Since 1981, the Federal Reserve Bank of Kansas City has sponsored the Jackson Hole Economic Symposium – an annual convention gathering dozens of prominent central bankers, finance ministers, academics, and financial market participants to discuss the issues, implications, and policy options pertaining to particular economic topics. Traditionally held at the stunning Jackson Lake Lodge, this year’s virtual symposium – recently held on August 27th – was both highly anticipated and widely followed by many market participants. While every symposium has the ability to (and often does) move financial markets, this year’s remarks by Jerome Powell – Chairman of the Federal Reserve (Fed) – were of particular interest due to one talking point: the tapering of the Fed’s most recent quantitative easing program.
What is quantitative easing you might ask? Let us first begin with an overview of the Fed – a widely known, yet poorly understood institution. The Fed was first established in 1913 after a series of financial panics necessitated the creation of a central monetary authority responsible for conducting monetary policy to ensure bank liquidity, price stability, and confidence in the U.S. dollar. The Fed has a two-part structure consisting of a central authority – the Board of Governors located in Washington, D.C. – and a decentralized network of 12 Federal Reserve Banks located throughout the United States. All seven members of the Board of Governors and a rotating panel of five Federal Reserve Bank presidents comprise what is known as the Federal Open Market Committee (FOMC) – the making body responsible for determining the direction of monetary policy. The committee meets eight times annually to set the target federal funds rate – reflecting the interest rate at which banks borrow and lend excess reserves to each other. The federal funds rate is perhaps one of the most important economic indicators in the United States as it not only affects monetary policy, but also reflects the health of broader financial conditions such as employment, growth, and inflation.
While the mechanics of such activities may seem rather complex, the premise is simple: raise rates in periods of economic growth to avoid overheating and cut rates in recessionary periods to incentivize bank lending and consumer spending. These open market operations have traditionally been quite successful in supporting long-term growth and alleviating financial crises, but the effectiveness of such activities has been limited in recent years – particularly since the Great Recession. Understanding that interest rate adjustments often take at least 12 months to be felt in the broader economy, the Fed was forced to develop a more direct means of market intervention in response to the global financial crisis – one that would stabilize markets almost immediately. The answer: quantitative easing.
Shortly after Lehman Brothers went bankrupt in late 2008, the federal funds target rate was already close to zero and the Fed realized that more drastic measures would need to be taken to avoid a complete economic collapse. Financial institutions were falling by the wayside and all confidence had been lost in the banking system. Worse yet, asset prices were in a free fall and certain securities – particularly those tied to subprime mortgages – were of such poor quality that the market for such instruments had nearly evaporated. Understanding that further rate cuts would largely prove ineffective, the Fed began increasing the money supply (or said differently, printing money) to purchase troubled assets – such as mortgage-backed securities – in an effort to restore confidence in the credit markets. This introduction to quantitative easing – initially referred to as the Troubled Asset Relief Program (TARP) – was meant to serve as a one-time solution but has since become a common tactic in the Fed’s playbook. With interest rates sitting at near record lows, stimulating the economy via traditional monetary policy (i.e., adjusting the target federal funds rate) no longer packs the same punch – so rather than lowering rates even further (into what would likely be negative territory), the Fed has opted to artificially reduce interest rates by purchasing various Treasuries and mortgage-backed securities. While this practice remains historically unconventional, the benefits of lower rates, market liquidity, and price stability seem to outweigh the risks during times of crisis – at least over the short-term. The only issue is that the Fed has become increasingly reliant on quantitative easing given the inherent limitations of traditional monetary policy, resulting in a rare form of market euphoria that remains largely dependent on such activities.
The Fed conducted three rounds of quantitative easing in response to the global financial crisis – spanning from late 2008 to October 2014. During this timeframe, the S&P 500 had rebounded by more than 150% since its recession lows as the Fed’s balance sheet grew from roughly $870 billion to $4.5 trillion in financial assets owned. In mid-2013, then Fed Chairman – Ben Bernanke – announced that the central bank would begin tapering its quantitative easing program as the economy had largely recovered from the Great Recession. The response was an almost immediate reactionary panic – now referred to as the Taper Tantrum – triggering a spike in U.S. Treasury yields as investors feared the market would once again crumble following the cessation of quantitative easing. The market’s reaction to such an announcement was proven unjustified as the economy continued to recover, but the tantrum did illustrate just how behaviorally reliant investors had grown to government support of free markets – a clear deviation from traditional laissez-faire economic policy.
