by Erik Swarts, Market Anthropology
We've all read the distilled disclaimer above a thousand times before. And yet, with full frontal cognizance of its universal truth, we ignore the warning for the sake of the still waters of current market conditions and our behavioral predisposition to follow. Follow leaders, trends - follow performance. It's a hardwired survival trait built into all of us, and generally speaking - exposes our achilles heel at times, when it comes to bends in the road and future expectations.
Speaking of which, we see that another large investment bank recently chimed in with long-term forecasts out to 2018 of divergent returns between equities and bonds. Seeing a 6 percent annualized total return in the S&P 500 compared to a 1% annualized gain for the benchmark 10-year Treasury note, the forecast assumes the Fed begins raising rates as soon as the middle of next year - with a 4 percent ceiling by 2018. Citing the same rate increase playbook referenced ad nauseam (94', 99' and 04' cycles) this year, we think it would behoove their expectations to heed the standard disclaimer mentioned above, as well as a wider breadth of market history that rhymes much closer with the current mix of market conditions present in equities, bonds and commodities - against the backdrop of extraordinary monetary policies extended over the past five years (cough, cough - the 1940's). Taking this into account, the dynamic of divergent returns would vanish as we would cut their forecast for the total return in the S&P 500 in half and more than double the annualized gain noted for the benchmark 10-year Treasury note.
Befitting of the paradox of both our capacity to collectively follow and ignore, participants appear to receive an almost daily dose of insight and reason from our Madam Chairwoman, who continuously reminds us that rates will stay lower - looonger. Besides the fact that long-term yields continue to move against a more contemporary conventional wisdom, what does Yellen consider that the rest of the Street choses to ignore? Hint - recent past performance does not guarantee future results? We think so, and expect that as these benevolent market conditions come to pass, the Street will change their tone and karaoke tune as well.
Although the economic data through the balance of year may run antithetic of the Fed's mandate on inflation, we view that risk - as we believe Yellen does, in shades of gray. The reality in the economy is that a strong pulse of inflation would eventually self-correct trajectory under its own weight - and without further tightening in Fed policy. This isn't the 1970's, where the Fed chased inflation with yields that had been rising for over two decades and where the saplings of globalization began to grow exponentially in the stand. No, we currently reside in the old growth trough of the long-term yield cycle, where generally speaking - the threat of perennial inflation is limited by more than 30 years of inertia on the downside of the cycle. Frankly, we are a bit surprised that this fundamental difference isn't considered more often and that the extremes of the 1970's are contrast for concern, instead of where yields currently sit and the extensive historical record which depicts that the trough - like Yellen, is lower for longer. Will there be spikes of inflation as pressures builds up from time to time under varying conditions. Certainly, but in the recent past and the parallels we noted in the 1940's - they all were ephemeral conditions.
Coming into the home stretch of the year we expect the current pulse of inflation to continue higher as the Fed walks away and foresee the chirping hawk choir grow louder and more emboldened with each reassurance by Yellen that she'll stand pat longer with lower. From our perspective, the double edge sword that Yellen needs to gingerly step between is a damned if she does and damned if she doesn't mentality with tightening, since the risk becomes that rising inflation could hit the brakes in the economy for her, reinforcing the belief that the Fed was foolishly behind the curve. At the same time, if they raise rates too soon the scenario laid out below could have the same outcome - but perhaps even sooner.
- The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession. - Reuters 8/12/14
All things considered, we tend to agree with Pimco's Paul McCulley that believes "behind the curve" is precisely where the Fed wants to be - for now. Trading more time for inflation risk - that we would argue poses a less long-term threat than many of the hawks continue to posture as severe. With that said and as pragmatic participants, this dynamic should bolster a rising interest in the precious metals sector and commodities - that should benefit from inflationary tendencies and a broad distrust of the Fed as they navigate another difficult policy chapter.
1994, 1999 - 2004. What do they all have in common besides rate tightening cycles ? A broad respect and lionization by participants of Fed policy and their Maestro that conducted the show. Does that sound like today? While we do find great utility in thoughtful comparative reasoning when it comes to market cycles - the fact remains that past performance never guarantees future results. Especially, when the comparisons are so far off the mark.
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