Halloween month is an apt time for our Gregorian calendar to cooperate by producing a Friday the 13th. Yet, nothing scary emerged this past Friday, at least not in the financial markets. Equities bounced higher with the Nasdaq Index closing at an all-time high – the S&P 500 and Dow Jones Industrial Indexes also hit new highs earlier in the week. The Fed’s boogeyman, inflation, was also a no-show as data from September showed core inflation was steady at 1.7% year-over-year. Indeed, excluding shelter costs (i.e. housing), core inflation rose only 0.6% year-over-year. It’s also worth noting that the 3-month average retail sales for September grew by only 2.6% on a nominal (non-inflation adjusted) basis. The hurricanes may have depressed that number to a degree, but reduced retail sales are consistent with our observation that after a long period of subdued wage growth, consumers are feeling the pinch from spending more than they earn. As the chart below highlights, Personal Consumption Expenditures (PCE) cannot remain above Disposable Personal Income (DPI) indefinitely as it implies consumers are borrowing, using savings or engaged in both to consume more goods and services than their paychecks provide for. Neither of these actions is sustainable. For an economy whose GDP is comprised of 70% consumption, a weakening consumer would be a spooky economic trend.
Sources: Bureau of Economic Analysis, Foleynomics and Covenant Investment Research
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Party On – From the smoldering ashes of the Financial Crisis, the ultra-accommodative form of monetary policy known as “Quantitative Easing” (QE) was born. The Fed was the first central bank to adopt these measures and, as the chart below highlights, U.S. stocks (and risk assets in general) got a leg-up on their international brethren. Since the first round of QE in November 2008 through last Friday, the S&P 500 Index has produced total returns of nearly 220% vs. 120% for the Europe Australasia and Far East (EAFE) Index.
Sources: Bloomberg and Covenant Investment Research
The European Central Bank (ECB) and Bank of Japan (BOJ) soon joined the QE party. The three banks together injected an enormous amount of liquidity into the markets. That liquidity had to go somewhere, and much of it ended up in financial assets resulting in higher equity prices, lower bond yields, higher residential real estate prices, higher commercial real estate prices, etc. You get the picture… liquidity in, prices up. Now we are at the point where the Fed will once again be the first to act on a major shift in monetary policy, this time withdrawing liquidity from the economy by shrinking their considerable balance sheet.
With the ECB and BOJ still buying assets at a combined rate of $150 Billion per month, the Fed’s initial move to shrink its balance sheet is unlikely to have a significant impact on financial markets… at least not yet. Unlike the start of Quantitative Easing, the first central bank to begin Quantitative Tightening is not the one that will have the most dramatic impact on markets. Rather it will likely be the second central bank starting Quantitative Tightening that will impact asset valuations. That central bank is expected to be the ECB. When the ECB begins to shrink its balance sheet, perhaps next year, two of the three large central banks will be simultaneously draining the proverbial punch bowl. That may be like the neighbor calling the police about a raucous party at your house – it’s not over yet, but it’s the beginning of the end.
It’s worth noting that the beginning of the end of the era of Quantitative Easing doesn’t imply the market will crash. But at that point, further gains are more likely to come on the back of improved earnings rather than higher valuations (also known as price-to-earnings multiple expansion).