As you know, so many times over the last two decades I have discussed the FED’s seeming inability to properly manage monetary policy, using the analogy of running the car from one ditch to the next.
Recently I wrote that I wanted to introduce them to the ‘next’ ditch. The ditch of the next recession. “But Chris, we’re not in a recession.” While that may be true, what is also true is that the “recession” will not be identified until long after the recovery has started. The fine folks at NBER (National Bureau of Economic Research) will identify at some point in the future when the recession started and when it ended. Of course, by definition, you can’t note when the recession ended until it ends. Therefore it will be largely useless information to investors when it gets published.
As investors, we want to look toward the future to try and figure out what the economy and business environment will look like in the next year, two years, five years. We know that nobody has a crystal ball and nobody can truly see the future, so we must make educated guesses based on historical precedence and experience.
There are no worse indicators than the backward-looking ones. You know, the ones that says what you should have done. The same ones that said you should have kept that really cool 1969 Camaro (or name your first car that’s now a collector car). Then again, we have to make choices and sometimes those choices require giving up something to get something (like risk and reward).
We use a lot of behavioral finance indicators to tell us how investors are feeling, and we’ve shown you some of those charts before. Here’s a quick look at the charts as they currently stand. You can see that the AAII survey is very bearish (which conversely is a good thing).
The Fear and Greed index is saying the same thing. “Buy when others are fearful.”
But sometimes, it is just as important to figure out not what investors are saying/feeling, but what they are actually doing. If you think about it, I can say I’m concerned about the market, but if I don’t change my allocation, is that really a concern? Here are the recently updated numbers from the FED.
So it appears that investors have gotten more conservative, although a nearly 20% pullback in the markets may by itself have pulled that number down a bit. Still, work needs to be done in order to get to historically attractive levels. With the FED reinforcing the behaviors of investors that they will always come in a bail out the market, it would have paid to just be long and ignored the markets over the last 15 years.
Has the FED changed? Well, not if you look at their recent action regarding the banking system. If you remember, the FED has been reducing its balance sheet that exploded because of COVID. It has been removing $95 billion per month from their balance sheet.
In case you can’t see, here is a blown up view of the last 2+ years.
You can see from the chart that the FED was reducing its balance sheet, like they said they would. But then all of a sudden, BAM! SVB went bankrupt and the FED, in just a few days, infused half of all the money they reduced from their balance sheet.
So once again, the FED has managed to reinforce the idea that the FED will backstop every economic issue that comes up, including the ones they helped manufacture. By the way, can they really come in and say they helped secure the banking system when they were a big part of the reason it happened in the first place? Now, I’m not making an excuse for the poor job that the bankers at SVB did with their Treasury portfolio, but keeping interest rates near zero for an extended period and then raising them at a speed never seen before has to bear some of the blame!
The FED’s tools, be it interest rate manipulation or monetary stimulus (both positive and negative) are the only levers for them to pull. We have often said, “If the only tool you have is a hammer, every problem looks like a nail.” In this case, monetary levers are their only tools. Nobel Laureate Milton Friedman once said:
So let’s take a look at money supply and test his thesis.
Money supply spiked to 25% during COVID (the spark that lit the inflation fire) and now has been negative for the last few months. As you can see above, when the money supply increases, we get lots of growth and possible inflation (or at least higher inflation than we previously had). When M2 goes down, the economy slows and inflation slows down as well. We are now in the ‘economy slows’ phase of the cycle. With that, is the market expectations that the FED will begin cutting interest rates (see the blue line below).
Compare that with the ‘Dot Plot’ from the FED. Notice they don’t expect rate cuts until late this year or 2024. The market expects the FED to cut rates in the next couple meeting.
The FED continues to say that rates will stay higher for longer and not to expect interest rates to come down too fast. That is a big disparity that will have to get reconciled. Either the market adjusts up (would be bad for the market) or the FED starts cutting to match the market (which means the economy is in worse shape than they believe). Either way, it seems like the equity markets are too sanguine right now. Time will tell. With short-term interest rates as high as they are, we are still pretty comfortable with our overall equity exposure and the resulting volatility.
The lingering question has to be how does inflation come down if the FED continues to stimulate the economy with lots of cash? I’m no Milton Friedman, but I think he would say it’s very unlikely that happens. Without anchoring to a higher rate of inflation, something’s got to give. Low inflation and a recession or higher inflation and no recession. I don’t think you get to have your cake and eat it too in this case.
Have a good week and as usual, if something doesn’t make sense or you want clarification, let’s talk.