investors have one more thing to worry about. International debt markets have had their share of issues including developed nations like Italy. I posted early in the year as credit default swaps on Italian sovereign debt were blowing out suggesting increased concern. Add the fact that Italy and EU leaders in Belgium are locking horns over their most recently announced budget and the picture doesn’t get any brighter.


Of more concern is that credit spreads here in the U.S. are starting to widen. Even the low end of investment grade paper rated BBB is showing signs of stress. In the last several weeks, spreads on some BBB paper have widened by 50 basis points. Interestingly some higher quality paper rated A are seeing spreads narrow indicating fixed income investors are moving up the stack to safety.

The Good News (Where to look for signs of stability)

Valuations have come in and Free Cash Flow yields for a lot of companies are strong and rising. Emerging Markets were one of the first dominos to fall. Any stability there could be a signal that financial conditions are easing. In the end these countries are our customers. With 40% of S&P revenue off shore stability in in international markets is key for large cap U.S. multinationals.


The week ahead

The FOMC minutes are front and center this week as investors will parse the release for any hint on Fed Policy. December 19th is likely a lock for a hike this month but with President of the Federal Reserve Bank of Minneapolis Neel Kashkari calling for a pause and other economists like Richard Clarida saying the Fed is close to neutral, you can bet there’s a heated debate taking place inside the room.
Last week’s Durable Goods orders was a big miss coming in at -4.4%. It’s true that when you strip out transportation and the volatile military and commercial aircraft component we get a positive print at +0.1% but no matter how you slice it October was a miss.

Consumer Confidence, Chicago PMI and the second estimate for GDP round out the week as we close out November and set up for the last few weeks of 2018.