A return to volatility Part IV

Updated: Apr 23

Written by: Jonathan V. Bever


It is now August; again, I find myself in Tokyo for a series of meetings. While I have friends here who are close like family, it is nice to get text messages from back home to feel connected in both places while only in one. Being here, I thought it would be an opportune time to update our blog: a follow-up to "A Return to Volatility Part III." There are several points to re-address, so the title remains consistent.

So, let’s begin by looking back at our February blog, which reflected on the volatility of the last 2 quarters of 2018. The stock market had been rocked by a serious of rate hikes by the Federal Reserve and their unrepentant desire to raise rates even more. If that wasn’t enough, they were also reducing their balance sheet. The reduction of their balance sheet is called Quantitative Tightening (QT), while an expansion of their balance sheet is Quantitative Easing (QE). Rate hikes and QT are like putting the brakes on while you are driving. The ended desire is to slow down the economy, but not to stop it or put it in reverse. This is done to fight inflation. A classic example of inflation is labor inflation. A simple supply and demand example works here. The more demand for labor in a low unemployment environment can lead to higher wages. However, we are arguing that labor inflation is not the most important variable; rather, in the new environment of QE and the desire to keep the Fed Target rate low, commodity inflation must be kept low; specifically, crude oil inflation must be kept in check. In February, we argued our thesis that Quantitative Easing and a low Fed Fund Target rate are a Faustian Deal, which once done is nearly impossible to get out: Good luck! The stock market stability or volatility proves our point.

Further, arguing the Fed would eventually cut rates, end quantitative tightening, and begin Quantitative Easing; ultimately, the Fed will take back all the rate hikes and all QT. We are not concerned with the rhetoric or excuse used to begin another round of QE, whether it is to save financial institutions or merely to provide liquidity. QE is QE. We believe this has nothing to do with political pressure; rather, it is the new monetary policy from which there is no escape outside of major global geological reset.

Rather than argue the validity of debts being too high or too low, or that negative yields seen around the world are sustainable or not, for now, we are accepting the current aberrations as the new “new normal” and remain diligent as we navigate these uncharted territories. The chart below illustrates our thesis.

The red line on top: The Federal Reserve Balance sheet which was being reduced (QT) and now is not only not going down but is increasing (QE). The blue line under The Fed Target rate and the 2 cuts done so far this year. Looking back, it is easy to see how the economy was slowed by rate hikes and QT- much like the brake calipers on a car squeezing the rotor to slow down.



Our argument holds: the rate cut cycle has begun, and so has QE. The next chart is the same, but we have added the S&P Index to show how the market advance has slowed, as one might expect as rate hikes and QT are intended to slow down the economy and has its effects on the company earnings.





Let’s go back to our blog from May: here we argued crude oil inflation is the real Achilles Heel to our economy which depends on the economic policy of money printing (which we currently have no escape plan). An escalation of conflict with Iran could lead to a spike in oil prices, which could prove problematic. To validate our concern regarding the importance of oil prices, after Iran allegedly brought down one of our drones Mike Pompeo was on CNBC shortly after that event and to paraphrase said: “some on Wall Street claim oil could spike to 150 a barrel if things with Iran escalate. We are taking measures to make sure there is plenty of oil and that oil prices remain low.

See link:   https://www.cnbc.com/2019/05/23/cnbc-transcript-united-states-secretary-of-state-mike-pompeo-speaks-with-cnbcs-squawk-box-today.html

Additionally, this September there was another alleged attack by Iran on the Saudi Arabia oil fields. Oil prices spiked immediately. Again, Mike Pompeo was on CNBC reassuring the public that there is plenty of oil and that oil prices would moderate.  QE is not the only reason to keep oil prices moderate. There is a direct correlation with the price of gasoline to the strength or weakness of our economy. According to the Atlantic: “Each 50-cent increase in the price of gasoline adds almost $60 billion to annual consumer bills…”


See link:  https://www.theatlantic.com/business/archive/2012/03/the-110-effect-what-higher-gas-prices-could-really-do-to-the-economy/254386/


Nonetheless, we reiterate our thesis that low inflation is a requirement, specifically crude oil inflation if we are going to continue to lower rates and begin another round of QE. Recession?

Lastly, we argued in our prior blog, when the Fed Target rate gets above the 5-year treasury yield, then within a year the probability of a recession greatly increases, but it isn’t a necessary conclusion. With the Fed putting liquidity back into the economy as we mentioned above, our hope is that we avoid a recession.



However, the Manufacturing ISM Index (Institute for Supply Management) has been under 50 for August and September. Above 50 is a sign the economy is growing and under 50 is a sign the manufacturing segment of our economy is contracting. The September ISM is 47.80. This number has not been this low since 2009. The good news is the weak manufacturing ISM leaves the door open for the Fed to cut rates anytime.

See chart: Top black line: S&P. Greenline: ISM



Tax cuts, low gas prices, low unemployment, a steeping yield curve, a Fed begins QE. While we do not see a recession necessarily coming, we have seen what some call an earnings recession. Many companies in the market have either missed their earnings estimates or lowered them. This is reflected in their stock price, as many good companies are not reaching new highs and are struggling to get back to their all-time highs. We believe this has created an opportunity for long term investors. We are cautious short term as volatility should persist as: could be more downward earnings revisions, tariff rhetoric, impeachment rhetoric, week ISM, and money managers implementing risk-on and risk-off strategies.

In short, volatility is here to stay for the foreseeable future. Keep an eye on the duration of sovereign debt, increase cash to reduce volatility, look for companies that may have bottomed in their earnings cycle, for companies with strong dividends, and consider total return strategies.



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