Play Cautiously with Vulnerable Markets

Rieder and Brownback argue that monetary policy restrictiveness, fading fiscal stimulus, and growing economic uncertainties leave markets more vulnerable today, and these risks are not to be toyed with.

In the game of Jenga, players take turns removing one block at a time from a tower constructed of 54 blocks. Each block removed is then placed on top of the tower, creating a progressively taller, yet more unstable, structure. The game ends when the tower falls and the loser is the person who made it fall. To us, the 2018 investing regime is evolving much like a late-stage game of Jenga, with the Federal Reserve and Treasury clinically and methodically removing the blocks of stability from underneath the financial and real economy “towers.” Indeed, ongoing rate hikes, Fed balance sheet reductions, and massive amounts of Treasury issuance to finance fiscal deficits are leading to increasing vulnerabilities for both financial assets and the prospects for economic growth over coming quarters. In our view, this vulnerability is evidenced by the recent acute spike in market volatility.

Monetary Policy likely to differ from standard market narrative

The conventional market narrative today surrounds already realized robust U.S. growth and earnings, and an earnest belief that sufficient momentum exists to push a capacity-constrained economy into a mode of overheating that will force the Fed to seek a restrictive policy stance. Our base case monetary policy scenario is far more benign, as increasingly skittish financial markets, along with signs that previous tightening has already started to bite parts of the real economy, suggest to us that the tightening cycle is nearing its end. To be clear, though, we do not think the Fed will mistakenly become too restrictive.

To be sure, third quarter U.S. economic growth remains strong by most measures, but we think there are numerous yellow lights flashing ahead of investors today. For instance, while ‘present conditions’ components of high-frequency survey economic data remain solid, related measures of ‘forward expectations’ have become noticeably weaker. Moreover, the two largest (and most rate-sensitive) sectors of the tangible economy, the housing and auto markets, are showing demonstrable signs of softness. That weakening can be witnessed with declines in mortgage applications, housing turnover, and a reduced rate of home-price appreciation. It can also be seen in a notable decline in used car prices. Finally, the powerful influence of 2018 fiscal stimulus will become a growth headwind in 2019, as temporary measures roll off leaving only the related financing burden behind. As that process unfolds, it’s very likely that the Fed’s judgement of the strength of the economy and the need for further policy rate hikes also adjusts (see graph), an eventuality that markets are not properly discounting now.

fiscal stimulus