Monetary Policy Divergences And The Stock Market

This week's central bank ‘speak-fest’ and the December decisions were just the beginning of the divergence, though. Whilst we expect the Fed to hit the pause button after its first hike and only raise rates again in June, we expect a total of 200bp of US rate increases between now and the end of 2017. Meanwhile, we expect the ECB to leave rates in negative territory, expand its balance sheet further and maintain an easing bias. From a macroeconomic standpoint, this policy divergence between the US and Europe is surprising. In the late 80s, the US economy was sliding towards recession whilst the German economy was overheating in the wake of reunification. Today, no such cyclical divergence between the US and Europe exists. In fact, on our forecasts, we expect both economies to expand at a similar pace of almost 2% next year and inflation to rise towards 1.25 to 1.5% on both sides of the Atlantic. While the euro area business cycle lags the US in terms of resource utilisation, notably the unemployment gap, it is not heading in a different direction as it was in the ‘80s. In my view, the great monetary policy divergence will be a high-wire balancing act. There is a risk that the still-fragile global recovery could lose its footing if one side pushes too hard. Excessive US dollar strength would not only dent growth and inflation in the US, it could also cause dislocations in dollar-indebted EM economies, notably Brazil, South Africa, Turkey, and Malaysia, and undermine financial stability more broadly.

Source: Morgan Stanley (N:MS) Sunday Start (December 6, 2015), “Ringing in the Great Monetary Policy Divergence,” by Elga Bartsch, Global Co-Head of Economics and Chief European Economist, Morgan Stanley Research.

We’ve excerpted Elga Bartsch’s analysis above to set the stage for today’s discussion. At Cumberland we have a range of forecasts on growth and inflation in the US and Europe. Some of us think Elga Bartsch is about right. Others think she will be high on both inflation and growth. But the key assertion in her commentary is that monetary policy divergence entails “a risk that the still-fragile global recovery could lose its footing if one side pushes too hard.” We agree.

So what does history tell us about this divergence and stock markets?

For an answer to this question, we examined some brilliant work by Tom Lee and his team at Fundstrat Global Advisors. Tom was kind enough to give us permission to quote his December 4 analysis.

Tom examined US–European divergences since 1971. He used the euro from 1999 forward and the deutsch mark for the previous period. His analysis begins at the time when the Bretton Woods fixed-currency regime was breaking down and the US was leaving the gold standard. President Richard Nixon ended the gold standard in 1971; the complete demise of Bretton Woods followed. For some history see research by Sandra Kollen Ghizoni of the Atlanta Fed: http://www.federalreservehistory.org/Events/DetailView/33.

Tom Lee found that “Since ’71, 45% of time when the Fed hikes while ECB (or Bundesbank) eases, the dollar weakens. The median policy divergence lasted 17 months. Tom notes that this historical record is a direct “counter” to those who argue that today’s policy divergence is unprecedented.

Tom Lee found that the S&P 500 “performs well when the Fed diverges, gaining 80% of the time (6 months out).” The median gain was 9%. (The rest of the details in Tom’s work regarding sectors and industry groups and their relative performance in a divergence are proprietary Fundstrat research. Cumberland is a user of that research, which is a paid service. We respect the proprietary work of others, just as others respect ours. Firms cannot stay in business by giving their work away. We thank Tom for permission to share the summary of his findings with our clients and readers. Clients will see the direct application of Cumberland’s conclusions in their accounts.)

Please note that today’s commentary is written before the Fed has officially announced any policy change for December 2015. As of today, markets and pundits widely expect the Fed to lift off a quarter-point at their December meeting.

We remain nearly fully invested in our US ETF strategies, and we remain favorably positioned in US dollar-denominated bonds with desirable spreads over US Treasury notes and bonds. We are still able to position clients in a 4% (or so) high-grade, tax-free bond at a time when the referenced US Treasury bond is yielding closer to 3% or lower. We believe that is a market mispricing that has been created and sustained by ongoing American investor fear of higher interest rates. US tax-free muni bond buyers have been afraid of rising rates for seven years and have paid a severe price in lost income. Four percent tax-free is very desirable in a climate of 2% growth and 1.5% inflation.

If the European and American monetary policy makers cannot achieve this 1.5%–2% inflation target and a 2% growth target, those 4% tax-free muni bonds become even more desirable. The achievement of higher inflation and faster growth is not a foregone conclusion, but the 4% tax-free payment stream is “money good” if the correct bond is purchased and held.

Note that Japan has been at near-zero inflation, near-zero interest rates, and near-zero growth for two decades now. The one attempt to move Japanese policy away from zero came in 2006, and the results were disturbing. Japan reversed that policy and has been at the zero boundary ever since. As an irony of history, one of the ministers in that 2006 government was named Abe. (hat tip to Brian Barnier for joggling memory).

We expect the Bank of Japan to continue with its zero policy for several more years. There is presently no way to know if the BOJ will move to negative rates although they have announced that they have no present plan to do so. Nor is there any way to know if they will add purchases of gold or other precious metals to the asset list for their central bank holdings notwithstanding that others in Asia are doing so.

David R. Kotok, Chairman and Chief Investment Officer.