Will the US economic ‘plane’ ever lift off the tarmac?
A weakening in US economic momentum appears at a bad time for the Fed.
For years now, stgeloped world Central Banks have engaged their ‘whatever it takes’ efforts to stimulate activity and demand in indebted economies, wrapping asset markets in cotton wool. The extra-ordinary monetary policies in the US, UK, Japan and Europe carry significant risks; the risk of a deflationary spiral is the greater fear.
To June, 3yr returns for traditional balanced portfolios, like the majority of Aussie super funds, have exploded beyond 12 per cent p.a. (more than 50 per cent higher than long run average returns). This is a direct result of the ‘helicopter drop’ of printed money into stgeloped economy bond markets. Equity, bond, property, infrastructure, emerging currency markets have all benefited.
In behavioral economics we call the cotton wool a moral hazard.
So investors and central bankers are today grappling with outcomes of extraordinary monetary policy, attempting to lift the plane off the tarmac of zero-interest-rate-policy (ZIRP). It’s proving difficult. Not because economic momentum hasn’t supported takeoff; US GDP is tracking at 3.9 per cent, well above trend. An unemployment rate of 5.1 per cent is reasonable. Subdued inflation has been a thorn.
The Moral Hazard Effect
The difficulty is imbedded in the policy’s moral hazard, causing market volatility at the hint of removing such an extraordinarily supportive environment. Put crudely, we’re witnessing ‘prescription drug dependence’, and the effects of ‘withdrawal.’ This is why many poor economic data points have been welcomed with share market strength, and vice versa. The elevated market volatility from ‘withdrawal’ brings uncertainty; with it confidence takes a battering. Confidence impacts the real economy, real people – the economic data.
So the question is, how much of the recent poor US jobs data is a function of market volatility, and what does that mean for jobs growth going forward?
All Important Payrolls Data
Taking in revised data, the last time the monthly US jobs data bettered the market’s expectation was the report for May jobs, a long time ago. Since the end of May, at the time of writing, the S&P500 has lost nearly 8 per cent from it’s 1yr high, oil down 25 per cent and the VIX, the US share market’s short term volatility indicator or ‘fear gauge,’ has risen from 13 to 21 (high of 40 in August). A reminder, an elevated VIX level is more important than its change up or down. If you have elevated fear, that matters more than changes in elevated fear. Elevated uncertainty means market gyration – that matters to confidence.
With that strong May jobs report, Table 1 below, the market started to focus on a very possible September Fed rate hike. Enter volatility. Yes, the Chinese growth transition and their extreme market volatility played a role in the gyrations, exacerbated by the backdrop of expected rising rates in the US.
Table 1: US Private Payrolls. ‘Actual’ is the revised data. ‘Forecast’ is the median market expectation. ‘Previous’ represents the data printed on release.
Data revisions have been particularly bad for August and September jobs. How much of the market volatility has leaked into the real economy, and job hiring? It’s hard to argue it’s had no impact.
Trading the Theme
The Fed raising rates is well and truly a 2016 story, but expectations for when will oscillate.
How can we trade this thematic?
The merry-go-round of The Fed’s ZIRP, the volatility associated with its removal, and real economy confidence impacting data has shown its colors. This has the potential to be very circular, enough to keep the plane on the tarmac for a lot longer than is expected.
The tail is inadvertently wagging the dog.
The moral of the moral hazard story: (I’ll call this The tail wags the dog trade)
Average into buying US equities (I’m not a stock picker), and emerging currencies when the VIX heads north of 20. It will take some nerve buying into uncertainty. With elevated volatility the circular environment described above is in play, especially if the volatility persists. The Fed’s hand is likely forced to extend supportive policy, as recent poor data has done, and risky assets will perform. Average out of the position when the VIX heads south of 15. This trade could materialise multiple times in the next six to twelve months.
USD/MXN is my favorite of the emerging currencies; this trade removes a lot of endogenous risk because Mexico is so closely linked to the US economy.
Risks to this thematic? – Missing the plane altogether.
A strong consistent rebound in payrolls data accompanied by stronger wages growth would see the US economy, and its equity market, really flying. A rate rise will be par for course, and the VIX will stay south of 20. Your balanced super fund will benefit here.