Tonight's Fed announcement the biggest yet

Wednesday, 19th December 2018 11:31 - by Shant

It has been a while since we went into a Federal Reserve meeting announcement with a genuine degree of uncertainty in the air.  Having 'prepared' the market in previous episodes, participants will now be directed to think for themselves and it looks (in part) that the statement on the future path of the Fed Funds rate will focus on a communicating this increased dependency on data. 

This will require market participants to determine the path through incoming economic signals rather than counting on the Fed to reassure participants of a gradual path of hikes.  Some forecasters believe the Fed may even drop this line - on 'gradual' tightening.  The spoon feeding it seems has, or is, coming to an end.  

In recent weeks, the acknowledgement that the balance sheet is contracting alongside higher interest rates has taken its toll on stocks, which have been riding the crest of an 8-year long wave of ultra-loose monetary conditions.  At some point, this was going to dry up, so now we wait to see whether the wave crashes down and sucks the major indices under - apologies for the melodrama.  However, one has to measure the degree of appreciation we have seen in stock market valuations over the years.  It has been parabolic, and whether one views this as a byproduct of mean reversion or confluence with the real economy, an eventual convergence was only a matter of time.  We also need to factor in the profit (or loss) taking measures which come about as a natural consequence of this material reversal in fortunes which have resulted in double-digit returns for funds over a number of years in the wake of the recovery from the great financial crisis 10 years ago. 

Bottom line, a major sell-off should not come as a surprise.  Naturally, anyone who remembers the subprime fallout of the summer of 2007 will be familiar with the severity of a market correction, and in light of the above, many have tried and failed in pre-empting this - until now.  This is not to say that tomorrow's events will not allow for some near-term relief.   A softer Fed tone should, in essence, come as a welcome relief for equity markets, but bear in mind, this is likely to be a temporary development in what is an overriding period of normalisation.  There are wider ramifications for valuation in terms of monetary policy relevant to the real economy and the underlying metrics as an ultimate determinant.  It should, therefore, stand out that the housing market should rightly be a greater concern in the current climate.  

Over the last 2 months, we have seen the US NAHB house price index falling significantly, from 68 in September, to 56 last month.  Unlike 2007 and 2008, householders are likely to be better insulated to a drop in prices, with lending criteria tightened over the last decade in order to avoid another similar episode as mentioned above.  The strong labour market should also prove supportive, both in terms of job security and confidence, as well as household income ratios.  However, in credit-fueled economies such as the US and UK, consumer spending will take a dip, and the sequence of events are showing direction this way.  This will impact on GDP and as we look for this confluence between stock markets and the real economy, the future does not bode well for earnings, and as a result, we can see little sustainable upside for current valuations.   

Over coming months, my focus will be on consumer spending, but alongside this, we also have to see whether low employment can generate some real momentum in wage growth.  Not that 3.0-1.2% is unhealthy by any stretch of the imagination, though with unemployment well below 4.0% and strong evidence of skilled worker shortages, one has to question why this isn't translating into higher pay.  Are margins getting squeezed? Is it a matter of productivity?  Either way, and whatever the reason, reduced household leverage and modest wage rises should be a warning sign for any consumer-led economy, and some of the data metrics in the US are confirming some of this developing weakness.  

No surprise then that the Fed is likely to take a more cautious stance tonight, though naturally, chair Powell is in an awkward position given the US president chiding the Fed for their policy stance.  Trading tonight's events will elicit the usual binary response from the short-term market, but longer term, the party looks to be coming to an end.  You just have to choose how you exit. 

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.