Volume 53 March 2015

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"We will be moving from an ultra expansionary monetary

policy to an extremely expansionary monetary policy."

-Federal Reserve Vice-Chairman Stanley Fischer

Ancient Greek playwright Sophocles wrote: “No one loves the messenger who brings bad news.” To wit, Sophocles would have had great difficulty explaining the domestic stock market over the past

six years as, ever since the Fed expanded its initial quantitative easing (QE) program in March of 2009, investors have not only disavowed this seemingly logical belief, but have actually celebrated bad news by pushing equity prices to ever higher levels.

For the most part, bad news has been treated as good news and vice-versa. This seemingly counterintuitive relationship between fundamental news and investor reaction to that news was both direct and largely indisputable until October of 2014, when the Federal Reserve announced the end of QE, and suggested that the first increase in short-term interest rates is likely to take place in 2015.

While the Fed had been so transparent in disclosing its intentions that this announcement certainly should not have been a surprise, it has nonetheless proven to be a game-changer in how investors respond to fundamental data. Prior to this announcement, the Federal Reserve was viewed as all important, and the influence of monetary policy literally dwarfed everything else. For so long as the Fed was committed to its policies of printing money and purchasing financial assets, nothing else really mattered. Bad news was interpreted by investors as good news because it meant that the Fed had little choice but to continue its very investor-friendly policies.

However, now that the Fed has told us that they are done with QE, it means that capital markets will increasingly be priced according to their own fundamentals rather than the tailwinds provided by monetary policy. That changes everything. Now good news is treated as good news, because it confirms that growth in the economy and in corporate earnings is increasingly sustainable, without the need to use the Fed as a crutch.

You can also make the argument that “bad news” is actually now being disproportionately treated as “extremely bad news” for two reasons. First of all, most equity and real estate assets are already selling at fairly high valuations from a historical perspective, which means that markets are likely to be very unforgiving of bad news because so much good news is already discounted into prices. The second reason is that, with interest rates already near zero and their balance sheet already bloated to potentially dangerous levels, there is

precious little that the Federal Reserve can do to stimulate the economy and/or the capital markets if the U.S. does start to slow significantly.

While the end of QE announcement (and the resulting change in how investors react to economic data) was made just over five months ago, its impact on the markets has been notably muted to-date. For example, while the advance in the domestic equity markets has lost some momentum since the announcement, stock markets have nonetheless continued to meander in a generally upwards trend. This makes sense, as the fundamental news has remained quite good over this five-month period, which supports the premise that the markets and the economy have indeed recovered sufficiently to stand on their own merits, and that they no longer require the support provided by the Fed’s aggressive monetary policies. However, there are now some dark clouds on the horizon that may cast some doubt on this optimistic premise.

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As we have stated in recent writings, the domestic economy and financial system have been the envy of most of the world. However, the economy has, on certain levels, also become a victim of its own success.

The fact that the U.S. started its aggressive monetary stimulus years ahead of its major trading partners has created a situation where the world’s various economies and monetary policies are in very different stages of recovery. This scenario creates a number of significant and far-reaching risks, as it encourages “currency wars” and other types of “beggar thy neighbor” policies.

Despite the hard lessons learned during the 1997-1998 Asian Financial Crisis (i.e. “the Asian contagion”), countries all over the world are once again debasing their currencies (versus that of their trading partners), as a means of increasing their share of global trade and creating some inflation to help to offset the current global deflationary pressures. Thus far in 2015, thirty central banks have already cut their interest rates. Further, Europe, Japan and China are ramping up their quantitative easing programs just as the U.S. is preparing to curtail its stimulus.

Europe is actually pushing interest rates down to negative yields, while the U.S. is preparing to raise short-term rates for the first time in nine years. In addition, the domestic economy has been accelerating, while most of the global economy has been slowing down. These divergent paths are causing extraordinary gains in the value of the dollar, and the strong dollar is starting to drag on both the economy and corporate earnings.

This is the first real challenge since the end of QE to both the sustainability of an economy that can no longer count on the Fed for support, and the ability of the markets to ignore the headwinds caused by what will ultimately be an increasingly restrictive, albeit still very accommodative, monetary policy. As was noted somewhat jokingly in last week’s speech by Federal Reserve Vice-Chairman Stanley Fischer, when the Fed does move, it “will be moving from an ultra expansionary monetary policy to an extremely expansionary monetary

policy." In other words, it is the Fed’s baseline assumption that they will be unwinding their very aggressive monetary policy very incrementally, and through small and infrequent interest rate increases and modest reductions in the size of their balance sheet.

From the perspective of an equity market investor, the risk that the economy slows too much to offset the drag of reduced monetary stimulus is just one-half of the risk. The second half of the risk is that the economy rebounds so strongly that it causes the Fed to abandon this baseline assumption and accelerate the withdrawal of monetary stimulus before the markets have had a sufficient

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The Fed has a very challenging task in front of it. It needs to steer monetary policy almost perfectly along the “golden mean”. If they allow the economy to slow down too much, it can stall at a time when the Fed has already exhausted most of its resources. If they allow the economy to grow too

quickly, investors are likely to react very negatively, as they anticipate a move on the part of the Fed to an accelerated removal of monetary stimulus.

