And so it came to pass....

Friday, 21st December 2018 12:04 - by Shant

As anticipated, this week's FOMC announcement proved to be a pivotal mark for investors and equity markets as the outlook on monetary policy outlined the fact that the Fed will continue tightening in response to the signals in the real economy as opposed to that of the markets.   

As is now widely acknowledged, the parabolic run up on Wall Street was significantly boosted by the unprecedented era of cheap and plentiful money as a result of QE initiated from the end of the previous decade.  The followthrough, exacerbated by a low rate environment, saw stock indices running away with gains at a time when the US economy was in a period of extremely slow recovery.  As we saw through the midway through this decade, the Fed under the chairmanship of Janet Yellen was loath to raise rates until meaningful wage growth and inflation materialised. 

Some would say that the Fed lacked the foresight to pre-empt this, and naturally, with US growth accelerating into the start of 2019, stock markets were still pushing the highs despite balance sheet contraction being put in place.  This effectively applied the brakes to a rampant equity market and the gradual realisation of this narrative has been effective in sparking the initial correction seen in the major indices.  That stock markets around the world were already in a state of decline at the time, with the Dax in Germany having diverged notably, as had the FTSE, though the EU referendum had a key part to play in this. 

There was, as a result, greater focus on the Asian stock markets with the Hang Seng falling sharply at the start of 2018.  The Nikkei maps a tighter correlation with the US leading S&P 500, with the tight interrelationship highlighted by a stable Dollar vs JPY rate for large parts of the year.  

Either way, the wheels have come off now and we are in a potentially dangerous scenario given evidence of widespread outflows and rising hedge fund liquidations.  There is a price to pay for excessive market behaviour and short of scaremongering, we expect the flow into the more traditional safe havens to start gathering momentum unless there is some further moderation from the Federal Reserve.  This week's rate hike has been widely criticised in the investment community - not just by Donald Trump - with this being a rare occasion in a tightening move being made at a time of stark weakness in stocks.  This month has seen one of the largest percentage losses in history, and depending on the Christmas period, may indeed be the largest by far.  We have to go back to the financial crisis in Oct 2008 to see a move of the same magnitude!

For this reason, it is highly plausible to believe that the Fed rate hike cycle has now run its course.  As we have already noted, there are clear signs that the pace of growth in the US is slowing, and with inflation seemingly anchored around the 2.0% level - see the sell-off in Oil price - there will be ample reason for Fed chair Powell to warrant a pause - and a long one at that - without fear of stoking rumour and speculation that he has capitulated to the US president's 'demands'.  In the past few months, Fed policymakers have been undecided over the neutral rate, though have acknowledge that Fed funds are now at the lower end of the neutral range.  It seems the market has decided that this is perhaps far enough in the current climate, with bond markets also concurring with this view.  This week we have seen the benchmark rate hitting 2.75%, which argues for another move at least in the current cycle, but further portfolio switching could easily wipe out another 25bps of yields here. 

At the time we saw 10yr Notes hitting 3.25% - twice in fact - it seemed a very attractive proposition in light of some of the earnings projections for 2019, measured alongside the risks to global growth.  These levels are increasingly attractive now and it seems unlikely that we could see a 3% handle once again.  In the unlikely event that we do, we expect portfolio managers to be duly enticed, which again reinforces the fact that we are now in a bear market. 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.