From QE to QT

Investors will be glad to say goodbye to 2018, and especially the final month of last year, which turned out to be the worst December for the stock market since 1931.  December is usually a solid month for the market historically, which is probably why so many investment managers were caught off balance by the swiftness of the downdraft that occurred.  We had been discussing the prospect of getting more defensive in our portfolios, but believed it would be a task for 2019.

Another odd thing about last year was how strong the market was at the start of the year.  In the first three weeks of January, the S&P 500 Index surged +7.5% before experiencing a sharp correction.  The middle part of the year saw a fairly steady stairstep higher pattern into October, and then the market swooned into year-end.  So far this year, 2019 has also gotten off to a solid start.  The S&P 500 has rallied over 5% in the first two weeks of January, but we are mindful not to be lulled into a sense of complacency by the early market action.  Rather, we think a bit of caution remains warranted.

As we entered 2018, we cautioned that the lack of volatility seen in the previous year (2017) was unlikely to be repeated and to expect a pickup in volatility. That prognostication came through in spades, more so than we would have liked. We still think that the elevated levels of market volatility that surfaced last year could persist for a while. For many reasons, the strong growth that the U.S. economy experienced since the November 2016 election is moderating, and the degree of said moderating growth will help determine the path for financial markets in the year ahead.

The first area on which we are focused is corporate profits (earnings).  Earnings estimates for 2019 peaked last August, and have been trending lower since.  The estimate cuts at about -3% aren’t huge, but it is the direction that is important.  Earnings estimates had been continually revised higher for a couple of years previously, so the change in trend is worth noting.  Remember that earnings growth is the biggest driver of stock prices.

When it comes to earnings growth, we also look at the rate-of-change.  That is, is earnings growth accelerating or decelerating.  Last year saw a huge spike in earnings growth owing in large part to the corporate tax cut that was enacted.  Each quarter last year saw yr/yr earnings growth in excess of +20%, peaking in Q3 when earnings surged +32%.  The flip side of that is that this year the comparisons will be very difficult, due to the fast pace of growth last year.  As such, the law of large numbers almost guarantees that earnings growth will slow in the coming quarters.

The second area of interest to us is economic growth (GDP).  Recall the chart below that we have shown before, which displays the streak of 9 consecutive quarters of accelerating GDP growth in the U.S.  That is quite a streak, again with the aid of strong fiscal stimulus initiatives from the new Administration after the 2016 election.  Those fiscal stimulus measures had their desired effect, but now they are beginning to fade and that will make future comparisons to those strong quarters of GDP appear more difficult on a yr/yr basis – similar to the earnings comparison we described above.

Another component of economic growth comes from consumer and business confidence, which translates into spending.  The consumer ended 2018 on a fairly positive note: unemployment is at record lows, wage growth is solid, inflation is benign, and the wealth effect has been positive.  Mastercard recently indicated that this past holiday shopping season was the best it has seen in six years.  But while consumers are feeling good, business confidence is seeing some weakness.

To wit, in a recent New York Times poll of 134 CEOs and CFOs, almost half believe that a recession will arrive sooner than the consensus among economists.  They also cited concerns about the instability across Europe.  If corporate managements lose confidence, they may slow spending and hiring, which would trickle down to the consumer level and thus exacerbate any economic slowdown.  So the business and consumer confidence surveys bear monitoring going forward.

So far the signs of economic slowing in the U.S have been modest, but slowing growth in China, Japan, and Europe have been more pronounced.  China is trying to help with stimulus measures, but on a far smaller scale than we have seen them do in past years.  And Europe faces continued uncertainty in the form of ongoing Brexit negotiations, an upcoming election of a new EU president, and also a new president of the ECB to be named in the fall after Mario Draghi’s 8-year term ends.

And last but not least is the Federal Reserve here in the U.S., and the current state of monetary policy across the globe.  As a reminder, in 2008 the Fed and several other central banks in Europe and Asia began large scale asset purchases – known as quantitative easing (“QE”) – to help support financial markets and the economy.  The Fed’s balance sheet ballooned over time from $870 billion in 2007 to nearly $4.5 trillion by 2015.  The Bank of Japan and the ECB grew their balance sheets in excess of the U.S.  In total, there have been over $15 trillion of assets purchases.  But now comes the tricky part—the unwinding.

The process of shrinking the balance sheets has been dubbed “quantitative tightening” or QT.  The Fed embarked on its QT campaign in October 2017, but with only a nominal amount ($10 billion) rolling off each month.  Over time it allowed the monthly amount to grow, reaching $50 billion by October 2018.  Some market strategists think the increase in QT in October 2018 may have exacerbated the selloff in the stock market.  We should find out more going forward, as QT is set to continue in the near-term.  Chairman Powell reversed earlier comments about a set path for QT, and said the Fed will be flexible and may ‘pause’ if conditions warrant.  But no time frame has been offered at this point.

For their part, the Bank of Japan and ECB have said they will end QE purchases, but have not given any timetable for reducing their balance sheets.  Our lingering concern is that if it took $15 trillion in global QE to help sustain the bull market over the last decade, what happens when that stimulus is withdrawn?  For this reason, as well as the big picture slowdown effects about which we wrote earlier, we continue to look for opportunities to adopt more conservative allocations in our portfolios.

Jordan L. Kahn, CFA

Chief Investment Officer

Sources:Sources:; Seeking Alpha; Raymond James;; Standard & Poors; Barron’s; Charles Schwab; Wells Fargo
This market monitor is provided for informational purposes only and should not be interpreted as investment advice.