Federal Reserve's dovish stance likely to ease global liquidity conditions
The Federal Reserve surprised financial markets in its recent FOMC meeting by delaying the start of tapering its asset purchases. The Fed justified its dovish stance by citing a tightening in monetary conditions, rising fiscal shock concerns, persistently low inflation and uncertainty over U.S. labor data. The Fed backed away from the 7% U.S. unemployment rate threshold for ending its quantitative easing program. In addition, the Fed lowered its growth projections for 2014 (2.9-3.1% GDP growth from 3.0-3.5%) and guided for a gradual pace of Fed Funds rate hikes in the 2015/16 time frame (i.e. 100bp/year or less). The Fed Chairman also emphasized that asset purchases are not on a preset course and are data dependent. Interest rate sensitive securities and global equities reacted positively as a result of this surprising policy shift; pushing the S&P 500 to a new high at 1725 and containing the 10 Year Treasury yield around 2.75%.
The market is questioning whether the Fed’s dovish decision is warranted at this stage of the economic recovery. The fiscal and monetary accommodation has certainly been significant since the onset of the 2008 financial crisis. As the Dallas Fed estimates show below, there has been a substantial output loss as a result of the crisis and the pace of the recovery has been weaker vs. previous cycles. GDP growth has been tepid in both real and nominal terms. The labor market recovery has shown some cyclical strength but in general it has been uneven in terms of the quality of jobs produced. As the baby boomer generation starts to retire, demographic headwinds are likely to accelerate. On the other hand though, household wealth has recovered meaningfully due to the rebound in housing and securities such as U.S. equities. Most likely, the Fed delayed its tapering decision due to the upcoming fiscal battles in Washington. From our perspective, we seek to be opportunistic if the fiscal debates cause near-term volatility.
As we discussed in past articles, the Federal Reserve is likely pushing on a string at this stage. Its quantitative easing program is simply facing diminishing returns. Despite abundant liquidity, excess reserves in the banking system exceed $2 trillion as the demand for credit remains fairly tepid. Credit creation measures such as money supply seem to be trailing off recently. Moreover, velocity of money i.e. the pace at which money changes hands in the economy is making multi-decade lows. Perhaps most of the Fed’s recent accommodation is felt overseas. Since the May tapering hints by the Fed Chairman, emerging markets have witnessed sizable capital outflows and increased volatility across asset and forex prices. Thus, in the medium term, apart from U.S. housing, emerging markets are likely to benefit from the Fed’s latest dovish shift. U.S. multi-national equities are likely to benefit from increased stability in global liquidity conditions.
Fed asset purchases have certainly helped on the margin in terms of risk taking in U.S. equities. Moreover, corporate capital allocation programs have been meaningful e.g. buy-back programs in the tune of $0.5 trillion/year. Fundamentally, the S&P 500 has kept pace with earnings and sales growth. From our perspective, we remain selectively positioned and we keep a strong focus on bottom-up valuations. At the sector level, we see value opportunities in sectors such as energy, technology, healthcare and late-cycle industrials. We continue to avoid expensive sectors such as consumer discretionary, staples and small caps. We maintain our bias towards cash rich large-cap equities with visible earnings growth and a history of dividend growth.
In conclusion, global liquidity conditions are likely to enjoy a reprieve in the medium-term. The market’s focus is likely to shift to the upcoming fiscal debates in Washington. We remain in an opportunistic mode and look to take advantage of favorable risk-reward opportunities that appear across both the equity and fixed income spectrums.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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