The market has been celebrating the Federal Reserve (Fed’s) more dovish stance, but two weeks after its U-turn investors remain split over whether the Fed was responding to December’s market meltdown or fears of a weakening economy. I wrote* in the FT earlier this week regarding the former, but what if it’s the latter?
Most US data show a still-robust economy yet I have considerable sympathy for any Fed concerns about the underlying economy. While the Institute for Supply Management (ISM) surveys point to continued expansion, they also signal a growth slowdown. There have been other, more worrying, signs. The Fed Loan Officer Survey reported a tightening in lending standards, while the NFIB Survey showed a plunge in capital expenditure plans in December – suggesting a sharp slowdown in business investment spending could be approaching. There is clearly scope for US data disappointment over the coming months.
In addition, given that policy works with a lag, much of the monetary tightening so far in this cycle is yet to fully flow through to the economy. Historical relationships show that credit spreads tend to start widening around two years after the Fed begins hiking – on that basis, there is an additional 125 basis points of Fed tightening still to hit credit markets.
There are also vulnerabilities in the global arena. I detailed in my previous Short and Sharp that I believe the Chinese economy will stabilize later this year. But if the US/China trade war worsens, companies that sell heavily into China would see their earnings numbers hit again. Growth in Europe is already spluttering, prompting many analysts to forecast recession for later this year.
Throw in the fact that the rising participation rate points to lingering slack in the US labor market and I could be convinced that the Fed’s decision was appropriate. And certainly, the Fed’s pause means that the outlook isn’t as dark as it could have been. It has loosened conditions via higher equities, tighter credit spreads, and a weaker dollar.
This isn’t enough, however, to turn the slowdown on its head – the economic trajectory cannot mirror the Fed’s own sharp U-turn.
If anything, sentiment has swung from excessively pessimistic to excessively optimistic. The market may once again be underestimating the imminent headwinds from a continued growth slowdown. Already depressed earnings expectations may need to be lowered further over the coming quarters. And in the meantime, the Fed’s data dependency means volatility will be elevated and markets may be subject to wild swings.
Make no mistake, whether the Fed was responding to weak markets or to a weak economy – Powell’s U-turn means I currently like US equities (and emerging market equities even more). But, I also don’t expect this rally to continue for long. If the underlying economy really is that weak, weakening earnings growth will weigh on equities. Or, if the Fed was simply propping up markets, renewed fears of inflation and rising interest rates are likely.
Whichever reason you prefer for the Fed’s U-turn, the conclusion is the same: enjoy the joy ride while it lasts.
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