A more than 9000 points down-and-up swing in the Dow Jones Industrial Index (DOW) within four months is how the market responded to the Federal Reserve’s initial “we know better” thinking and its subsequent mea culpa!
We typically avoid using “colorful” language in our commentary, but have taken the liberty to do so in this communique to unambiguously convey our total disdain for the actions of the Federal Reserve (FED) over the last few months. Not only have they caused incredible volatility in the financial markets but have also, we suspect, damaged the credibility of the institution itself.
Let’s look at the sequence of events beginning with the comments on October 3, 2018 by FED chairman Jay Powell (whom we have prematurely praised previously) about interest rates being “long way from neutral.”
Almost instantly the markets started to react negatively as can be seen in the chart on left with equities falling and volatility rising. Investors had already been apprehensive about the FED’s prior policy of “gradual” increases in interest rates given the stagnation in key economic sectors of housing and automobiles as well as the noticeable softening in many international markets. So, the introduction of “long way from neutral” took the markets by complete surprise. The implication of those comments was unmistakable: markets were underestimating future rate hikes.
But why would that be the case when inflation (both Core and Headline) has been around the FED’s target of 2% for years now as seen in the chart below. In our view, the only justification for raising interest rates is when inflation begins to threaten price stability. So, the eagerness to raise rates seemed almost nonsensical. Preemption was likely the FED’s reasoning as was buffer creation which would enable lowering rates in the next economic downturn. Excuse our bewilderment here, but it seems to us like the FED was engineering the next economic downturn in order to be able to use a policy tool. It’s like making a person deliberately sick so that some already produced medicine can be used. WTF!
Some participants may have hoped that this was just a single off-the-cuff comment that would surely be “clarified.” No such clarification came through. In fact, on December 19, 2018 chair Powell, speaking at the press conference after a FED meeting not only defended the 0.25% rate hike that the FED had just passed but also defended the possibility of three future rate hikes in 2019 that many FED voting members anticipated. No prizes for guessing the equity market’s reaction…the DOW lost nearly 2000 points over the next four sessions to record the worst Christmas eve in its history.
After having caused significant wealth destruction and witnessing the carnage in financial markets, the geniuses at FED then changed their tune and began talking about “patience” and “flexibility” with future rate hikes. As expected, markets started to recover and on January 16, 2019 Chairman Powell in an interview with David Rubenstein of Bloomberg, emphatically stated that the FED would do whatever it took to support the economy including halting the balance sheet run-off that had been in place for well over a year. Wow…a man of real conviction!
Risk markets haven’t looked back since with the DOW now having almost recovered it entire 5000 points loss during the 4Q18. This entire episode though lays bare the utter amateurish and below average thinking of our “highly educated” FED officials. So, the next time someone mentions the sophisticated and complex nature of the work done at the FED, you might hear us say - WTF!!
It would be meaningless to talk about performance numbers for 2H18 without mentioning the dramatic moves markets have made in the first two months of 2019. Hence, we will be sharing year-to-date numbers as well. Similarly, given the broad-based nature of the sell-off in the latter part of 2H18, the drivers of performance for both periods will to some extent be the mirror image of each other and, therefore, we will focus our discussion on the actions that we took in the half, particularly in 4Q18. Our intent is to highlight how we were able to take advantage of opportunities during some of the most trying circumstances through factors that were within our control.
OppoQuest's Core strategy (CORE) posted a gross return of -12.57% for the 2nd half of 2018 versus -4.98% for the benchmark, S&P Target Risk Growth Index (SGI). However, year-to-date (through 02/25/2019) CORE has generated a gross return of + 17.61% versus +7.23% for SGI. As of the week ending 02/22, most equity market indices have had the longest stretch of uninterrupted weekly gains since 1964! Clearly, this volatility did create opportunities for those participants who had been at least somewhat defensive coming into the 4Q18. We were one of them. Nevertheless, having the ability to take advantage is only half the equation. The other half is willingness to take advantage. We were in the group of the willing too.
So, the most important change we made during the 4Q18 was to increase CORE’s Technology exposure by almost 6% points. Cash exposure went down from close to 11% at the end of June 2018 to less than 2% and we reduced REITs, Utilities, and Healthcare exposures as well. Of course, the rationale was to sell positions that had held up very well in the sell-off and buy ideas that were hit hard but retained solid growth potential. Within Technology, we have initiated two new positions; one in global e-commerce platforms and other in US cloud-based software companies. Additions to existing positions included names in Industrials, Energy, Biotech and Financial sectors. The cumulative effect of these actions resulted in almost 11% points of reduction in the strategy’s defensive positions while increasing the strategy’s offensive positioning by the same magnitude. It was one of the largest reallocations we have conducted within such as short period. Our year-to-date 2019 performance across all strategies strongly validate those actions.
OppoQuest's Conservative strategy (CONS) ended its outperformance streak versus its tracked benchmark, the S&P Target Risk Moderate Index (SMI) with 2H18 gross returns of -8.96% against -3.01% for the benchmark. However, year-to-date (through 02/25/2019) CONS has generated a gross return of +13.47% versus +5.27% for SMI. Repositioning actions in this strategy during the 2H18 were similar to CORE and were also weighted heavily towards 4Q18. Technology sector additions and new positions were around 7% while another 5% was reallocated to Industrial, Energy, and Financial sectors. On the other hand, exposures to Utilities, REITs, and Healthcare sectors were reduced significantly and Cash position of 5% at the end of June 2018 went to less than 1%.
