The Fed’s Two-Day Correction

There were ostensibly three factors behind the recent stock market correction: (1) fear of a slow down in China, which can’t be stopped regardless of measures out of Beijing; (2) a sell off in commodities, which is pressuring emerging markets; and (3) continued concern about when the Federal Reserve will increase interest rates and how the lift off will impact asset prices. After two weeks of volatility, I am more convinced that the Fed may have had a larger role in the correction than the other two factors. Many look back to last Monday (aka “Black Monday” in China, where the main stock market index plunged 8.5 percent) as the beginning of the brutal downside action. Despite reports that Chinese government intervention was coming; there was none that day. All of the sudden, there was talk about the spread of contagion from a collapse in the Chinese stock market, to the Chinese economy, to emerging market economies and then to developed economies.

Let’s peel back the onion on this theory. According to Capital Economics, “The debacle in China’s equity market tells us little directly about what is going on in China’s economy.” The reason is that the massive bull market bubble, which began in 2014 and peaked on June 12th, “was speculative, rather than driven by any improvement in fundamentals…we are witnessing the inevitable implosion of an equity market bubble.” Since the top, the bears have wiped out $4.5 trillion of Chinese stock market value. Despite the massacre, the Shanghai Index is up 1.4 percent this year and a staggering 48 percent from a year ago.

Fear of a hard economic landing in China has been floating around for some time. In the big picture, the days of China’s double-digit growth rates are behind it. But because the total Chinese economy has increased in size, it continues to contribute more than a third of global growth. That’s why a slow down in growth from the government’s 7 percent target, to something closer to 5 percent this year, will reduce Chinese demand for a host of commodities, hence the rout in oil, industrial metals and emerging market trading partners who export those items to China.

And for those who were banking on the Chinese government to shield them from the effects of a slowdown, one hedge fund manager told me, “Too many investors believe that officials in Beijing know what they are doing. In fact, China is really in the minor league when it comes to economic management. Think of the U.S. as any big major league franchise, like the Yankees, the Giants or the Cardinals…China is like the Toledo Mud Hens-lots of great potential, but not in the show just yet.”

Of course all policy makers make mistakes (see: ECB), so maybe the take away is that when central bankers get nervous, we should all get nervous. And that leads us to what could have been the most important factor in the recent sell-off: the U.S. Federal Reserve. Yes, the impact of China and falling commodities is important, but some believe that that the selling pressure began on the Wednesday before Black Monday. That’s when minutes from the last Federal Reserve meeting were released. The officials’ views on current conditions painted a picture not of an economy rebounding strongly after a tough, weather-related first quarter, but of one that still faces downside risk, including “persistent weakness in the housing sector”. That comment prompted a lot of chatter because the data seem to indicate that housing is gaining a lot of momentum.

All of the sudden, it appeared that the Fed was not entirely sure what was going on and how it would respond to global events – that uncertainty sent shivers across trading floors. The stock drop only ceased after New York Federal Reserve President Bill Dudley, said that turbulence in the financial markets made a September rate hike “less compelling” than it was a few weeks ago.

With an economy growing at a better than three percent annualized pace, a labor market creating more than 200,000 positions per month, consumers and businesses spending more freely and a housing market finally making inroads, the best justification the central bank has for keeping rates at emergency levels is that there is little evidence of inflation. Still, it is hard to justify treating the U.S. economy like it is still in the intensive care unit. At some point, the central bank is going to have to normalize policy and when it does, nobody really knows how financial markets will react.

MARKETS: With one trading day left in August, stocks are on track for their worst monthly performance in three years.

• DJIA: 16,643 up 1.1% on week, down 6.6% YTD
• S&P 500: 1,988 up 0.9% on week, down 3.4% YTD
• NASDAQ: 4,828 up 2.6% on week, up 1.9 YTD
• Russell 2000: 1163, up 0.5% on week, down 3.5% YTD
• 10-Year Treasury yield: 2.19% (from 2.05% a week ago)
• October Crude: $45.22, up 11.8% on week
• December Gold: $1,134, down 2.2% on week
• AAA Nat'l avg. for gallon of reg. gas: $2.49 (from $2.61 wk ago, $3.44 a year ago)

THE WEEK AHEAD: It will be a busy, pre-holiday week on the economic calendar, highlighted by the August employment report. It is expected that the economy created 225,000 jobs and the unemployment rate should edge down to 5.2 percent.

Mon 8/31:

9:45 Chicago PMI

10:30 Dallas Fed Mfg Survey

Tues 9/1:

Motor Vehicle Sales

9:45 PMI Manufacturing Index

10:00 ISM Mfg Index

10:00 Construction Spending

Weds 9/2:

8:15 ADP Employment Report

8:30 Productivity and Costs

10:00 Factory Orders

2:00 Fed Beige Book

Thurs 9/3: 9:45 PMI Services Index

10:00 ISM Non-Mfg Index

Fri 9/4:

8:30 August Jobs Report

No inflation in sight: Don't be complacent

Inflation is tame by almost any measure. Prices are up by less than 2 percent over the past year, despite the Fed’s purchase of more than $2 trillion dollars worth of bonds. In fact, for all of the hand wringing over the Fed’s “money printing” monetary policies, the weak economy has kept wages flat and forced many businesses to cut prices, which has kept a lid on overall prices. But when conditions improve, inflation could rear its ugly head. As a reminder, inflation occurs when the prices of goods and services rise and as a result, every dollar you spend in the economy purchases less. The annual rate of inflation over from 1914 until 2013 has averaged about 3.35 percent annually. That might not sound like much, but consider this: today you need $7,606.96 in cash to buy what $1,000 could buy in 50 years ago.

Currently, inflation is running well below the long-term average pace. As of April, the government’s measure of inflation, the Consumer Price Index (CPI), has increased only 1.1 percent over the last 12 months (1.7 percent without food or energy costs included.)

However, the Fed’s strategy to flood the economy with money could eventually unleash inflation in the future, an event against which every retirement investor must guard. The key is to attempt to grow your portfolio at a quicker pace than the rate of inflation, while keeping focused on the total risk level you are willing to assume. Not an easy puzzle to solve! And here’s one more sobering thought: there has not been any single asset that acts as a perfect inflation hedge.

The following are the assets most frequently used to protect portfolios against inflation:

Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. Many investors therefore turn to investments in these assets for protection, but as a former commodities trader, I must warn that this is a volatile asset class that can also stagnate or worse, lose money, over long stretches of time (see the massive drop in the gold market this year). Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.

Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents. But the nation’s housing bubble has cured most of us of the notion that one “can’t lose with real estate.” Real estate prices could stay depressed for a long period of time.

Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but the long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks might plunge before reverting to the longer-term trend.

Treasury Inflation Protected Securities (“TIPS”): Bonds are susceptible to inflation, because rising prices can diminish a bond’s fixed-income return. But the US government directly offers investors inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI. Sounds great, right? When the expectation of future inflation is runs high, investors pay up for TIPS, which in the past year, has driven the interest rate on these bonds below zero. [In April, five-year TIPS drew a yield of negative 1.311 percent.] That’s not a typo: when investors get worried about future inflation, they are willing to pay the government now to protect them later. The current pricing of TIPS makes them hard to recommend, even as an “insurance policy” against inflation.

International Bonds: One of the dangers of inflation is that it destroys the value of the U.S. dollar. As a result, there is an argument to allocate a portion of a bond portfolio to a small percentage of international bonds, which are denominated in a foreign currency. This is another one of those asset classes that tends to be volatile.

While inflation may be looming, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way towards providing protection. If you are worried about inflation, these other asset classes should be used sparingly to round out your overall allocation.