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All the (Investing) World Needs is a Fed Meeting

Raphael Fiorentino
28th April 2020 - 6 min read

The Fed’s Open Market Committee is holding today and tomorrow one of its 8 regular annual sessions. As the graph below shows, the mere fact that the FOMC meets is normally enough to boost equity returns. If only getting more protective masks was that easy!

FOMC-Adjusted Equity Indices: simply replacing actual equity returns generated on the few days that the FOMC met since Dec-2014 (with average returns generated in the 3 days before/after the meetings used as replacement) reduces both US and International equity index prices by 30%

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In fact, for all the talk about US equities remaining overvalued relative to the real economy (e.g. see above relative direction of commodity prices) and to history (e.g. see below current level of S&P’s Shiller CAPE – Cyclically Adjusted Price Earnings Ratio), simply removing the market impact of FOMC meetings suffices to “normalise” their pricing.

S&P’s Cyclically Adjusted Price Earnings Ratio: drops to 20x when removing the market impact of FOMC meetings since 2014 and to 13x when removing the impact of FOMC meetings since 1983

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The problem is that plundering financial returns from the future erodes capital productivity (see below ratio of US net household wealth to US GDP -- it now takes over $5 of capital to produce $1 of output versus $4 only 10 years ago), as well as ships (non-food non-energy) inflation, un/under-employment as well as (bigger) government size problems into the future.

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But the fact is, the Fed had to commit yet more staggering amounts lately to various domestic and foreign institutions. Its integration in, and the dollarization of, the world’s financial system, as well as the extreme dependence of the world’s financial institutions on it, makes the Fed the central banker of last resort more than ever. And no other (group of) central bank(s), government(s) and currency(ies) would be able to run structural twin deficits and lose its leadership in global trade (to the Euro area then to China) while keeping interest rates, inflation, unemployment, and debt attractiveness in check at all time.

In a post-Bretton Woods era without gold-convertibility to regulate exchange rates and prevent runaway global imbalances (indulged by countries only too happy to keep importing US demand), each new crisis must be met with ever stronger intervention by the Fed to prevent a dollar melt-up and a global debt deflation spiral. The 10-year US treasury has turned into a paper gold bullion and it is the Fed’s infinite conversion capacity that manages to bail out an increasingly vast web of too entangled to fail financial institutions.

Thanks to the Fed then, Butterwire’s global macro indicators (derived from financial asset prices) are already displaying signs of recovery expectations (see below, e.g. green arrow pointing to a bottoming of global growth expectations), and conversely to several previous “episodes” that led to Central Bank interventions (in 2008, 2013, etc), market return expectations have not even dipped into negative territory this time (see yellow line in the graph below) thanks to the Fed’s pre-emptive “strikes” ahead (e.g. repo market) and into (see the long list of 4-letter acronyms) the covid-19 crisis.

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While the Butterwire engine remains bearish equities and continues to favour stocks with high recession resilience scores (together with precious metals and government bonds, see screenshot below)...

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…it is stocks with a recovery score (i.e. drawn from the bottom performers of the previous 12 months) that have been the best performing category month-to-date (see yellow line in the screenshot below).

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Even the decent performance of the 27-holding portfolio detailed in last month’s note pales in comparison to that of recovery stocks (see screenshot below).

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To find out more, we went back to Butterwire’s stock universe data as of 31/1/2020 (available for download here) and analysed the profile of all the stocks that outperformed over the whole February-April (L3M) period vs. April only (L1M).

Whereas the L3M outperformers indeed had a clear fundamental (high base score) and macro (high recession resilience score) edge, it is not so for the L1M outperformers which were wholesale beneficiaries from the Central Banks’ Puts (see graph below).

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Another manifestation of the profound effect that recent Central Banks’ actions have been having on global equities is their global macro betas (see graph below). We assigned our global equity coverage to one of 3 categories:

  • Acyclicals regroup consumer staples, utilities, telecom and pharma stocks: they show the lowest sensitivity to global growth expectations, perform best during downturns when monetary policy is most accommodative, and thrive in stable/disinflationary (input) price conditions
  • Early-Cyclicals regroup consumer discretionary and financial stocks, which respond most quickly to changes in growth expectations
  • Late-Cyclicals regroup energy, industrials and materials stocks, which outperforms most at peak global growth expectations and peak price inflation expectations.

While each category’s global macro betas (calculated based on 3-year trailing log-returns) were consistent with the above narrative up until 2017, the picture has now changed dramatically with a:

  • Much higher sensitivity to rising global growth expectations across the board (ever less growth backed by ever higher P/Es).
  • Much higher sensitivity to rising expectations of monetary easing across the board, leading to increasingly more “in the money” (i.e. pre-emptive) Fed puts with each market tantrum.
  • Reversal in sensitivity to price stability expectations as the typical commodity-driven cycle (late-cycle inflation => recession-deflation => early-cycle reflation) has been superseded by a debt-driven one where deflation equals systemic bust, not a mere relief from high commodity prices.

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In conclusion, we did manage, at great expenses, to pass peak covid-19 at the end of March as predicted. Thanks to indications of the bug’s seasonal sensitivity, chances are that within a month we will see very few new cases surface (in the Northern hemisphere). And the Fed’s decisive intervention has successfully bailed out the investing world.

But there is still considerable uncertainty on the likelihood of a second covid-19 outbreak by end of year, and crucially, there is considerable evidence that the effect of the past quarter on the producing world will be enduringly devastating (cue shrinking private sector and expanding public sector).

From an asset allocation standpoint, this reinforces the type of balanced short vol/long vol allocation advocated by Artemis Capital in their research on the dragon portfolio. From a stock selection standpoint, this means both continuing to avoid value traps (e.g. exit alerts and/or low base score / high value score) while watching out for catalysts of momentum reversal (e.g. low value score / high dividend yield and/or take profit alerts) amongst preferred low vol / high (financial) fitness, recession-resilience, and momentum holdings (e.g. stocks listed in the green/blue columns of the EU large cap heatmap below).

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