Written by: Jonathan V. Bever
This is a follow up blog the last blog, “Return to Volatility: Part II”.
As I sit in a swank coffee shop in Tokyo, drinking my cappuccino (listening to Bill Withers “Lovely Day”) I am feeling unusually cool, I am puzzled why I am not out sightseeing rather than working on my blog. The answer is obvious, our human condition is to find the balance between work and leisure.
Of course, getting paid the right price to commodity our leisure by exchanging it for work is an endless debate. Some DC politicians think we can print money ad infinitum (giving leisure to those who are not productive); which of course leads to ad absurdum; so, let them make their argument so we can move on to repairing our economy with common sense.
I am getting off track regarding volatility.
Anyway, I find making my work as leisurely as possible gives me hope that one day I will have more leisure than work. Further, I know there is special Sakura Sake ordered for the sake tasting later tonight, for which I am looking forward. Why write a blog at all? Writing helps to organize thoughts and make sense of what we experience. Perhaps like uncluttering one’s home, writing helps to unclutter the mind.
The last two quarters of 2018 will be remembered as the return of volatility since Quantitative Easing (QE) began in 2009. The stock market seemed to fluctuate by a high percentage each day in both directions as the end of year Holidays approached. There was no market trend to bolster investor confidence and assuage investor’s apprehensions. A market with a trend, lends comfort, as it’s sign posts provide an understanding of what to expect next.
So, a market up one day and down the next, cascading lower is unnerving; likewise, to de-risk in a storm is also unnerving as the potential for some unexpected good news could send the market right back up, having dumped investors off at a near-term trough. Market fluctuations emboldened the “perma-bears” to believe that not only is a recession coming, but also, we just might already be in one. Of course, the economic data the Federal Reserve uses to justify rate hikes were not flashing recession. So, how do we make sense of what’s going on and find our compass to find true North.
One attempt of this blog is to get at the nature of volatility, which is easier said than done, because there are not necessarily a finite number of causes. There are many causes as there are new innovations, investment products, public sentiment, Fed policy etc. The more we understand the cause of, or absence of, volatility the better we can build our asset allocation or stock portfolio. The absence of volatility can be negatively described as complacency. However, we believe it can also be that a balance of variables has been achieved; to name a few: interest rates, inflation, stock market Price/Earnings ratios, National Deficits, Federal Reserve policy, currency prices and this list can keep going, but you get the idea: perception of balance. In the prior blog, we argued the Federal Reserve by raising rates, and unwinding Quantitative Easing (called Quantitative Tightening) meant they were trying to get out the Faustian contract it made, and the stock market reacted violently at the end of 2018; and it wasn’t long before the Fed did its historic “pivot”.
As mentioned in the previous blog, oil prices sold off from the summer high above $70 on West Texas Intermediate (WTI) to around $50. This is not inflationary. Further, as you will see from the chart below, lumber prices fell in half from over $600/1,000 board feet to around $300. My friends in the lumber business keep me on the pulse of their industry (more about lumber in another blog).
Source: Bloomberg
Again, this is not a sign of runaway inflation. So, why was the Fed so nervous that they felt the need to get ahead of the inflation curve to raise monetary interest rates in December 2018?
We argue, it turns out that commodity prices are very important, and just might be the Achilles Heel to money printing and low interest rates if it causes an unexpected spike in inflation. Let’s not forget our National Deficit keeps climbing, therefore it is imperative that rates stay low on the one hand, but not too low that inflation spikes.
We believe the Fed is correct to be concerned with inflation. It is possible that the Achilles Heel of the Fed is inflation especially an unexpected spike in inflation. Specifically, we argue oil inflation is the real Achilles Heel. Looking back to 2005 WTI oil prices went over $60 a barrel for the first time. The Fed Target Rate was pegged 2.48% in March 2005 and by July 2006 went to 5.25% and would remain elevated. The situation worsened, crude oil prices continued to climb to $140 by June of 2008. According to Reuters oil hit an intraday day high of over $147 on 7-11-2008. When financial trouble began in 2008, the then Fed Chair Ben Bernanke, was criticized for raising rates as much as he did in the years leading up to the crisis.
Source: Bloomberg
We probably can all remember the financial crisis that followed later that year and into 2009. Interesting to note, oil prices really didn’t collapse until after Lehman Brothers collapsed on September 30th, 2008. It has been debated why Lehman wasn’t bailed out like all the other mega cap US financials.
Source: Bloomberg
We argued in early January 2019, the Fed would eventually cut rates and go back to QE; we had no idea the “Fed Pivot” would happen shortly after our blog in January of 2019. Nonetheless, we were right. The Federal Reserve Chairman was on television with the prior two Fed chiefs Ben Bernanke and Janet Yellen, assuring the public that the new Fed will be patient and data dependent rather than follow their Dot Plot. Basically, this gave the perception the Fed would leave enough stimulus to keep the economy from derailing. The rhetoric worked; since then the stock market has recovered, and volatility has been put to sleep. However, don’t go to sleep as an investor. In our prior blog, we argued that the Fed target rate being above the 5-year treasury is not good news a year out as historically this portends a recession is highly probable. A Fed raising rates further would make a recession much more likely. It remains to be seen if the Fed will have another rate hike this year. We argue the Fed will end their rate hike cycle, end Quantitative Tightening, and ultimately cut rates and begin another Quantitative Easing cycle. This could lead to a period of transition as the Fed finds the balance for the right amount of liquidity in the money supply. It is possible as we see how nimble the Fed is, the economic cycles are much shorter. There is plenty of fodder for bulls and bears to argue over.
We believe the Fed can put as much liquidity in the market as they feel is necessary. However, we also believe their Achilles Heel is the price of oil. If the issues with Iran escalate and oil prices spike the unintended consequences might be exactly what you think: Inflation.
Our thesis remains: have extra cash, hold quality equity investments, and modestly increase your duration a little with highest quality fixed income. Eventually, the transition will run its course, so long term investors can accumulate, traders can trade, and for the foreseeable future let volatility be your friend not your enemy. Kanpai!
Disclosure:
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.