US financial markets have been on something of a roller coaster since US-listed stocks posted all-time highs in September of 2018.
Volatility first returned to the markets in early October after Federal Reserve Chairman Jerome Powell remarked during an interview with PBS that “interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” Stocks fell 6% in the subsequent six trading sessions, and from mid-October to mid-December, the S&P 500 traded in the 2600-2800 range. After a Federal Open Market Committee (FOMC) meeting on December 19, 2018, in which Chairman Powell commented that the Fed would continue selling US Treasuries “on automatic pilot and use monetary policy, rate policy, to adjust to incoming [economic] data,” the markets went into a mini-meltdown, with the S&P closing at 2351 – a 19% decline from the September 20, 2018 high, and the lowest price in 20 months – on Christmas Eve. Stocks turned around on December 26, 2018, and received a boost six sessions later, on January 4, 2019, when Chairman Powell revised his December 19, 2018 remarks by telling the annual meeting of the American Economics Association that “if we came to the view that the balance sheet normalization plan was part of the problem, we wouldn’t hesitate to make a change.” These comments helped propel stocks on a rally that has only in the past five sessions shown any sign of abating. The Dow Jones Industrial average has closed 8 of the past 10 weeks in positive territory, and the S&P 500 has recently traded in the high 2700s, only 5% off of September’s all-time high.
What explains the whiplash in stock valuations?
We believe that perhaps the single most important factor was the markets’ changing perception of the Federal Reserve’s stance toward economic growth. By law, the Federal Reserve system is responsible for regulating the US money supply, and since the end of 2017 the Fed, through its FOMC subcommittee, has been gradually implementing a policy described in the media and financial markets as “quantitative tightening.” The Fed’s spokespersons have claimed that the goal of quantitative tightening is to return US monetary policy to a “neutral” stance toward the economy – that is, an orientation that neither hinders nor foments economic growth (this is the place from which Powell said Fed policy was still a “long way” in his October comments). A more precise way to describe the goal of neutrality is to say that the policy attempts to achieve full employment (a correlate of economic robustness) and the Fed’s target inflation rate (currently 2.0%) simultaneously. Since 2008, Fed policy has been not neutral but “dovish,” or encouraging of high levels of liquidity and economic growth.
To return monetary policy to “neutrality” from “dovishness,” the Fed has two primary tools:
- raising the bank overnight lending (aka Federal Funds) rate, and
- selling bonds it owns into the open market, a process sometimes referred to as a “balance sheet runoff” or “the Fed reducing its balance sheet.”
It was the Fed’s monthly “balance sheet run off” or sale of $50 billion of Treasuries and financial crisis-era mortgage backed securities that Powell said was on “automatic pilot” on December 19, 2018. Raising interest rates curtails the ability of banks to lend money, which in turn decreases the economy’s liquidity by contracting the availability of credit. Selling billions of dollars of Treasuries and mortgage bonds into the open market similarly diminishes liquidity by removing dollars from the economy, and replacing those dollars with interest-bearing notes: banks can lend dollars, and consumers can spend dollars, but neither lends or spends bonds. By contracting the money supply, the Fed can temper the rate of economic growth, an outcome which, the theory goes, would not only move monetary policy toward a more “neutral” stance, but also reduce the danger of inflation overshooting the Fed’s 2% target.
Why does this matter so much for the stock market?
We believe a primary determinant of stock prices is earnings, or after-tax net income (profit). Stock prices are extremely sensitive to earnings forecasts, because a portion of the intrinsic value of a stock rests in its representation of an ownership claim to fractional share of all future cash flows generated by the underlying business. That is to say, owning a company’s stock gives the shareholder a claim upon the business’ future income, and that future income stream discounted (adjusted for the time value of money) to the present day comprises a part of the intrinsic economic value of the purchased shares. If the market believes that a company’s income will decline, or that its income potential has decreased, the stock’s price will appear expensive relative to its intrinsic value (part of which is the sum of discounted future cash flows) and, all other things equal, more people will sell the stock than will buy it, driving down its price.
In the fourth quarter of last year, markets appeared to interpret Chairman Powell’s comments about the Fed seeking monetary neutrality to mean that the Fed would continue hiking interest rates and selling bonds, regardless of the danger that those policies might pose to the underlying economy. Investors apparently concluded that the assumptions about high corporate earnings growth upon which stock prices had been based in August and September were flawed – and the markets sold off. By selling off, the markets “priced in” information that the Fed intended to temper economic growth, and with it, corporate earnings growth. It appears the rebound in prices since Christmas is explained in part by the market’s perception that the Fed had decided not to, or clarified that it wouldn’t, curtail economic growth as zealously as markets believed at the end of 2018. Whatever his motive, Chairman Powell’s comments on January 4 certainly re-set stock market valuations on their formerly upwardly trajectory.
This is not to suggest that the only inputs to which stock prices have responded since September are the markets’ own fluctuating perceptions of the Fed’s activities. The ongoing US-China “trade war,” corporate earnings reports, and macroeconomic data all appear to have exerted a major effect on stock prices – and valuations would probably have varied even more dramatically had markets’ expectations regarding any of those things been significantly altered. But I do mean to highlight the extent to which price action over the past five months has been attributable to markets’ interpretation of the Fed’s actions.
Federal Reserve monetary policy is adaptive, and often evolves based on real-time data to anticipate or fix problems in the economy. The Fed’s late-2018 insistence on returning to “neutral,” for instance, represented in part an effort to preempt the rise of inflation above the Fed’s 2% target level. Chairman Powell’s communications around that strategy spooked markets, but in early January Powell struck the tone necessary to mollify markets’ concerns and stocks have rebounded rapidly. Three things to watch going forward will be perceived changes in the Fed’s monetary policy, the possibility of resolution in the US-China trade war, and deteriorating US economic data.
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