If this were not difficult enough already, the Fed’s job is likely to be further complicated by three other elements. The first of these is a concept called “the terminal rate dilemma”. Simply stated, it means that, once the Fed starts to raise short-term rates, the markets have historically tried to “front-run” the Fed. Put another way, if the Fed increases short-term rates by 0.25%, instead of simply pushing up longer-term yields by a similar 0.25%, investors have historically tried to get ahead of the Fed by quickly moving yields to the level at which they anticipate that the Fed will ultimately finish its interest rate increases. This effectively lessens the Fed’s ability to control interest rates. A similar dilemma exists because interest rates are so low in other parts of the industrialized world. Since money is fungible, it is free to flow to wherever it is “treated best”. This means that longer-term domestic

interest rates may be influenced much more by the attractiveness of U.S. rates (relative to Europe and Japan) than they are to the short-term rates that are set by the Fed. The risk that longer-term rates may trade largely independent from

short-term rates is what former Fed Chairman Greenspan deemed “a conundrum”, and may further hinder the Fed’s ability to steer monetary policy.

The third complicating factor is that monetary policy normally works with a considerable lag of six to twelve months, which means that the U.S. economy has probably not yet felt the full impact from the quantitative easing program that ended last year. This considerable lag greatly complicates the Fed’s ability to know when to start tightening monetary policy.

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How all of this plays out remains to be seen. Analysts’ insight into the future is particularly limited this economic cycle, as what the Fed is trying to accomplish has never even been attempted before. What is clear, however, is that economic data is probably more relevant and more important to the markets now than it has been since the aforementioned March of 2009 expansion of the Fed’s first

quantitative easing program. With this in mind, we will use the remainder of this report to discuss some of the major macro-economic factors both generally and with a particular emphasis on changes in how the markets are reacting to them.

We will pay particular attention to the value of the U.S. dollar, to its dramatic appreciation against the currencies of its trading partners, and to its impact on earnings and economic growth.

It is logical to expect for this appreciation in the dollar to be a bearish influence, as it hurts the competitiveness of U.S. exports and diminishes the value of earnings made overseas and then converted back to dollars. In fact, according

to J.P. Morgan, every 10%

increase in the value of the dollar

shaves 5% off of domestic

corporate earnings.

As you can see, even excluding earnings from energy-related companies, which are expected to fall by 63% in the first quarter, corporate earnings expectations are being slashed by Wall Street analysts, in response to a falling dollar and weakening demand from overseas. This is after earnings already fell in the fourth quarter by the largest amount in four years. The influence of the stronger dollar is not limited to corporate earnings. As noted above, it also has a direct impact on the growth rate of the U.S. economy. Indeed, according to famed economist and Wharton School finance professor Jeremy Siegel, the more than 20 percent gain in the dollar over the past year has been "tantamount to a Fed tightening of maybe up to 50 basis points". In other words, the stronger dollar is already starting the Fed’s work, which may allow the Fed to further delay any actual interest rate increases.

Analysts face a bit of a dilemma when attempting to gauge the state of the domestic economy. On one hand, we are seeing declines in key components like construction spending, retail sales, industrial production, and consumer confidence. On the other hand, job growth has been very strong and the unemployment rate has collapsed from 10% in October of 2009 to only 5.5% today.

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Some of this anomaly between strong job growth and weakness in the remainder of the economy can be explained by America’s significant decline in worker productivity (meaning that the number of

hours of labor required to produce a certain level of economic output is now declining at a much slower rate, so more workers need to be hired to support the same level of economic growth). Others have tried to explain this divergence by the fact that the Commerce Department changed its payroll data collection process in 2011, and that the new process is overstating actual job creation. The job creation numbers aside, we believe that the slowing in the U.S. economy is modest but real, as is reflected in the below chart that shows the two primary economic surprise indexes (Citigroup and Bloomberg). Both show a sharply-declining line, which indicates that domestic economic data is coming in worse than expected. This should be of

particular importance to the equity markets, which are priced based upon future expectations. When news comes in less bullish than expected, it is normal for prices to adjust downwards in recognition of the disappointing news. Indeed, we have reached a point where the U.S. data is coming in worse than expected by a greater margin than in any other major region of the world.

By the same token, it is very important to keep in mind that this margin of

disappointment is not due to the domestic economy being in worse shape than the

economies of its major trading partners.

To the contrary, the U.S. continues to have among the most robust and dynamic industrialized economies in the world. The margin of

economic disappointment is instead attributable to the fact that, unlike most of the world, the U.S. had very lofty

economic expectations coming

into the October 2014 “end of QE” announcement (because the U.S. economy’s recovery from the global financial crisis was already quite well advanced).

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Indeed, when you look at the domestic economy on an absolute rather than a relative basis, you will notice only a slight decline in the rate of improvement in the Coincident Economic Index, which measures the economy in real time, and that this index is still upwards-sloping and currently shows no indications whatsoever of slipping back into recession.

Even more telling, from our perspective, is the

Leading Economic

Index, which anticipates

the trajectory of future economic growth. This anticipatory indicator continues to show very rapid improvement, which suggests to us that today’s moderating pace of real-time economic growth is only transitory, and that the longer-term prospects for the U.S. economy remain quite robust.

From our perspective, when all of this

information is taken into consideration, it suggests that the domestic bull market remains intact, but that there will be a variety of headwinds that investors will need to face in 2015 that are likely to result in significantly higher market volatility and

more moderate results. While domestic equity returns are almost certain to disappoint relative to recent years, we still expect for them to be relatively attractive compared to most other asset classes (aside from foreign equities) in 2015.

At the same time, we continue to prefer the equity markets in Europe, Japan and, to a somewhat lesser extent, India and China, as they are benefitting from either quantitative easing or political and/or economic reforms. In addition, Europe and Japan are priced for only modest investor expectations, which means that it should be reasonable for them to surprise to the upside and push share prices higher. Many of these markets, aside from Japan, also offer lower valuations (i.e. more value) than what is generally available in the U.S. markets, and Japan has the benefit of the government actually buying Japanese equities on a regular basis. The old concept that “you never fight the Fed” has certainly gone global.