article 10-24-2016

Is The Fed Out of Options?

Portfolio Manager Charlie Dreifus explains the Fed's conundrum, why there's too much hesitation in the market and economy, and the challenges to subsequent growth.

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The Fed's Conundrum
The market outlook remains fragile. High valuations, a choppy economic outlook, record profit margins, and little if any foreseeable earnings growth all combine to suggest that the market is likely to recalibrate lower if a significant black swan should appear.

There are many structural problems around the world yet central banks are left with fewer tools to deal with them. Could a longer, slower-growing U.S. economy push country "x" off the rails? These higher global risks would perhaps result in lower P/E's despite the positive of lower inflation and record-low interest rates as a result of that risk off environment.

It is not surprising, therefore, that the TINA (There Is No Alternative) principle remains in effect—equity valuations vis-à-vis U.S. Treasury yields remain the primary (only, in my opinion) prop to valuations.

I believe all would agree that action was needed during the Financial Crisis. What causes concern is the central bank's actions eight years after the crisis.

The Fed faces several critical questions: Is this framework, as well as the models it uses, useful in our current situation? Has something fundamentally changed that calls for new protocols? Should the inflation target be lifted significantly higher than 2%? Should we change from an inflation target to a targeted nominal GDP growth objective?

Perhaps we are simply stuck until the answers reveal themselves. All of this stems from an acceptance of the neutral Fed Funds rate—a level that neither stimulates nor slows the economy—that has been, and is likely to remain, very low.

Thus, the Fed cannot really raise interest rates by any significant degree for quite some time. This will keep the yield curve flattish and inflation expectations low.

The Fed wants, and perhaps needs, a higher neutral rate because it would allow the central bank to raise rates higher, thus providing more ammunition to fight the next recession. It also means that the Fed's balance sheet does not shrink until the neutral rate rises.

The animal spirits are missing, amid too much uncertainty to take chances, it seems. This lack of risk taking also makes traditional monetary policy less impactful. In fact, some have coined the phrase "stagnation light" as an apt description of the current economic situation in the U.S.

The current situation deepens the conundrum for the Fed in that the risks are asymmetrical. If the Fed tightens too early, it's likely to prove a significant policy error, while tightening too late may not be nearly as consequential. The Fed has many tools with which it can tighten; however, at this point it has too few to ease at its disposal.

Too Much Hesitation
To me, hesitancy has become the lowest common denominator to the situation in which we find ourselves. Investors are hesitant to have high equity or long bond exposure, consumers are hesitant to purchase, and CEOs are hesitant to invest (and borrow) for M&A or capital expenditures.

The current environment has perhaps led investors to become complacent in accepting relative valuation. However, the market can, and no doubt will at some point, recalibrate and seek a margin of safety that will cause shares to decline, perhaps significantly. This is why I believe that downside protection is especially important today.

We are in Humpty Dumpty land where all the monetary policy in the world cannot make economies whole again. Given the response to monetary policy, as well as aging demographic and productivity/reform issues that need resolution, we need fiscal policies.

A repatriation deal, should it materialize, could move the needle. The amount overseas today is four times the amount what it was in 2005, the year of the last repatriation deal. At that time, half of the amount eligible was voluntarily sent back to the U.S., and both the dollar and the market moved higher as companies raised dividends, repurchased shares, entered into M&A (mergers & acquisitions), made capital investments, and paid down debt.

There was also substantial job creation following the 2005 tax holiday. The arguments in favor have been building. The main ones currently are that it would provide fiscal stimulus and infrastructure financing while taking away potential from the EU tax grab and considerably slowing tax inversions.

Yield repression, and not net income growth, has allowed the market to rise via advancing P/E ratios. Can this be sustained? Emotions often rule the market's direction and movement. Consider the Tech Bubble of 1999-2000 and the delusions surrounding powerful profit or sales growth expectations.

Today's ruling emotion is desperation that's fueling the search for yield. Is this another delusion? Perhaps not. If we face low growth for an extended period, inflation and yields will likely remain low. Simply put, we need economic growth to increase revenues and that, along with productivity, would allow for meaningful earnings growth. It's the only way out of this mess.

In my opinion the only metric that shows the market as being anything other than fairly priced or overpriced is the alternative yield on so-called risk-free bonds. However, these risk free-returns, some of which are actually negative, may be a faulty measure as they continue to be suppressed by central banks.

The Growth Challenge
As mentioned, we ultimately need earnings growth for stable or higher markets. For that, we need revenue growth, and for that we need improvement in nominal GDP growth worldwide. At this point, all of this is hard to envision.

Right now we are faced with extended market valuations and extended profit margins, offset by low rates that are the result, however, of weak growth worldwide. It is clear that earnings need to advance for equities to make any significant move higher. As we have explained, this may be a challenge for the near to intermediate term.

This does not mean that companies might not report higher earnings per share, and this is where our deep dive into governance and accounting will add value. Companies that resort to embellishing their results will face a day of reckoning. We will be avoiding those companies and will thus miss their subsequent fall from favor.

The market desperately needs top line revenue growth. It is inevitable that earnings will decline further without it. And with little room for rates to decline, that would leave nowhere for the market to go but down.

This is why fiscal measures are so very important at this juncture. The concern over the lack of sustainable organic drivers of growth is real and unfortunately still lacks a solution. As expectations for economic improvement continue to get pushed out in time and/or reduced, the greater the chance of secular stagnation, with the resulting pressure on earnings.

We believe that companies with high-quality financials, stable prospects, and (hopefully) rising dividends will prove to be attractive havens. Are large-cap dividend-paying stocks the new form of long-term bonds? Are these (hopefully growing) dividends sufficient to overcome the equity market’s higher volatility?

We continue to be on the prowl for companies that can, and often do, increase their dividends annually. If one is selective and does not overpay, these companies can offer the unusual combination of higher total returns with less risk. Payout consistency is a good proxy for overall safety, particularly when combined with a deep dive into the financials that reveals conservative, transparent accounting as well as good governance.

We remain concerned about the overall market's high valuation, and thus the potential selloff that a black swan event could set in motion. However, we also think that these issues are somewhat offset by both the demonstrable absolute attractiveness of our portfolio and the likelihood that rates will remain low longer.

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