The first Fed rate hike in seven years was supposed to trigger a powerful equity rally as the bulls expected money to pour out of bonds into stocks; especially into the cyclicals.
The logic behind this market call was simple and seductive. History shows that the economy and earnings keep on accelerating as the Fed initially shifts away from monetary policy accommodation and history was expected to repeat itself.
Unfortunately for the equity bulls, as Mizuho's Steve Ricchiuto explains, this time things are different and instead of the Fed rate hike triggering the traditional Santa Claus rally; it looks like the FOMC is actually the Grinch.
The key message delivered by the Fed though the SEP, the DOTS and the Chair’s post meeting press conference is that this is the best the economy is going to get. Instead of seeing the economy in the early stages of an upturn when growth and earnings are strongest; the Committee believes the economy is mature and at the point when inflation vigilance takes center stage.
The decision to hike rates was also justified under the notion that should the economy falter; the FOMC needed room to cut rates. Neither of the arguments advanced by the Chair Yellen to justify the Committee’s decision put a positive equity spin on the move. The tone of the post-meeting statement stressed that the policy normalization process was not on auto pilot, but the Chair did suggest that the bar for additional rate hikes had been lowered.
Moreover, the dovish rate hike call suggested the FOMC would hike rates but lower the DOTS sending a positive growth message. Instead the FOMC kept the terminal funds rate a full 100 basis points above the Street’s estimate even though the quarterly path is now a little more back-ended.
Essentially, the rate hike was executed because the Committee wants to limit the economy’s upside in the wake of the perceive labor market tightening.
This means equity investors need to assess whether current valuations are justifiable in an environment of at best 2%-2.5% economic growth, declining energy prices, a firming dollar, and a lack of pricing power.
And in fact, the dollar is getting notably stronger than some believe...
Although typically, investors will look at DXY (The Dollar Index) - which has been been practically unchanged over the past nine months, the trade-weighted dollar (TW$) has ripped on to new highs...
And it's getting worse... sine Janet jawboned...
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DXY is composed of mainly the euro, yen, and pound, and so, as China and South Africa 'allow' their currencies to devalue, DXY does not feel the pressure while TW$ does.. As Evercore ISI notes, this helps explain the weakness in commodity prices and puts further downward (deflationary) pressure on US inflation.
Which, as Raul Ilargi Meijer noted prophetically a year ago [15]...
My overall impression is that the Fed has given up on the US economy, in the sense that it realizes – and mind you, this may go back quite a while – that without constant and ongoing life-support, the economy is down for the count. And eternal life-support is not an option, even Keynesian economists understand that. Add to this that the -real – economy was never a Fed priority in the first place, but a side-issue, and it becomes easier to understand why Yellen et al choose to do what they do, and when.
The higher dollar will bring some temporary relief for Americans, in lower prices at the pump, and for imported products in stores, for example. Higher rates, however, will put a ton and a half of pressure bearing down on everyone who’s in debt, and that’s most Americans. The idea is probably that by the time this becomes obvious and gets noticed, we’re far enough down the line that there’s no going back. Besides, we could be in full-scale war by then. One or two IS attacks in the west would do.
The higher dollar – certainly in combination with higher rates – will also mean a very precarious situation for the US government, which will have to pay a lot more in borrowing costs, but our leadership seems to think that at least in the short term, they can keep that under control. And then after that, the flood. Maybe the US can start borrowing in yuan, like the UK?
To reiterate: there is no accident or coincidence here, and neither is it the market reacting to anything. That’s not an option in this multiple choice, since there is no market left. It’s all central banks all the way (like the universe made up of turtles). It’s faith hope and charity, and the greatest of these is the Federal Reserve. If they didn’t want a higher dollar, there would not be one. Ergo: they’re pushing it higher.
And do not forget that corporate CEOs have alreasdy voiced their opinion [16]- "It's not the economy... it's the dollar" - That would appear to be the message from the companies of the S&P 500 who have reported in Q3. As FactSet reports, the majority of companies reporting so far have cited "the strong dollar" as having a negative impact on earnings. Not record domestic inventories (liquidation beginning) [17], the plunge in world trade [18], not the economic collapse in take your pick of Brazil (depression) [19], China (credit endgame) [20], India (exports/imports crash) [21].
What is being missed here is that "The Dollar" is the symptom, not the cause of the problems. Capital is flowing for a reason to drive the USD stronger (or printed for a reason)... because the underlying economies are collapsing (yes and interest rate arb hopes).
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It appears, for now, financial engineering (buybacks) has kept the dream alive relative to the soaring USD vs Asian/EM countries (US growth opps); and "hopeful" projections have kept Forward estimates of earnings alive - even as The USD soars against the American companies' most favored growth nations...
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But at some point it's inevitable - unless there is a seismic shift in Fed Policy (QE4?) - that the USD's strength vs Asian/EM nations will crush earnings... and estimates will be unable to rise with even the biggest hockey-stick forecast.
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Remember. crises often start slowly... then erupt suddenly; and equity markets are always (without exception) the last to figure it out [23].
The credit cycle has well and truly rolled over.