Although the Fed began to reduce the size of its balance sheet after discontinuing its purchases in October 2014, interest rates remained historically low as the stock market continued to reach all-time-highs. A combination of low interest rates and stimulative fiscal policy provided a late-inning tailwind for many sectors – especially big tech – and the woes of 2008 seemed like a long-lost memory despite the Fed’s significantly elevated balance sheet. Fast forward to the 2019 Jackson Hole Symposium, where the selected topic of conversation was Challenges for Monetary Policy – to which Jerome Powell offered the following opening remarks:
The current U.S. expansion has entered its 11th year and is now the longest on record… Thus, after a decade of progress toward maximum employment and price stability, the economy is close to both goals. Our challenge now is to do what monetary policy can do to sustain the expansion
— JEROME POWELL
At this time, U.S. Treasury rates had fallen quite dramatically as long-term growth remained in question. Just one month following the 2019 symposium, the Fed began its fourth round of quantitative easing to preemptively offset such risks – but little did they know the easing had only just begun. As the world welcomed a new decade, interest rates remained at all-time-lows as equity markets continued to notch all-time-highs. The S&P 500 closed at a record of 3,386 on February 19th – promptly sliding nearly 40% over the following 23 trading days in reaction to the coronavirus pandemic. With the 10-Year Treasury Rate sitting well below 1%, the FOMC slashed the federal funds target rate to 0% (by all accounts an unprecedented move) and introduced a $2+ trillion quantitative easing program over the next several months given the inherent limitations of traditional rate cuts. This program has remained in effect since the onset of the pandemic, with the Fed’s balance sheet doubling in size to a staggering $8.5 trillion. Equity markets have responded quite favorably to such policies with the S&P 500 rising nearly 100% since its pandemic lows – but despite this recent period of generous returns, many investors are beginning to acknowledge the primary risk associated with a generous money supply: inflation.
Interestingly enough, some degree of inflation – traditionally 2% – is not only viewed as healthy, but a critical component to economic grow. The issue is when inflation runs hotter than expected during periods of stagnant growth – the combination of which results in a dilemma known as stagflation. Although inflation wasn’t top of mind for policymakers in the crux of the pandemic, Jerome Powell’s comments during the 2020 Jackson Hole Symposium are particularly sobering when viewed in hindsight:
Over the longer run, the sluggish economic growth and historically low interest rates that preceded the pandemic pose additional challenges for policymakers. Although the future is always uncertain, slow growth and low rates are widely expected to persist.
— JEROME POWELL
Fast forward to this year’s symposium, wherein the market was once again sitting at an all-time-high as anxious market participants awaited Jerome Powell’s virtual remarks – hoping that his tone was optimistic enough to keep the rally going. Despite the hours of bureaucratic presentation, his key remarks can be summarized as follows:
- The Fed maintained its dovish view on inflation – focusing instead on economic growth as they remain convinced such inflation is merely transitory. While this posture remains highly contentious given the number of dissenting views (ourselves included), recent moves in interest rates and commodity prices do suggest that inflation might be temporary – although we’re not fully convinced.
- The Fed acknowledged that it plans to begin tapering its 2+ year quantitative easing program – slowing the rate of government-backed debt purchases in an attempt to restore a more normal policy setting. Although the timeline for said tapering is still unknown (and likely subject to delay should employment numbers not improve), one could reasonably conclude that history repeats itself and rates modestly rise in response to such activities.
These comments came at a time when the delta variant – and soon to be mu variant – continue to complicate the reopening and economic recovery, the impacts of which are staunchly different on Wall Street vs. Main Street. As someone that recently purchased their first home in Austin, I can tell you from personal experience that inflation is certainly present in the housing industry – and if you’ve tuned into any quarterly earnings calls over the past several months, most executives agree that inflation is a clear and present danger for their firms. Perhaps such price increases are truly transitory, but when you consider the $8+ trillion dollars of publicly-traded debt held by the Fed and subsequent 2x increase in the money supply over the past 18 months – it’s difficult to imagine a scenario where interest rates and inflation don’t both rise above consensus expectations. The only problem is determining which is the chicken and which is the egg, and how the unwinding of such efforts impact a market trading at three times its historical multiple. The Fed is a powerful institution with significant political ammo, but we at Silicon Hills recognize that the market is relying on several assumptions that may prove too good to be true. While our sentiment remains generally bullish, we also believe that such risks can and should be hedged within the portfolio by:
- Focusing on tactical, yet disciplined solutions that allocate risk with the ebbs and flows of the economic cycle – a solution we deem far superior to traditional buy-and-hold strategies given the velocity of today’s market.
- Recognizing the important, yet limited role of fixed income in portfolio construction and introducing additional hedges that participate in upward-trending markets while providing alpha (outperformance) in times of crisis.
- Understanding that high-multiple equities are priced at exorbitant levels and are most likely to be the first victims of a market selloff – especially if interest rates and/or inflation are the cause of said selloff. Rather than passively investing in concentrated indexes, we isolate a series of equity factors that provide broad participation across lower multiple names – emphasizing metrics such as cash flow and profitability. Some of our most recent work provides additional insight into these very topics – the first written by my colleague, Scott Wimmer, and the second written by myself:
We understand that predicting markets – let alone interest rates – is incredibly difficult, but we also believe that a durable portfolio should withstand even the most uncertain economic regimes. While many aspects of the current environment are truly unprecedented, we also contend that history tends to repeat itself – especially when the storyline originates in Jackson Hole.
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