MorningWord 10/8/14: Central Bank Withdrawal

by Dan October 8, 2014 9:58 am • Commentary

The first rule for investing during our five year long economic recovery from the financial crisis has been “Don’t Fight the Fed”.  As crisis policy turned into monetary policy, there has been much debate about the effectiveness of QE on the real economy as opposed to merely the reflation of risk assets (see last week’s post by former chief Morgan Stanley economist Stephen Roach for a good discussion).

Monetary policy has had lots of positive effects on the real economy, including keeping the country out of a double dip recession while much of the rest of the world has struggled. But all of this asset inflation has disproportionately benefited a small part of our population, as corporate America continued to de-lever, cut costs and restructure, while real wage growth went sideways at best. Now that we have reclaimed pre-crisis levels in unemployment and claims (my take from Friday: MorningWord 10/3/14: America F@#K Yeah!!), it’s fairly easy to make the case that the “jobless recovery” wasn’t real but the “no-wage-growth recovery” is.

For those grading the Fed on their dual mandate to manage inflation and unemployment, it would be hard to say that after $3 trillion of asset purchases over the last 5 years with interest rates at zero the entire time, and a current rate of inflation (many would argue that we are on the precipice of a deflationary spiral and the Fed has been too focused on inflation risks that never existed) and the lack of wage growth, that the economy is on solid footing. But the pressure for the Fed to back off has been building. And we’re approaching a moment in time where the economy will test itself with out such massive training wheels for the first time in a few years.

For any of you that have NOT fought the Fed over the last five years, it may make sense to take a more skeptical view of the market from here on out, as what they do (or don’t) in the next few months could very well determine whether or not the U.S. falls into the economic malaise that it appears much of the rest of the world has fallen into.   I have little idea what they will or should do.  I am not an economist or a strategist.  But as you have heard us say on many occasions since the “Taper Tantrum” in May of 2013, it does not appear our economy or that of any in emerging markets are ready for Central Banks to back off, placing us in a fairly precarious place.

While there are no shortage of external worries (balls in the air if you will) the current threat from an Ebola outbreak in the western world could be the most significant potential issue (warranted or not,  my take on it from yesterday: MorningWord 10/7/14: Fearing Fear Itself) .  In the last few days, as cases of infected have been identified in Europe and the U.S. we have seen our share of specific industries curtailing business activities in certain areas of the world:

Bloomberg 10/8/14: London Mining Slumps as Bank Credit Dries Up Amid Ebola Outbreak

Bloomberg 10/7/14: Carnival, Norwegian Fall as Ebola Forces Ships to Reroute

Washington Post 10/6/14: U.S. will augment Ebola screenings for airline passengers in U.S. and Africa

You get the point, this could be just the tip of the iceberg on the panic, or the whole situation could die down very quickly.  Regardless, costs and lost business opportunities are mounting and that will be reflected in corporate earnings of the sectors most affected.

For months now we have seen some fairly dramatic volatility in emerging market and European equities, bonds, commodities, currencies and small cap / high valuation stocks. All while large cap U.S. equities have been a stalwart.  Largely because of the health of the U.S. economy on a relative basis, but also because most have been adept at playing the hand they have been dealt, from the most agressive Central Bank in the world the past few years. They have been buying back their own stock hand over fist, per Bloomberg:

They’re poised to spend $914 billion on share buybacks and dividends this year, or about 95 percent of earnings, data compiled by Bloomberg and S&P Dow Jones Indices show. Money returned to stock owners exceeded profits in the first quarter and may again in the third. The proportion of cash flow used for repurchases has almost doubled over the last decade while it’s slipped for capital investments

So at a time when the Fed is about to end their epic monetary policy later this month, our economy is on weak footing from external factors.  The S&P500 has been a safe haven, and as share buybacks may be running out of steam, we have seen the entrance of a new form of financial engineering in the form of the Corporate Split-Up (Ebay/PayPal and HPQ of late and many others being considered, like Symantec this morning).

These are not bullish signs as corporate America has struggled to orchestrate earnings growth at a time when sales growth has been hard to come by, and the recent rise in the dollar may be a double whammy for corporates as international demand declines and translated earnings back to dollars hurts EPS as well.

Despite the S&P 500 only 4% from the Sept all time highs, we have seen deterioration in some of the stuff that has gotten us here (aside from mega-caps). I am not gonna even detail the Russell 2000 correction, but here are a few others that are under the radar:

XHB nearing 52 week lows:

XHB 2yr chart from Bloomberg
XHB 2yr chart from Bloomberg

Sotheby’s, thought to be a beneficiary of the massive inflation in Art, nearing 18 month lows:

BID 2yr from Bloomberg
BID 2yr from Bloomberg

The first big break of the 200 day moving average for the MSCI World Index in the past 2 years:

MSCI world index, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg
MSCI world index, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg

Add in the decline in commodities and corporate credit, and the asset selling has taken on an indiscriminate character.  Few financial assets have been spared.  Perhaps the time is fast approaching when investors reconsider whether U.S. large cap stocks are such a good own when it seems that all other assets are aggressively for sale.