Sometimes taking a step back, allowing markets to take their natural course, enables one to observe the bigger picture trends and themes without letting your predilections affect your judgement. October has been a month where investors and fund managers have had their thesis challenged. Themes that have held all throughout 2019 came into question in October following Fed Chair Jerome Powell's October FOMC press conference.
At first, the rate cut had a hawkish bias to it -- it was the last rate cut for this year with the market pricing in at least 1-2 rate cuts more for the balance of the year. However, in the following press conference, a one-liner seemed to change the name of the game altogether, when Powell said it would take a "significant" increase in inflation for them to even "consider" raising rates.
Boom. There you have it. The market cheered and never looked back. This was taken as confirmation by the Fed that they would let monetary accommodation stay easy and support asset prices inflating further (if that is possible). The word "significant" in this case seems to imply that Core Consumer Price Inflation (CPI) would have to not only shoot above 2% considerably, but also stay up there for some time before they raise rates. This is opposite to their entire 2018 strategy.
Whether we believe the Fed or not is yet to be decided. Going back just to June this year, the Fed said they see the economy in a good place and would not consider cutting rates, only to change that tact a month later, saying "they will do what is necessary to sustain the expansion." So, we have a Fed that flip-flops as the market turns bullish to bearish. Can we really take what Powell said in October as set in stone, then?
We shall find out next year. Perhaps the S&P 500 will be closer to 3300 than 3000? Be that as it may, it is the green light investors have looked for all year -- especially Trump, who has been hammering the Fed all year to cut rates, down to 0% even.
The U.S. market has been in a tight range for about the past 18 months, viciously shooting higher and lower as Trade Wars escalated between the U.S. and China. The U.S. economic expansion was nearing its end in 2018 as the Fed was using the strength of the economy to wean it off easy monetary policy and reduce the balance sheet. Trump then started the Trade Wars, causing economic and financial mayhem in the system. He promised a better world for his country.
A year and a half later, he has nothing to show for it other than volatile markets, deteriorating global growth, seriously weak U.S. manufacturing, companies with higher labour costs and imported goods and farmers at the brink of demise. The only thing that has maintained its strength has been his precious U.S. stock market, $ (SPY) . When are people going to learn that the market is not the economy, but it does make for some pretty charts to point out during one's election campaign?
Now as Trump gets closer to his nomination, he cannot afford to let his market fall, which means that he will slowly give in to China's demands and make sure a Phase 1 deal gets signed soon. The hard, muscle-flexing tactics of August are long gone and China knows it. On Friday, after all of this, China has agreed to buy less U.S. ag products now than they would have normally if the Trade War never happened. Now that is definitely Making America Great Again! But being the spin doctor he is, Trump will turn this into a phenomenal win, even if it will only be a fake deal.
All these Trade Wars did was to scare the U.S. Fed from holding off on Quantitative Tightening and actually inflate the system even more. Trump's philosophy has always been about leverage. Powell caved in, as the system was on verge of cracking during the repo crisis in September and dollar shortage. Voila, now Trump is seen as easing off on Trade War threats with China and the Fed has already pumped about $400 billion into the system by expanding its balance sheet.
The former will start to see economic data improve as trade slowly picks up. We may be in a window of goldilocks environment, good growth and low inflation. This environment is great for risky assets, namely cyclically geared assets like Banks, Retail, Materials, Energy, Mining and Commodities -- all linked to positive GDP growth.
There is no doubt that data reported now is disastrously weak, showing contracting PMI and indicators suggesting global GDP is receding. But investing is not about what is known, it is about what is yet to come. That is what is causing the markets to rally on Friday. For right or wrong reasons, we need to follow the liquidity as that dictates price behaviour.
The theme this year had been to be long bonds, long gold, long Bitcoin (as gold safe haven proxy), and short equities. Within equities, investors were long Utilities and Consumer Staples vs. short Banks, Retail, Materials, Energy and Mining. October has seen a vicious unwind of the above portfolio, perhaps profit taking post Fed or into year end. U.S. 10-year bond yields rallied from 1.4% to 1.90% on Thursday as the curve has flattened. Equities are breaking out of their range of the past year to make new highs as money rotates back into cyclicals out of defensives. This spread has rallied massively -- and this is before the economic data has even started to improve.
We know the Fed is a backward looking indicator. They always cut too late and raise even later. The Fed has done the needful and now is on hold for the foreseeable future. The market will get no interruption on their part as they keep buying U.S. Treasury bills and injecting liquidity on overnight repo operations until the end of the year. If the Trade War does in fact start the trade between nations, we will start to see better data going forward. In that scenario, the cyclical stocks and China exposed commodities like Copper and Oil will continue to run into year end.
The more theosophical argument remains whether the Fed will have the guts to actually ease off on liquidity injections and raise rates as S&P 500 makes new highs. What better time than now, unless the delicate house of cards built on a system of cheap debt breaks down once and for all. But then again, the Fed only reacts when numbers show up in the system. By that time, who knows what the multiple of the S&P 500 might be.
