US Central Bank becoming uneasy with distortions caused by ongoing monetary stimulus

In our last quarterly note, we shared an analysis demonstrating that the Russell 2000’s increased volatility in the first three months of the year, while unsettling, was not yet predictive of further declines.  At the time, our Navigator system was indicating that the bullish regime in US equities remained in place.  In the second quarter, despite similar ongoing volatility, the Russell went on to recover all of its losses and closed the first half with a year-to-date gain.   At the end of the second quarter, our system continued to indicate bullish sentiment in the US equity market. 


One year ago, in our July 2013 client note, we expressed a point of view that was rarely heard at the time, but which has since become widely accepted – that the Federal Reserve’s current monetary stimulus program supports equity prices and reduces financial asset volatility in a way that interferes with normally functioning markets.  In our October 2013 client note, we pointed out that US equities experienced significant volatility and drawdowns within weeks of termination of the past two QE programs.  The minutes of the Federal Reserve’s June 2014 Open Market Committee meeting indicated that the coming three months will be the final full quarter of the program, barring any unforeseen circumstance.  Unlike with the past two programs, this termination has been very carefully orchestrated and communicated, and the US economy appears to be on a better footing.  As of now, our Navigator system is not indicating increased equity market stress in anticipation of this event.  However the second half of 2014, and particularly the fourth quarter, will likely bring a further increase in equity market volatility as investors’ faith in the economy’s ability to support itself is tested. 

As has been true in the past several quarters, the US economy is giving mixed signals on which to judge this ability.  There are certainly many positive signs:  The unemployment rate has fallen steadily in 2014, with May’s rate of job creation the highest since the financial crisis began in 2008.  The ISM’s manufacturing and non-manufacturing PMI indicators have risen steadily in 2014 and are at levels consistent with growth.  The ratio of negative to positive pre-announcements by publicly traded companies has fallen from its all-time high - recorded late last year - back into a range more typical of a growing economy.  Perhaps most significantly, the $2.7 trillion of excess reserves accumulated by banks as they sold fixed income instruments to the Federal Reserve during quantitative easing is now finding its way back into the economy at an accelerated pace in the form of increased lending (see figure below). 

Fed assets chart.png

To date, this money has been sitting on bank balance sheets earning a paltry 0.25% annual return.  Although these excess reserves are technically an increase to the nation’s money supply, because they were not moving through the economy, they were not stimulative at all, and instead drove the money multiplier to the lowest level in over fifty years.  As this money is loaned out, it should increase the money multiplier and have a dramatic effect on money supply, GDP, and possibly, inflation.

But there are also signs that the economy may still be fragile, and perhaps not able to sustain growth without the Federal Reserve’s help.  The following chart of S&P 500 profitability by Yardeni Research indicates that corporate profit margins in this cycle may have peaked and begun declining.  A legitimate question is just what level profit margins would normalize to in the event of such a decline, given that the recent peak is higher than at any time in the post-war era.



The strong employment growth in June was driven entirely by part-time jobs; the economy actually lost 523,000 full-time jobs in the past month, indicating either that employers lack confidence, or that structural changes in the economy (such as increased benefits cost) may have longer lasting effects.  Although the rate of new home sales in the first five months of 2014 was nearly equal to that of 2013, new mortgage originations have been falling steadily since 30-year mortgage rates began rising in mid-2013.  In April 2014, originations reached their lowest point in 14 years, indicating that more homes sold today are being bought either by individuals using cash, or by institutions.  Finally, there is concern that China’s ongoing real estate decline – a 5.3% year-on-year fall in June following much steeper declines in each of April and May – will cause a slowdown in the broader Chinese economy and will possibly drag down growth across Asia. 

Regardless of the direction the economy takes, there are signs that financial markets may be in a period of unsustainable low volatility.  In 2013, corporate share buybacks reached their second highest level ever - $598B, versus the all-time peak in 2007 of $729B.  Jeffrey Kleintop, Chief Market Strategist of LPL Financial, estimates that these buybacks were responsible for half of the S&P 500’s EPS growth in the first quarter of 2014.  The rate of buybacks appears to be slowing - according to TrimTabs Investment Research, announced buybacks by all listed companies fell to their lowest level in two years in the second quarter of 2014.  The first half of 2014 was among the most active six-month periods in history for IPOs, behind only the first half of 2000.  As of the end of June 2014, the S&P 500 had gone 59 trading days without a 1% daily move in either direction, the longest such streak in 19 years (the streak was just broken as we finalized this note).  Mark Hulbert, writing in the Wall Street Journal, reported that US equities are more expensive now - on the basis of price / sales, price / earnings, and price / book – than at 85% of the 35 bull market peaks that have occurred in the past 114 years. High yield bond spreads versus treasuries are currently at their lowest point ever – even lower than before the financial crisis.  In the three months ended May 2014, the 10-year treasury yield fluctuated by no more than 20 bps, the narrowest three-month range in the past 35 years.  Finally, central bankers themselves have become more outspoken about the imbalances created by ongoing monetary stimulus.  William Dudley, Vice Chairman of the FOMC and President of the New York Fed, said the following in May: “Volatility in the markets is unusually low.  I am a little bit nervous that people are taking too much comfort in this low-volatility period.  As a consequence, they’ll take more risk than really what’s appropriate.”

In short, we believe our Mariner and Navigator strategies will continue to prove useful in protecting and growing your assets as markets adjust to the post-QE environment.