By Bill Adams
The US Major League Baseball playoffs which just ended have got me thinking about a rundown — when a runner gets stranded between two bases. We call that “getting caught in a pickle.” As the runner tries to return safely to the base behind him, defensive players try to close the gap and tag him out. After thinking about the volatility over the past few months, I have realised that the financial markets have been caught in the pickle, racing back and forth between risk-on and risk-off themes. Maybe the US Federal Reserve is the culprit.
The Fed recently met for their regularly scheduled September meeting. But there was nothing regular about this meeting. It was the most long-awaited and over-analyzed meeting in recent memory — one that ultimately ended with no change. The Fed threw the markets a curveball with commentary and economic projections that were much more cautious than expected. Initially, risk markets responded favorably, but then sold off. Since the meeting, we have seen considerable levels of volatility, as Fed officials try to explain themselves, but opening up their playbook could be doing more harm than good.
Today’s Fed strives for more transparency than any organization in history, speaking with the press each quarter, and offering detailed financial projections as well as their outlook for short and long term interest rates. Yet the more they communicate, the greater the uncertainty as the market appears to react with counter measures. What the Fed has actually achieved is a transparency of indecision. If this is indeed the source of volatility, then removing that uncertainty might permit markets to move forward.
So what have we learned since the Fed’s September meeting?
The Fed could have more than a dual mandate. In addition to full employment and low inflation, the Fed focused its attention on China and other emerging markets at the September meeting. Recent global events and financial market volatility were not enough to change the Fed’s view on US fundamentals, but they were strong enough to increase uncertainty. Hence the decision to leave rates unchanged. Investors can no longer focus solely on the portion of the US economy tied to exports. Our financial economy is inextricably linked to the global marketplace and the interconnectedness of that marketplace is stronger than ever.
Global central bankers are currency traders. Policy makers attempt to communicate their views on macro-economic conditions and potential changes in interest rate regimes to the market long before any decisions are made. Central bankers generally do not want to surprise the market, nor do they want to fuel unnecessary volatility. However, in the current market environment, the real and practical transmission mechanism of interest rate policy is the currency markets. The moves here are swift and impactful. Currency moves alter the competitive balance of a given country’s imports and exports, while also impacting domestic inflation dynamics. In short, central bankers plan rate moves, and the currency markets implement them.
The US dollar and credit spreads are doing the job of the Fed. A strengthening US dollar tightens monetary conditions for our economy. Additionally, the risks and volatility now evident in the US corporate credit market work to tighten financial conditions. So, regardless of any official interest rate policy changes by the Fed, monetary conditions are tightening. This will likely slow the pace of economic activity, and, ultimately, may keep interest rates in a “lower for longer” state.
The velocity and trajectory of rate moves trump the timing of the first move. Long term interest rates determine the cost of capital and should be a focus for anyone looking to value companies. In this regard, both the Fed and the market continue to reduce expectations further out into the future. For some time now, concerns have centered on higher interest rates and bond bubbles. Now the dialogue is increasingly moving toward how low and for how long.
Focus on fundamentals. Do not let the short-term, trading-oriented marketplace dictate your long-term investment approach. An investment manager’s time is better spent analyzing fundamentals, talking to companies and ignoring the noise outside their spectrum of control. Make good portfolio decisions for a long-term investment horizon; we believe fundamentals will win over this horizon. Anything can happen in a single baseball game, but in a seven game series, the better team usually wins.
I believe it is time for the market to embrace the Fed’s desire to begin the rate-hiking cycle. My baseball analogy, nevertheless, leaves a nagging fear. For the defensive team, the goal of a pickle is to get an out. However, if you cannot get the out, the aim is to, at least, chase the runner back to the base from which he started. Is the market chasing the Fed back to more accommodative easing, or do economic fundamentals really warrant more Fed-induced liquidity?
Bill Adams is chief investment officer, global fixed income at MFS
Comments