Monday, 23 July 2018

Fed fallout

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Jim Saft says the taper may be vindicated but watch from a distance.

Sure, the Federal Reserve will probably carry on tapering, and sure, they may ultimately be vindicated by better economic data, but it is hard to see why you, as an equity investor, should stick around to find out.

James Saft

James Saft

Reuters Columnist

Friday’s US jobs data, the worst by some measures in years, was the equivalent for the Fed of one of those scenes in a movie where the ground at the cliff face begins to give way beneath the hero’s feet.

Having just last month inaugurated what they and investors hope would be a stately and calm process of reeling back on the amount of bond buying the Fed does every month, beginning with a cut from US$85bn to US$75bn, the US central bank was unexpectedly confronted with some inconvenient facts. Not only were the payroll figures the worst in nearly three years, confounding market expectations, but the unemployment rate, which is at the center of the Fed’s policy of trying to manage longer-term expectations for when it will actually raise rates, fell to 6.7%.

That, just a hair above the 6.5% rate at which the Fed says is an important threshold in its thinking about when to raise rates, threatens to make a confusing mockery of the policy of “forward guidance”, under which it tries to anchor rate expectations by tying its policy to future economic data.

Look beneath the surface though and optimism is fast eroding. According to Thomson Reuters data nearly 10 times more companies are guiding earnings expectations lower than higher, the most on record.

This is all gripping stuff, and likely will transfix financial markets for months if not years to come, but the typical investor might be forgiven if she decides, by taking a bit of those fat gains from 2013 off the table, to make it more of a spectator sport and less a trial by ordeal.

There are plenty of good reasons for caution. In descending order, the first four: The Fed, which has launched itself down a chute which will be difficult to climb back up; the economy, which may not be playing along with the Fed’s desire to normalize policy; the stock market, which is expensive; and company earnings, which may be rolling over.

The Fed bathed in a warm sea of praise when it began the taper, with the general consensus being that, preceding Ben Bernanke’s exit as chairman by a month, the move marked a fitting end to a job well done and a crisis well handled.

The cost of a climb-down   

That may or may not be true, but what is incontrovertible is that the Fed now has a large investment in the taper in terms of its prestige and credibility. It will be psychologically difficult to climb down. Reverse course now and investors will quite rightly wonder what to expect next.

Everyone, especially central bankers, say they follow John Maynard Keynes’ supposed practice of changing his mind when the facts change, but everyone also hopes to heaven they never have to.

So we can probably count on the Fed to wait for more data to confirm their thesis of a slow but steady jobs recovery, while in the meantime financial markets will be forced to contend with the withdrawal of a real stimulus.

They also often wait too long. At the point at which the Fed’s psychological sunk costs in the tapering exercise are exceeded, they could find themselves expensively behind the curve of events.

Meanwhile the jobs data paints a picture of an economy which not only can’t produce jobs, but continues to have trouble producing gains in income for those lucky enough to be working. Hours worked are stagnant, as are earnings compared to inflation. And if you are looking for a hot field, look no further than temporary employment, but don’t expect benefits or job security.

And with the S&P 500 index trading at nearly 16 times investors’ rather optimistic expectations for next year’s earnings, we can’t say it is cheap. Nor do companies, especially in technology, look inexpensive when compared to sales. Company shares have risen in value at least in part because Fed policy encouraged money to flow into the stock market. Now that that flow is reversing, other factors will need to pick up the slack or prices will fall.

And now, with the Fed locked into tapering, at least in January, stocks may face a serious test in coming days as companies release their fourth-quarter earnings results. At first glance, investors are optimistic, penciling in an expectation that earning rise 7.3%. Look beneath the surface though and optimism is fast eroding. According to Thomson Reuters data nearly 10 times more companies are guiding earnings expectations lower than higher, the most on record.

Let the Federal Reserve stick to its guns, but you may want to be out of the line of fire.

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