Time to see whether the “three steps and a stumble” rule will apply or not in 2017

While markets were spot on when they put just a 4% chance on a rate rise from the US Federal Reserve at its first policy meeting of the year last Wednesday (1 February) the American central bank is still targeting three interest rate increases, of 0.25% each for 2017.

That would take the Fed Funds target rate to a range of 1.25% to 1.50% from its current range of 0.50% to 0.75%. Futures markets, as monitored by the CME Fedwatch website, currently put just 1-in-4 chance of the Fed raising rates three times this year.

The first move is expected on 14 June (still only a 49% chance of an increase) rather than 15 March or 3 May, as this chart shows below:

Futures markets still question whether Fed will raise rates three times this year

Futures markets still question whether Fed will raise rates three times this year

Source: CME FedWatch , as of 2 February 2017

Such reticence is understandable for two reasons.

  • First, the central bank has thus far moved at a snail’s pace. The Fed began to taper QE in December 2013, stopped adding to monetary stimulus in autumn 2014 and raised interest rates by 0.25% in each of December 2015 and December 2016.
  • Second, the latest bout of inactivity is hard to explain, at least on the face of it. Inflation now stands at 2.1%, above the 2.0% target, unemployment is just 4.7% and wage growth is 2.9%. The ISM manufacturing industry sentiment survey, or purchasing managers’ index, stands at a two-and-a-half year high. The uneven rate of GDP growth may provide a better explanation, although the New York Fed Nowcast expects an acceleration in Q1 2017.

US GDP growth has been uneven ….

US GDP growth has been uneven

Source: FRED, St. Louis Federal Reserve database

… not least because inventory liquidation has held back growth (and stock levels are still high by historic standards).

not least because inventory liquidation has held back growth

Source: FRED, St. Louis Federal Reserve Database

Chair Yellen added to her list of reasons for not raising rates when citing uncertainty over the Trump administration’s fiscal stimulus plans, although bulging government, corporate and consumer debt levels probably have more to do with it, alongside lofty (if shrinking) inventory levels, and also fears of what the dollar might do (surge) and the S&P 500 might do (slide) if headline borrowing costs move up too sharply.

This neatly brings us to the old adage “three steps and a stumble.” Market lore has it that the third interest rate increase of a cycle is the one that really starts to start share prices, as increased returns on cash and rising bond yields start to tempt investors away from equities. If and when the Fed does next move, this will be the third increase of this cycle.

Three steps and a stumble

AJ Bell’s analysis of the seven rate increase cycles seen in the USA since 1970 suggests the old saying has more than a grain of truth in it, something that should put investors at least on a state of alert as America’s S&P 500 flirts with new record highs and US stocks trade at near peak valuations on market-cap-to-GDP basis.

The data clearly show that the S&P 500 has historically traded strongly into the first rate hike but then has lost momentum as monetary policy has been tightened making little or no progress, on average, for the 12-month period that followed increase in headline US borrowing costs.

US equities have historically lost momentum after the third Fed hike of an upcycle

1st Hike 3rd Hike Days From To Before first rate hike After third rate hike
    1 year 6 months 3 months 3 months 6 Months 1 Year 2 years
15-Jul-71 19-Jan-73 554 3.50% 6.00% 32.0% 6.7% -4.1% -9.1% -7.2% -23.1% -24.8%
01-Aug-77 20-Sep-77 50 4.75% 6.25% -4.2% -3.2% -1.0% -6.8% 2.6% 3.2% 22.9%
31-Mar-83 24-Jun-83 85 8.50% 9.00% 36.6% 27.0% 8.8% -4.0% -6.8% -3.7% 38.5%
04-Dec-86 21-May-87 168 5.88% 6.75% 23.9% 33.2% -0.3% 14.3% -8.0% -1.8% 21.5%
04-Feb-94 18-Apr-94 73 3.00% 3.75% 4.5% 4.7% 2.7% 5.0% 4.3% 29.7% 77.8%
30-Jun-99 16-Nov-99 139 4.75% 5.50% 21.1% 11.4% 5.5% 5.7% 2.8% -20.0% -38.2%
30-Jun-04 21-Sep-04 83 1.00% 1.75% 17.1% 2.8% 1.2% 4.0% 7.2% 12.9% 33.7%
16-Dec-15 0.25% 5.1% -1.1% 3.9%    
           
