Liquidity and the Fed Balance Sheet
Over the last several years, advisers have been subjected to article after article saying the market is expensive and therefore stocks should be sold. And yet stocks have made new high after new high. At this point advisers do not need to be reminded that stocks are expensive. What would be helpful, obviously, is some guidance on either when, or from what level, stocks will begin to meaningfully decline. As long as the Federal Reserve and other Central banks can effectively freeze the business cycle in mid-uptrend, the “when” is not going to be anytime soon. It therefore makes sense to make sure the business cycle is not advancing to the point that central banks are forced to meaningfully tighten in order to head off inflationary pressures.
Right now we are facing a situation of mild concern. The point of maximum liquidity appears to be passing. The U.S. Federal Reserve is set to begin shrinking its balance sheet in October, and it plans to raise interest rates again in December. This has started putting mild upward pressure on interest rates, since today’s very favorable bond supply-demand condition will get modestly less favorable. The more interesting dimension to this move is its impact on the stock market. We have written several times about the three scenarios the markets currently trade on (most recently on August 30th). The somewhat hawkish turn by the Fed in theory marks a shift away from Scenario 1 (lower for longer) industries like technology and factors like low volatility, large cap, and growth in favor of Scenario 2 (cyclical expansion) industries like financials and materials and factors like small cap and value. In and of itself this is fine and healthy[i]. Hopefully, the market can spend significant time rewarding Scenario 2 stocks. At the very least, portfolios today should not have an overweight to growth relative to value, and low volatility as a factor should be de-emphasized.
If global investors begin to believe that the interest rate cycle has indeed turned, emerging markets are going to feel the pain as well. Rising U.S. interest rates usually (but not always) are accompanied by a stronger dollar, which reduces global liquidity. You can see this in emerging market debt prices in September. This bears watching. The long term bull case for emerging markets is intact, but EM funds are taking in a lot of money right now just as short term conditions as deteriorating. It’s our opinion that now is not the time to be adding to EM.
PIMCO’s Raising Fees
PIMCO has announced an 11 basis point hike in fees on its Income Fund Class D (PONDX), and a 5 b.p. hike to other classes of that fund. Given that the fund has just under $96 billion in assets, and that PIMCO is cutting fees on some of its other funds, the firm is indirectly telling investors, “We have more money in this fund than we want. Please move some to our other funds.” As annoyed as I am with PIMCO’s action, I do not have a suitable substitute.
Trends Don’t Last Forever
Just keep this in the back of your mind: The fact that the world central bankers have been unsuccessful in stimulating inflation in the post-crisis environment does not mean inflation is dead. Structural issues like an aging global population and a dramatic decrease in oil prices have been headwinds to inflation in recent years. However, it is not a given that those forces will remain strong three or five years from now. This bears watching because with the amount of debt the world has outstanding even a 100 basis point move higher in interest rates could negatively affect stock and bond prices.
[i] The market has shifted emphasis back and forth between scenario 1 and scenario 2 stocks for most of the past five years. By far the bulk of the time scenario 1 stocks outperformed, save the seven month mini-correction from June 2015 to February 2016 when investors shifted to scenario 3 (recession) – favoring high quality bonds and high dividend large cap stocks.