Market Update 12.19.18
-Darren Leavitt, CFA
The Federal Reserve increased rates by 25 basis points today and suggested they were poised to raise rates two more times in 2019. The hike was generally accepted to be the consensus, but investors were perhaps looking for a more dovish outlook for 2019. Interestingly, the market seemed to react more to Powell’s answers related to the reduction of the Fed’s balance sheet- this reversal of QE has been on “autopilot” for a while now and, has, for the most part, been accepted by investors as a policy toward normalization. Equities sold off after the announcement, cyclicals were the hardest hit while defensive sectors such as Utilities, Real Estate, and Consumer Staples offered some cover. The yield curve flattened on the announcement with the 10-2 year spread decreasing to 13 from 18. Longer-dated Treasuries continued their rally as investors sought safe haven assets and also on the thought that inflation seemingly continues to be non-existent.
The actual move to raise rates by 25 basis points was the most likely outcome. Going into the meeting, the probability of a hike was just north of 70%. However, this expectation had come down from ~95% in just the last couple of weeks. Political pressure on the Fed to leave the rate unchanged was dismissed, and in Powell’s press conference he reiterated the independence of the Federal Reserve.
The outlook for rate hikes going forward was more dovish than prior expectations but perhaps not dovish enough. The Dot Plot which lays out the aggregate rate expectations of all the Fed governors was reduced from 3 to 2 in 2019. These expectations are not set in stone and will likely change as more economic data is assessed. The market is currently at odds with the Fed’s expectations and views this dot plot as restrictive rather than neutral policy. The Fed reduced its growth forecast for 2019, 2020 and 2021. The Fed also agrees that they have been unable to meet their inflation goal which continues to undershoot their objective. So investors ask- why does the Fed need to raise rates in an environment where growth looks to be slowing, and inflation is seemingly nowhere to be found? Isn’t this restrictive policy?
Questions regarding the reduction of the balance sheet or quantitative tightening really seemed to be a spark for the markets being sold. The policy to unwind the balance sheet has been in place for some time now and has been running on “Autopilot.” When asked about whether or not the Fed would pause on the reduction of the balance sheet, Powell seemed dismissive to the notion. I have seen some figures that the reduction of the balance sheet in 2019 is the equivalent in impact to 3 rate hikes. If this policy is in fact set in stone, it in itself may be construed as restrictive and if coupled with the dot plot rate expectations- well, much too restrictive.
All that said, the market was technically set-up for more weakness. Once the S&P 500 broke the February lows of 2532, stop orders were put in motion, and 2500 was the next level in sight. The potential for a government shut down, and expiration on Friday does not help matters. The market appears to be oversold here and may provide an opportunity for a decent bounce. While global growth seems to be slowing, a 2.3% growth rate with no inflation and strong employment does not sound too bad. Additionally, the US market still looks like the best horse in the race. It has been a tough year, but in a relative sense, the US has outperformed. Fed-EX announced their earnings yesterday and conveyed that their European performance was horrible, China was slowing and also a disappointment- but the US market remained okay. Time will tell and as you all know there is certainly a lot to consider in this market. Our tactical models have performed quite well in this sell-off with outsized positions in US Treasuries coupled with a decent position in international bonds. Our current equity exposure is limited to the US and has been centered in the S&P 500. As always, please let us know if you have any questions.
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