INSIGHTS

On August 29, 2016

AAM Viewpoints - Going Down the Rabbit Hole in Jackson Hole

The repeated focus, dissection and ultimately frustration on the commentary and projections coming from The Federal Reserve is one of the few constants in the investment world. Last week we had our annual Federal Reserve Jackson Hole meeting where we were not let down by the Fed’s ability to hedge on future action. For those who were bearish on the markets and had been calling for a recession (for some time might I add), the fact the Fed would consider raising rates leads you to confirm your already vocal calls for a crash to come. For those who were more baby bearish where the economy is not too hot or cold, you came away with the sense that the Fed was contemplative about hikes and paid special attention to the call of a recent pickup in economic activity.

If there are five classifications for the investor (exceedingly bearish, slightly bearish, ambivalent, slightly bullish and extremely optimistic), the one investor who has nearly zero neighbors, is the extremely bullish. There clearly have not been Fed officials, politicians, money managers or common investors who subscribe to a market where high returns are probable. Peruse nearly every sentiment indicator, every cash position, both in households and fund managers as well as fund flows, and one finds a very interesting crossroad that has rarely occurred at times when the market is touching all-time highs. For contrarian investors with long timeframes, this perfect storm is a test to the fortitude of your investment beliefs and projections for future returns.

The Federal Reserve serves a crucial role, but also a lagging role. The question I ask most advisors is, “Would you wish for the Federal Reserve or credit rating agencies to be proactive or reactive?” Nearly always they would answer for proactive, and why not, don’t we want to be aware of a problem before it happens? The question I ask them is, “How reliable are their projections both in magnitude and in timing?” If projections don’t have an extremely high accuracy on both of these fronts, why would proactive actions be the overwhelming choice? As such, the optimum choice is an actively monitored and evidence-based action plan that is reactive in nature. Therefore, Fed action (and rating agency action, discussion for another time) will ultimately be a lagging indicator and should be treated as such.

Consider a couple of points from the Jackson Hole presentation to put the Fed’s plan and overall purpose into focus. First, the theme of the conference “Designing Resilient Monetary Policy Frameworks for the Future” should be the first clue. Resilient monetary policy can be interpreted for and Economist or Engineering lexicon as “Something that morphs in changing conditions but is also quantifiable.” Whenever human rational and irrational behavior is injected into an “experiment” all logical conclusions are thrown out. This is perfectly evidenced in her comments that “focus on whether our existing tools are adequate” and that the “pre-crisis (the Great Recession of 2007-2009) toolkit was inadequate to address the range of economic circumstances.”

We now enter into the justification phase of the current situation from the FOMC (Federal Open Market Committee). “Based on the FOMC’s behavior in past recessions, one might think that such a low interest rate could substantially impair policy effectiveness.” We now begin to get into the theoretical aspect of the Fed’s job and as such, we should come back to the central point; we believe the FOMC will ultimately be reactive but with several theoretical solutions at their disposal. What is most important isn’t necessarily the actions to be taken but that various vague solutions might be implemented and therefore, side effects and unintended consequences will occur. This is evidenced by the current state of $13 trillion in global debt trading at negative yields. When did the Federal Reserve – or any central bank for that matter – think that this environment would not only occur, but would do so with such paramountcy and ultimate submission by the purchases of such costly debt? The range of potential tools to be used are both immense and ultimately limited only by the “creativity” of the FOMC in the future. As such, we feel much of what is being said specifically should be taken with a grain of salt and focus should be on the trend.

The trend that appears to be the most likely is moving rates higher. Notice we said “appears” as there is still quite a large contingent calling for lower rates to eliminate the recession that is obviously around the corner…of course the economy has turned this corner for several years now without the true recession occurring. A recession will occur at some time, so those prognosticators will be right at some point and the four words they have been breathlessly waiting to type – “I told you so” – can finally be used. The trend set forward by the FOMC is the final clue that the exhausting and nauseating focus on the FOMC’s statements can be summed up in one chart; a little for everyone in whatever camp you may be in. Below is the future rate projections for the next two years with the median and the 70% confidence interval.

For those of you counting at home, this range in the next two years is a Fed Funds Rate as high as 4.50% and as low of 0.25%; a range of 4.25% in the next two years.

The Federal Reserve is essential to modern markets and economies and they have had a fairly decent track record over the long run but must also be classified as a lagging indicator and not confused with a leading indicator. Though the release of their minutes, constant array of speeches and testimony to Congress are an admirable attempt to see behind the curtain, ultimately the action and rhetoric become both confusing and affirming depending upon the reader’s bias. Ultimately, getting the trend right with one’s own vigilant and vigorous review of the underlying economy is important. This affirms our long-standing mantra of not fighting the Fed (or any other central bank for that matter) and consider investing in the consequence of their policies and not necessarily their same structures. Things we see that confirm a leisurely yet deliberate move to hike rates is the increasing component of wage pressure building, the higher rate of inflation which the core rate CPI (Consumer Price Index) stands at 2.20% year over year (excluding food and energy) and the more recent move in commodities (up over 8% year to date) and LIBOR (London Interbank Offered Rate) which has risen 21 basis points in the last two months.

Though we understand why each classification of investor has its reasons (exceedingly bearish, slightly bearish, ambivalent, slightly bullish and extremely optimistic), often times the one environment that has the least support is often the one which occurs.

CRN: 2016-0808-5500 R

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