AVERAGE   165 4.48% 5.57% 17.0% 10.2% 2.1% 1.3% -0.7% -0.4% 18.8%

Source: Thomson Reuters Datastream

The good news for bulls of US equities is that history is no guarantee for the future. Optimists can also take solace from three other trends:

  • First, the Fed is increasing rates incredibly slowly. The average time span of the first three hikes over the past seven cycles has been 165 days, whereas it has already taken the Yellen Fed 411 days to manage just two. There is no guarantee the Fed will steam toward a third rate hike this year (let alone three in total) given the glacial pace of action and the ever-growing list of reasons for not tightening monetary policy.
  • Second, the Fed is hiking from a very low base. Prior rate cycles started at an average of 4.48% and ended at 5.57%, compared to the zero-to-0.25% starting point this time around.
  • Third, the S&P 500 has tended to regain its footing within two years, presumably in the view that the Fed was hiking because the economy was strong and corporate earnings were moving sharply higher. On six of seven occasions the S&P 500 has gained in the two years after the third hike – the exception was 1999 when the bursting of the tech bubble led to a market collapse (in a possible warning to investors today, as 2000 was also a time of very extended valuations).

Caveat emptor

The data does suggest some caution is warranted, though, especially as the exception to the good market gains on a two-year view came in 1999 when the bursting of the tech bubble led to a market collapse. Valuations on a market-cap-to-GDP basis and Shiller Cyclical Adjusted Price Earnings (CAPE) were higher in 2000 but then only 1929 has that dubious distinction apart from the peak of the tech boom.

US stocks look expensive relative to history on a market-cap-to-GDP …

US stocks look expensive relative to history on a market-cap-to-GDP

Source: FRED, St. Louis Federal Reserve database, Thomson Reuters Datastream. Based on the US Wilshire 5000 index.

… and on a Shiller CAPE multiple basis

and on a Shiller CAPE multiple basis

Source: www.econ.yale.edu/~shiller/data/ie_data.xls

Valuation is never a timing tool for markets and a terrible predictor of short-term stock market returns, but it is a fair guide to long-term (10-year-plus) returns – after all the higher price investors pay now for an asset and access to its cash flow, the lower the long term return, since any firm is only going to generate so much cash during its lifetime.

The combination of a third rate hike (if it comes) and lofty valuations is a therefore potentially dicey one.

It looks all the more precarious when taken in the context of very low volatility. This can be measured by the so-called ‘fear index’ the VIX. This US benchmark measures implied movements in options markets trades near record-low levels. A low reading suggests investors are relaxed and expect few if any shocks, a high one that there is panic in the air and bad news is expected.

The VIX also tends to trade inversely to the S&P 500. Bottoms in the VIX tend to coincide with market tops, as complacency gathers, as tops in the VIX with market bottoms as panic runs rampant and markets become oversold.

VIX volatility index stands 40% below its historic average

VIX volatility index stands 40% below is historic average

Source: Thomson Reuters Datastream

It can also be seen in a different way, namely via the number of times the S&P 500 has moved by more than 1% in a given trading day. Our analysis of the data back to 1995 shows a remarkable lull in such moves. Since 1 October there have been just four instances of a daily gain or loss of more than 1%. That compares to a 20-year average of nearly 20.

S&P 500 is seeing only limited movements on a daily basis, relative to history

S&P 500 is seeing only limited movements on a daily basis, relative to history

Source: Thomson Reuters Datastream

Seek out the spikes

High valuations, low volatility and widespread complacency mean much is clearly expected of Donald Trump’s economic programme. He may well deliver and drive US stock valuations higher yet, especially as the volatility data suggest we should get some warning before the balloon goes up.

Even the Crash of 10 October 1987 was preceded by increased volatility and 28 daily movements of 1%-plus in the prior three months, well above the post-1995 average of nearly 20.

If there is to be an accident, a spike in volatility could be one lead indicator to watch. Surges in volatility in 1998-1999 and 2007 turned out to be the beginning of the end of equity bull runs but we have yet to see this.

Besides increased intra-day trading swings, this column will also be following its other preferred lead indicators such, as the Dow Jones Industrial Transportation index and the Philadelphia Semiconductor (SOX) index. Both continue to trade reassuringly strongly for now, near their own record highs.

Russ Mould, AJ Bell Investment Director