IN SHORT

 

Since the acute downturn investors suffered over the holidays, markets have, for the most part, sprinted out of the gate in 2019. Nonetheless, Counting Crows had it right when they said it was a long December. Back then, we wrote a piece that concluded: (a) market swings would likely continue on headlines around Fed policy and trade tensions with China, and (b) investors should use upward swings to right risk portfolios. Well, we have certainly seen those market swings. The day we published, the S&P 500 was at 2600. Ten days later, it was at 2350 (about 10% lower). Now, only about two months later, the S&P 500 is back near 2700.

Even despite losses on Thursday, global equity markets are firmly in the green so far this year (S&P 500 +7.9%, Stoxx Europe 600 +6.6%, Hang Seng +8.3%, TOPIX +5.0%, year-to-date as of Thursday’s close). Risks that plagued sentiment towards the end of last year seem to be turning a corner: the U.S. and China are making progress on trade (though it remains to be seen if a Trump-Xi meeting will happen before the March trade deal deadline), U.S. economic growth is holding up, and most notably in our view, the Federal Reserve (the U.S. central bank) announced it’s taking a breather on its hiking cycle. How did we get here, and more importantly, what does it mean for investors going forward?

The Fed: A long way from “a long way from neutral”

You might remember Fed Chairman Jerome Powell’s October remark that the Fed had a lot of work to do to reach the theoretical “neutral rate” (the interest rate that’s neither stimulating nor restricting economic growth). It seems like we’ve also come a long way since that statement.

Financial conditions are key to understanding how the Fed views the economy. The chart below shows an index for U.S. financial conditions, which includes variables like stock prices, interest rates, corporate spreads, and the level of the dollar. It is meant to approximate how easy or difficult it is for a business to gain access to capital. When the line is rising, financial conditions are getting tighter (more restrictive). A decline suggests easing conditions. For argument’s sake, the dashed line at 100 can represent “neutral” financial conditions. The Fed uses the index as a proxy for how their monetary policy might be transmitted to the real economy through financial markets.

Line chart shows the Goldman Sachs financial conditions index from July 2014 through February 2019. It is meant to approximate how easy or difficult it is for a business to gain access to capital. A dotted line at 100 represents “neutral” financial conditions. Since a low in July 2016, the line has been steadily rising, then exceeds “neutral” in late 2018. In 2019, the line has gone down slightly to below the “neutral” level.

As you can see, when Chairman Powell suggested in October that the Fed cycle still had “a long way” to go until neutral, he wasn’t necessarily wrong—estimates of broad financial conditions were still below a neutral level. However, as markets began to price higher risks around global growth and political uncertainty at the end of last year, stocks fell and spreads widened, bringing financial conditions closer to neutral without any actual policy rate hikes from the Fed. Now, with financial conditions close to neutral and tepid price inflation, the Fed seems to be on hold (at least for now).

Equities usually welcome a Fed pause, but deciding whether to chase the rally should depend on your current portfolio.

 
 

So now that the Fed seems to be on hold, what can we do about it?

In fixed income, consider adding duration (i.e., fixed income assets that are more sensitive to changes in interest rates). All else equal, the U.S. 10-year Treasury yield should approximately equal the fed funds rate (the Fed’s policy rate) plus a premium for uncertainties around things like inflation in the future. After the latest news from the Fed, it also seems that the peak level of the fed funds rate in this hiking cycle is likely to be lower than we expected. What does this mean? Well, the peak in the 10-year Treasury rate is likely to be lower than expected. Why does this matter? As shown in the chart below, the 10-year Treasury yield usually converges with the fed funds rate towards the end of the hiking cycle. You can also think about this dynamic as the yield curve flattening (longer-term yields are converging to shorter-term yields).

Line chart comparing the 10-Year Treasury yield and the Fed Funds Rate from 1989 to 2019. Both lines have steadily gone down since 1989. The two lines run relatively in tandem (when Fed Funds Rate goes down, the 10-Year Treasury yield line goes down), and eight times, the lines have converged.

History has shown us that as the yield curve flattens, it can be advantageous to add duration. We think investors who are still short duration should add at these levels. If the Fed does indeed resume its hiking cycle for one to two more hikes, longer-term rates like U.S. 10-year yields may increase slightly from here. But, we think that what an investor could lose from that rate move (remember: as bond yields move higher, prices move lower) seems worth the protection that duration could provide if the hiking cycle is indeed finished.

Equities usually welcome a Fed pause, but deciding whether to chase the rally should depend on your current portfolio. In the past, when the equity market has recognized a Fed pause, a rally has ensued. In 2006, the rally lasted for around a year. In 2000, the rally was only a few months. Either way, history suggests there’s a runway for equity multiples to continue to expand as the risks that dominated 2018 (a tightening Fed, a trade war with China, and deteriorating data) appear to be less acute. In fact, the market seems to have already done a lot to put the risks of 2018 in the rear view mirror. On Christmas Eve, the market had a 13.5x forward P/E. Today, the S&P 500 is at 15.9x.

Line chart comparing the S&P 500 Price Index and the S&P 500 Forward Price/Earnings from February 2018 to February 2019. The lines have moved in tandem over this time period. From a high in October 2018, they both dipped and reached a low in December 2018. In January and February 2019, they have since increased.

Investors should remember that, even with its hiking hiatus, the Fed is not out of the picture. The Fed remains “data dependent,” and future hikes are still a possibility should economic conditions heat up. The current pause likely works to sustain the recent equity rally a bit longer than we initially thought, and investors who took our advice to add duration and move up in quality last fall have gained the ability to chase the rally in risk assets. For those who still hold outsized exposures to equities and high yield and don’t own enough duration, we continue to recommend using this latest swing upward in risk assets to de-risk portfolios.

Have a great weekend!

 
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Jake Manoukian

Client Advice and Strategy
J.P. Morgan

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Madison Faller

Client Advice and Strategy
J.P. Morgan

 
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