Living in the 70s

Although the Federal Reserve is unlikely to make any formal changes at today’s meeting, it does seem likely that they will hint at further stimulus or policy support over the coming months. As we have often noted, you should never underestimate their ability to out-dove the markets. The potential changes are: a more state/data contingent forward guidance regime or a possible shift in the inflation/unemployment goal post target. The probable reason for further dovish guidance is the recent deterioration in unemployment claims, consumer confidence and mobility data since the June meeting which point to a moderation in the pace of the cyclical recovery.

Markets have already reacted to this potential shift over recent weeks. The most obvious being the decline in real yields and the increasingly non-linear rally in precious metals. From our perch, the rally in gold to date has primarily been a function of the decline in the value of the competing asset or the real yield on Treasuries. It is not a function of consumer price inflation today, but the inflation in money, liquidity and the coincident aggressive increase in fiscal spending. Stated differently, the fiscal expansion backed by monetary policy. In contrast to the phase following the 2008 crisis, there is also greater policy consensus on not winding back the stimulus until the unemployment rate and inflation normalises. While the parallels with the 1970s are often dismissed given the shift to a service sector economy, the similarities on world trade, fiscal policy, dollar weakness and the rise in gold are striking.

Looking forward, there are a few areas of extreme asymmetry or opportunities in markets if we are near a pivotal moment in the inflation outlook. First, sovereign fixed income markets are not priced for any inflation risk at all. The US 10 year yield still trades at 0.60% and has not recovered at all since the March low. While that is a function of beliefs on future expected short rates, asset purchase programs and large excess capacity in the labour market, it is contrary to the recovery in ISM surveys, and a range of other macro data. However, as we have noted previously it is not entirely inconsistent with the equity market. The sustained low level of fixed income yields is consistent with the underperformance of value sectors relative to growth. Put another way, the performance of sectors like banks since March are probably a better reflection of the economy than the S&P500 (chart 1).

The additional point to note is that the outperformance of growth and the mega-cap technology companies has also been consistent with the conditional elements of valuation. In contrast to the S&P500, the fabulous five (Apple, Amazon, Google, Facebook and Microsoft) have increased returns on equity over the period and widened the profit gap with the broader market and lagging sectors (chart 2). Second, most of the major technology companies are net-cash on balance sheet. Third, companies that have long duration growth ought to have a greater valuation multiple at a lower interest rate. As an aside, most of the Fab Five report this Thursday. The key point is that the outperformance of the mega cap technology companies has been warranted by profits, balance sheets and the decline in the discount rate. However, positioning and beliefs now reflect that prevailing bias. Therefore, they are vulnerable to any near term disappointment or a genuine rise in consumer price inflation or interest rates.

In conclusion, our bias is that the Federal Reserve will continue to remain dovish and support liquidity and credit. Unemployment will justifiably be the Fed’s key focus even if business closures and hiring decisions have little to do with the price of money. Monetary policy alone is unlikely to create consumer price inflation (based on the Fed’s definition). However, the pivot to aggressive fiscal policy backed by monetary policy might lead to a genuine shift in the inflation outlook once the economy recovers and the output (unemployment gap) is closed. The bond market, bond volatility and “value” sectors of the equity markets are not priced for this risk. In contrast, gold, precious metals and commodities may be starting to sniff it out. Economies and technology have changed dramatically since the 1970s, but there