July 21, 2014

RMG Wealth Management LLP

We sense that the US Federal Reserve is shifting away from a dovish stance, inspired by Chair Janet Yellen, and towards a more balanced position. Although this did little to immediately upset equity and bond markets, we do believe that this shift in policy is important in the big picture.

Financial markets have become very complacent that The Fed will remain ultra accommodative (aided by ECB and Bank of Japan QE) and we wonder whether a correction will finally arrive once markets fully understand the changing Fed policy stance.

So, what is new at the Fed? As we have outlined before, the dual mandate of maximum employment and low inflation is close to being met. With the economy now back to a more normal state, policymakers are beginning to think monetary policy needs to be normalised as well. This thinking is obvious in comments by regional Governors although had been absent in Yellen’s comments until last week’s semi-annual testimony on Capitol Hill,  when Yellen said “If the labour market continues to improve more quickly than anticipated, the increases in the federal funds rate likely would occur and be more rapid than currently envisioned,”

The unemployment rate has fallen fast, from 7.5% to 6.1% in the last year. Moreover, with the participation rate steady since last October, this reflects genuine jobs growth. We believe that the unemployment rate can fall below 6% in the next few months – a full 15 months ahead of the Fed’s recent forecasts. There are also signs of labour shortages which are leading to pockets of wages growth.

If this becomes more widespread as the unemployment rate continues to fall, the Fed will have to act very quickly to avoid being even further behind the curve.

There is no doubt that Yellen has been more dovish than we had hoped, but she is shifting her stance here more into line with the regional Governors and perhaps also her new deputy, Stanley Fischer. When might this more hawkish FOMC become more publicly apparent? We see three key dates; the next two FOMC meetings on 30^th July and 17^th September and the Jackson Hole symposium at the end of August.

Not only did Yellen shift her stance on future monetary policy, she also noted “stretched” [i.e. bubble] valuations in certain sectors in the equity market and confirmed that they were “…closely monitoring developments in the leveraged loan market,”. Investors in Junk bonds certainly heard this message as junk spreads widened by the most since the taper tantrum last year. As can be seen in the chart below, there is a strong correlation between junk spreads and the equity market. In fact, before major equity market highs the junk spread often starts to widen before the equity market peak. This makes sense as the liquidity in Junk bonds is almost non-existent when the tide truly turns, and so investors need to sell before the real turn down in risk taking is more obvious. We view the current junk spread widening as yet another ominous sign for the equity market.

There can be little doubt that the US equity market is expensive (even the widely, and in our view incorrectly, used forward PE is higher now than in 2007, and with profit margins 70% above the long term average) and we believe more bubble-like than many would care to admit. What causes investors to rethink their equity holdings at this stage in the cycle is the price itself. By this, we are saying that the next 10% correction could be enough to break the current bull market and morph into a much larger bear market. This “selling begets more selling” thesis can be illustrated in the chart above which shows the S&P 500 with NYSE margin debt.