Dear Santa Powell,
Merry Christmas to you and the elves at the Fed! We know you get lots of letters this time of year, but this one is important.
It’s not easy being an investor these days. We’re experiencing a slowdown in global growth. The trade war with China continues. Oil prices are plummeting. Europe is a mess. Brexit is not going well, there are problems in Italy, and France is grappling with the Yellow Vest protests. The political divide in America is widening and we have a President who is facing multiple investigations, perhaps with more on the way as the Democrats take over in the House. Russia has seized Ukrainian naval ships off Crimea. There are reports that the Chinese have hacked the Marriott database. The stock market is now in negative territory for the year. Small cap and emerging market stocks are in a full-blown bear market. The high-flying FANG stocks, which had been leading the bull market, have declined sharply. GE is in trouble. Even Apple, which has become the new market bellwether, is doing poorly. The risks of a recession have risen. And yet, in the face of all this, you’re continuing to raise interest rates.
The combined liquidity drain from raising rates and reducing your $4.5 trillion balance sheet is taking a toll. Stanley Druckenmiller, Ray Dalio, and Jeffrey Gundlach all agree – monetary policy is way too tight.
We’ve been told that the key to an effective “Dear Santa” letter is to not ask for too much. Maybe one or two things. All we ask for this Christmas, then, is the top item on our wish list … a pause. That’s it. We’re not even asking for a rate cut. Just a pause. You say you’re “data dependent”. Well, the data seems clear. Can you please just hold off on hiking occasionally in 2019? That’s all we ask.
Yes, we know President Trump has said monetary policy is too tight as well. He’s even called you crazy (and, just for good measure, “loco” too). We firmly believe you must maintain your independence from the administration. Politics should not interfere in your decision-making. But, do it for us. And if not for Wall Street, do it for Main Street. We’re telling you the economy can’t stand many more rate hikes.
Oh, one more thing to mention … we’ve been good this year (at least by Wall Street standards).
Sincerely,
Wall Street
P.S., We left some cookies and milk by the fireplace
In last quarter’s commentary, Naked and Afraid, we wrote about investors’ concerns over rising interest rates. At that time, investors were spooked by a sharp and sudden spike in interest rates. The yield on the 10-year U.S. Treasury bond had risen from 2.41% at the beginning of the year to 3.23% in late October. Back then, investors feared that accelerating economic growth could lead to higher inflation, thereby causing the Fed to raise interest rates more aggressively than expected. This caused a sharp sell-off in risk assets, including an 832-point decline in the Dow Jones Industrial Average on October 10th. It’s been nearly all downhill ever since (although for various different reasons at different times).
In our commentary, we noted that we felt that investors’ fears were understandable, but largely overblown. We didn’t expect accelerating growth to lead to runaway inflation and aggressively rising interest rates. Rather, we expected growth to moderate somewhat as the tax cuts began to fade. This appears to be exactly what is happening now. There are signs that growth is slowing. And, not just in the U.S., but globally as well (in part due to the trade war). Interest rates have not continued to rise as investors feared, but rather have declined instead. The yield on the 10-year Treasury bond is now 2.82%, down from the October high of 3.23%.
The market appears to be sending the Fed a message. The question is whether the Fed is listening. Hence, the “Dear Santa” letter above. To be fair, today’s rate hike by the Fed of 0.25% was well-telegraphed in advance. In Wall Street parlance, it was “already baked in” – like a mincemeat pie on Christmas Day. As veteran UBS floor trader Art Cashin predicted, the Fed likely didn’t want to be seen as being bullied by Trump. All eyes are now focused on 2019. Will the Fed hike in March or pause and wait until June? Will they hike in September or pause and wait until December? For our part, we expect that the Fed will pause during 2019. We expect only two rates hikes next year, instead of the four that we got this year.
Why do we think the Fed will pause? Unlike his predecessors, Janet Yellen and Ben Bernanke, Jerome Powell is not an academic. Rather, he comes from Wall Street. You might say, he’s one of us. He doesn’t have a Ph.D. in economics, but rather a degree in Politics from Princeton and a law degree from Georgetown. But, this doesn’t mean he’s inexperienced in economics or Fed policy matters. He was an investment banker, a private equity investor, served as Undersecretary of the Treasury, a visiting scholar at a Washington think tank, and a Fed Governor since 2012. The point is that as a veteran of Wall Street, with government and Fed experience under his belt, rather than a strictly academic background, he’s less likely to slavishly adhere to a policy stance based on econometric models in the face of economic data that otherwise contradicts those models. The belief on Wall Street is that he’s ultimately a pragmatist.
If the Fed pauses in 2019, as we expect, this should help reduce the risk of a recession. It means the dollar may finally stop rising, which would be good for international and emerging market stocks. And, it means bonds will no longer face as much of a headwind from rising rates as they have in the past. And, it should help the stock market stabilize and ultimately rebound as investors realize we’re in a Goldilocks economy – “not too hot, not too cold.” All of this would be good news for investors with diversified portfolios. Nearly every asset class is down this year, which is highly unusual, and in our view, not likely to last.
As we’ve written before, we think the economy is in pretty good shape. What we’re experiencing right now is a growth slowdown, which is causing an adjustment to asset values. We don’t see a recession on the horizon – at least not in 2019. Instead, we see continued economic growth, albeit slower than it had been previously, but decent growth nonetheless. If the Fed pauses, and the economy continues its growth path, stocks and bonds should rebound in 2019. But, we’re ever-mindful of the risks out there. Rest assured, as always, we will be watching things very carefully, and reacting accordingly.
While we don’t think Jerome Powell is likely to be swayed by a tweet from Trump, since he wants to maintain the Fed’s independence and steer clear of politics, our hope is that a respectful “Dear Santa” letter from Wall Street might have the desired effect of triggering a pause, and that would be a good thing for Wall Street and Main Street.
And now, on to that letter to “Santa Trump” asking for an end to the China trade war …