Market Update - December 21, 2015

• The Federal Reserve is late in starting a tightening cycle; this presents the world with yet another unknowable scenario where the U.S. launches a monetary policy regime that has never been tried before.
• The Fed’s false narrative about tying the rate increase to inflation and employment is to blame for the Fed’s dithering; not only are the published statistics for inflation and employment misleading, they are second order effects after GDP growth and earnings growth.
• Using modern earnings expansion and contraction cycles as a metric for evaluating tightening and loosening cycles demonstrates how late the Fed has been to start a tightening cycle; the last two earnings expansions lasted 24-34 quarters and the Fed started tightening 9-13 quarters into the expansion.
• We have now gone 28 quarters since the start of earnings expansion and earnings appear to have put in a cycle peak after 24 quarters; history suggests that the Fed should have started tightening back in 2012.
• The problem for the Fed is that despite the abnormal situation that we are in, market participants will review past tightening cycles for guidance as to where we are headed; after the Fed’s announcement, the markets are now expecting 3.25% Federal Funds Rate (FFR) in 2017.  
• The FFR averaged 2.95% in the 2001-2007 expansion and 4.96% in the 1991-2000 expansion; the last three tightening cycles occurred over 1-2 years taking the FFR up 1-3% and resulting in an FFR in the 5.25%-6.50% range. 
• One of the most likely unintended consequences of a late tightening cycle is that the yield curve will actually flatten as opposed to steepen as it has in past cycles; if the Fed does, in fact, go close to 2% over the next year, it is entirely possible that we approach a yield curve inversion that is often associated with recessions.
• The Fed’s false narrative clouds the reality of where we are; we are reaching the end of an expansion cycle and the tightening cycle should be ending, not starting.
• The Fed knows it must normalize rates in advance of a recession if we are to avoid the plight of Europe and others that are suffering weak economies and monetary policies at the zero bound; the new-normal of negative real interest rates is yet another policy that will have broad unintended consequences.
• History will certainly look unfavorably on this entire experiment of preventing market forces from setting the cost of capital; unfortunately, that history continues to be written as the Fed continues to fumble and feign.

Now that the Fed has apparently terminated its ZIRP policy and started the interest rate normalization cycle, it is important to understand the context and possible implications of their actions.    Of course, this cycle is like no other cycle in history, both in terms of the economic backdrop and the policies that preceded this action, so attempting to divine the future by looking in the rearview mirror is a bit of a fool’s errand.    Be that as it may, understanding history is about all we have to go on at this point.

The Federal Reserve’s Intended Federal Funds Rate (FFR) averaged 5.7% from 1955-2007.   There were notable periods of divergence from this average: 

• 1955-1968:  The FFR averaged 3.29% and ranged from 1.57% in 1958 to 5.66% in 1968.   
• 1969-1990:  The FFR averaged 8.49% and ranged from 5.05% in 1976 to 16.39% in 1981.  
• 1991-2000:  The FFR averaged 4.96% and ranged from 3.02% in 1993 to 6.24% in 2000.
• 2001-2007:  The FFR averaged 2.95% and ranged from 1.13% in 2003 to 4.88% in 2006
• 2008-2015:  The FFR averaged 0%.

There have been three tightening cycles since 1994:

• 1994-1995:   The Fed raised interest rates 7 times over 1 year with an average increase of 0.43% per raise, taking rates up 3% from 3% to 6%.
• 1999-2000:  The Fed raised interest rates 6 times over 1 year with an average increase of 0.29% per raise, taking rates up 1.75% from 4.75% to 6.5%
• 2004-2006:  The Fed raised interest rates 17 times over 2 years with an average increase of 0.25% per raise, taking rates from up 4.25% from 1% to 5.25%

Modern history would then suggest we might be able to expect at least 6-7 rate increases pushing rates up 1-3% over a 1-2 year period.   This in fact is what the current market expectations are pricing in – an FFR in the 3.25% range by 2017.     

The Fed has attempted to align a tightening cycle with inflation and employment targets; this has had the effect of postponing a rate increase until very late in the cycle.   Had the Fed elected instead to use S&P 500 earnings cycles as their guide, there would have been a substantially different outcome.   Here is some historic perspective on the relationship between earnings cycles and monetary cycles:

• The 1994-1999 tightening cycle started 9 quarters after the cycle low print in S&P 500 operating earnings.   In 4Q91, S&P 500 operating earnings reached a cycle low of $4.63/share.  The first rate increase occurred in 1Q94; S&P 500 operating earnings per share had increased to $7.17/share.   25 quarters later, the expansion peaked in 2Q2000 where earnings reached a cycle peak of $14.88/share.    The tightening cycle started after 25% of the eventual duration of the earnings expansion had passed.
•  The 2004-2006 tightening cycle started 13 quarters after the cycle low print in S&P 500 operating earnings.    In 2Q01, the S&P 500 operating earnings reached a cycle low of $9.02/share.   The first rate increase occurred in 3Q04; the S&P 500 operating earnings per share had increased to $16.88/share.   11 quarters later, the expansion peaked in 2Q07 when earnings reached a cycle peak of $24.06/share.   This tightening cycle started after 54% of the eventual duration of the earnings expansion had passed.

So the Fed has now started a tightening cycle 28 quarters after the cycle low print in S&P 500 operating earnings.   In 4Q08, the S&P 500 operating earnings reached a cycle low of ($0.09)/share.   While it remains to be seen whether we have seen the cycle peak in earnings, the operating earnings peak in this cycle occurred in 3Q14 at $29.60/share and we have now experienced four consecutive quarters of declining operating earnings.   3Q15 S&P 500 operating earnings were $25.45/share, or 14% lower than the cycle peak.    The Fed has not, in modern history, started a tightening cycle when earnings were falling.

Had the Fed started the tightening cycle 16 quarters ago, they would have started at the beginning of 2012.    The Fed could have brought the rates up slowly, reaching a modest 1-2% over 2-4 years.   The effects of such a slow and modest rate increase on GDP, earnings, and unemployment would have probably been nominal.    But, the Fed fumbled.   Now, the Fed is roughly at the zero bound in interest rates with the strong possibility that we are now entering a protracted contraction cycle in earnings.  Now the Fed is in the position of feigning that we have reached an “all clear” to tighten based on employment and inflation, when the reality is that they must normalize rates as soon as possible to provide policy room in the event of a recession.