Given that CONS’s mandate include lower volatility and income generation, the technology positions added were mostly large-cap, dividend paying ideas although the primary reason they are in the strategy is their upside potential. As a reminder, we never look at ideas simply because they have been beaten down or the yield attached. Only if we are convinced that a beaten down idea possesses the ability to rebound, then it would be considered. All these changes resulted a slight increase in the yield of the strategy to 4.53% from 4.13%.
The FED’s idiotic blunder (sorry, we just can’t hold back!) and its subsequent mea culpa has significantly improved the future prospects for risk assets. Other headwinds like political and trade uncertainties are yet too clear, but we don’t think their resolution is essential for a sustained uptrend in risk assets. It actually scares us now to be reminded that the FED is a bigger factor than trade and wields more power than even the three branches of our government…yikes!
If you thought that FED members might have learnt their lesson after 4Q18 and would likely stay away from challenging market expectations, we hate to burst your bubble. Loretta Mester, the most hawkish FED member and the Federal Reserve Bank of Cleveland President, was at it again as recently as February 19, 2019 saying “if the economy performs along the lines that I’ve outlined as most likely, the fed funds rate may need to move a bit higher than current levels. But if some of the downside risks to the forecast manifest themselves, and the economy turns out to be weaker than expected and jeopardizes our dual-mandate goals, I will need to adjust my outlook and policy views.” Nice…although well-balanced, we are struggling to understand the utility of mentioning rate hike possibilities when the markets just went through a tumultuous episode for exactly the same issue. We fear it has to do with the simple human emotion of considering oneself always right. You know the trait that we all observe in our teen aged kids. In all fairness to our kids though, they do listen, at least once in a while, and own up to their mistakes. We are not going to hold our breath for the same behavior from Ms. Mester!
The good news is that no other FED official has raised the issue of higher rates since 4Q18 and so our baseline case is that the FED will stay put, although we admit we are wary of making that assumption. Something tells us, they will be back. The focus now is entirely on the trade negotiations with China and the USMCA (NAFTA 2.0) vote in the new Congress. While we have no inside track, reports coming out of the administrations on both sides indicate progress. As for the USMCA, there seems to be some sort of blackout period going on. We can only hope there is movement in the background that will bring the agreement to a vote and follow-on actions. In the event that both these agreements fail to see the light of the day, we don’t think the markets will react too negatively because things simply revert back to pre-tariff era which would not necessarily be a bad outcome.
The one concern that we have heard from some of our clients and other participants is the long duration of current bull market in equities. The chart on left shows that it is the third longest and gaining fast on the 2nd longest. The obvious question we get asked is: How long can it go? There has to be a big correction coming…right? We expansion strain hanged the As expected, U.S. equity markets have recovered fully from the shake-out in the early part of this year as focus returned to fundamentals. The economy continues to hum along with the 2nd quarter GDP growth being revised upwards to 4.2% which is its best pace since 3Q14. The widely followed Atlanta Fed forecast indicates that momentum will continue into 3Q18 with expectations of GDP growing 4.6% as of the 08/24/18. And all this strength comes despite trade frictions and tariff actions which are almost certainly subduing numbers.
While the set-up looks really good, there are some issues that could potentially derail this strong economic momentum. First, the U.S. yield curve is getting closer to inversion and the Fed hasn’t been clear about whether it will continue to raise rates if inversion actually occurs. As a reminder, inversion of the yield curve happens when the difference between long-term interest rates (typically referenced by U.S. 10-Year Treasury Note) and the short-term rates (typically referenced by the 2-Year Note) becomes negative. Currently, that difference is around 22 basis points or 0.22% as can be seen in the chart on the left.
What is more important is that every inversion since 1980 has been followed by a recession. While we are not big fans of formulating economic forecasts based on historical patterns, the inversion of yield curve is more than a pattern. In our view, it’s more like a law of physics and challenging it makes no sense. So, if the Fed believes that they can keep raising rates in the face of an inverted yield curve, like Loretta Mester of the Cleveland Fed seems to suggest, then we are headed for a classical policy mistake by the Fed. Her comments, in fact, appear to go along that dreaded notion in investing “things are different this time.” We do draw some comfort by the views expressed by James Bullard of the St. Louis Fed who has expressed clearly that the Fed should not challenge the yield curve. We sincerely hope that other Fed members are more in line with Mr. Bullard and not Ms. Mester.
The second factor that concerns us, but to a much lesser extent, is the upcoming mid-term elections in the U.S. Most polls indicate that the Republicans are going to lose their majority in the House while retaining it in the Senate. If that happens then the worst-case scenario would be political gridlock which would be neutral for risk assets like equities. However, if the Senate were to flip as well, then we could see political risk creep in and volatility rise. Needless to say, we would prefer gridlock over the other outcome.
Finally, the simultaneous renegotiations of trade agreements with multiple trading partners presents some risk given the complexity and time-consuming nature of these discussions. So far, there hasn’t been noticeable adverse consequences on the overall economy of the tariffs being levied on one another but that will likely not last forever. The successful agreement with Mexico is a major positive in that regard as it shows willingness on both sides to reach consensus. While we do expect others like Canada and the European Union to follow suit, China will likely present the biggest challenge to the administration.
Overall, we remain cautiously optimistic that the strength of the U.S. economy will sustain. Our positioning in all strategies is balanced now having added some risk during the February sell-off. So, we have enough risk to participate on the upside and just enough defensiveness to capitalize on any downside. Goldilocks would love that!
Founder & Portfolio Manager