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Posted on MAR 25, 2019

Investment Commentary | Monday, March 25

This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.


Double Fault

Recently in Florida, I had the opportunity to play my 12‐year‐old son in tennis. I am a poor recreational player, while he has been taking lessons and playing regularly since he was three. The only lesson I've ever received was from him, during this match, when he kindly pointed out the mistakes I was making and how to correct them. I learned quickly, however, that I could get in his head, causing him to double fault. Doing this often enough, I was able to win a few games. Hoping your opponent double faults often enough, however, is not a strategy.

One could say the Federal Reserve's communication last week was their attempt to move from double faulting to deploying strategy. Or, you could argue that this turn‐about is exactly what “data dependent” looks like. The Fed has used those two words to regularly describe their current interest rate policy. Examining their statements and the stock/bond markets' reaction provides some insight.

Faulting to a Fault

The Fed's communication during the fourth quarter of 2018 led to a near 20% decline in stock prices through November and December. At that time, it indicated a determination to raise interest rates more than once in 2019 and beyond. Equity investors saw weaker economic growth coming and felt the Fed was misreading the future potential for growth and inflation and might act too aggressively.

In addition, the Fed's communication between September and December was unclear to market participants. It seemed to be caught between a desire to normalize policy and the fact that regardless of our economic growth rate, the specter of significantly higher inflation was nowhere in sight.

As Jerome Powell closed out his first year as Fed Chairman, he received very low marks for communicating the Fed's position clearly enough to markets. However, it may have been that his communication wasn't the problem; rather, the Fed's view of the economy wasn't consistent with investors'.

Regardless, our view has been that bond investors would benefit from a relatively stable interest rate environment and that lower intermediate interest rates could be on the horizon.

New Strategy

After last week's Fed announcement, which indicated concern about the future growth rate of the economy, the Fed seemed to take any interest rate hikes in 2019 off the table. The 10‐year Treasury yield rallied to near 2.4%—it had been near 2.75% already in 2019. At the same time, stock markets in the U.S. sold off near 2% just on Friday.

One might wonder how stock investors can go from being encouraged by the Fed's indication that rate hikes have ended for now to becoming better sellers. Last year's dramatic sell‐off was precipitated by investors' view that the Fed didn't understand where the economy was headed in 2019 and would tighten monetary policy too far. Now that it is clear the Fed has changed strategy, the concern is that it sees something investors don't in future economic weakness. The problem with this thinking is that it presupposes the Fed is generally right about the future, which it is not.

What the Fed is, and will continue to be, is data dependent. While Chairman Powell may get low marks for his communication clarity, he has shown us that he is willing to change policy quickly when the data suggest an outcome different from the Fed's current view. And in this, we have useful information to make investment decisions as we move through the rest of 2019.

Which Data

If this is true, then we need to understand what our guideposts are as we move through the rest of the year. For bond investors, this is most likely a combination of employment and wage growth, inflation and leading indicators of economic activity. While we anticipate intermediate bond yields to remain relatively stable, many are looking for a third or fourth quarter pick‐up in economic activity. This could suggest that the Fed may be back in the picture in 2020.

Nearer term, too much will be made about the fact that the yield curve has inverted (the difference between short‐ and long‐term interest rates is negative). While this fact has a good track record of predicting recessions, it has a terrible record on the timing of them. We believe that bond investors should use the benefits of a stable rate environment to buy yield on the short to intermediate part of the yield curve.

Stock investors have a more complicated task in 2019, albeit less so now that the Fed has indicated it is not hiking interest rates and will end the reduction in its balance sheet assets by October.

Corporate earnings will drive stock investors' decision making, and last Friday's sell‐off is an indication that they've moved on from worrying about the Fed. The sell‐off came as a result of weak manufacturing data and so worried those investors about future corporate earnings growth that they sold off everything. To be clear, stocks had rallied more than 12% this year, before this decline, so markets were ahead of themselves. Near‐term, earnings expectations will decline as worry about future economic growth mounts. As we move closer to April, when companies begin to report their first quarter earnings, investors will look for indications of future weakness in companies' forward‐looking statements.

For our part, we are neutral in our view forward, believing that stock valuations had gotten ahead of themselves and that the negative reaction to a slowdown in growth may have done the same. The balance may tip toward a stock price sell‐off near‐term; however, the growth slowdown may not be as bad as currently expected on every weak data point.

For those wondering how I fared in the match, I lost. The double‐faulting strategy didn't hold up against someone with more skill and speed than me.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

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