How Did Things Turn So Bullish?


From the Bank of Canada to the Federal Reserve, interest rate hikes are on hold…

For the markets, this is a welcome sign of relief. In Canada, growth is weak, household debt levels are enormously high, and the BOC, which often works in lockstep with its American counterpart, is thankful the Fed is finally pausing on rate hikes.

North American equities have not only stabilized, but are rising on an almost daily basis. The CBOE Volatility Index, or VIX, which is the most recognized measure of volatility, collapsed 5% Thursday alone. Since peaking on December 24th at 36, it has been cut in half to just 17.80 on Friday.

Volatility Index Chart
Volatility Index 1-Year Chart
source: Yahoo Finance

The risk on trade is coming back as volatility dissipates. For speculators like us, this is good news (but we remain cautious). It means greed is overwhelming fear and our markets are likely to be more liquid. More specifically, in a ‘risk on’ environment, the TSX Venture and CSE have a better shot at delivering home runs.

Today’s Weekly Intelligence Newsletter is all about Fed policy and finding niches that are expected to outperform in 2019.

Fed Pauses on Rates as Markets Stabilize

After a tumultuous December (which saw US equity markets nearly crater into bear market territory), the most recent three Fed chairs came together for a roundtable in early-January. Speaking at the American Economic Association’s annual meeting, it was all smiles from Jerome Powell and his immediate two predecessors Janet Yellen and Ben Bernanke. The love fest went on for well over an hour as the policy makers took victory laps and reaffirmed the market of their many financial tools.

The Fed, as we well know from the past ten years since the financial crisis, is always ready to act in case of weakness in the economy.

Click image above to watch Fed Chair Powell’s speech on rate path guidance from early-January.

Fed Balancing Act Long from Over

The Fed has to toe the line. With US national debt flirting with $22 trillion, and $1 trillion deficits projected in 2019 and 2020, America cannot afford a crisis of confidence in the dollar. Likewise, the Fed cannot let the markets be overly volatile, especially now…

As we’ve outlined in past Weekly Intelligence Volumes, the Fed is reducing its balance sheet. Thus, it is tightening even without raising interest rates by retiring debt/disposing of assets from its balance sheet; thereby, putting more pressure on foreign bond buyers to step up and finance once distressed assets.

Check out the Fed’s balance sheet over the past year:

Fed Balance Sheet Continues to Decline
Federal Reserve Balance Sheet Reduction Past 12 Months
source: FederalReserve.gov

While the above looks impressive, one needs to see the Fed’s balance sheet over a longer time horizon to gain proper perspective. Now, the Fed’s balance sheet is about to drop below $4 trillion – a significant milestone. However, its deleveraging plan only works if the US economy continues to grow, and the world stays confident in US debt…

Federal Reserve Balance Sheet – 10 Year Chart

10 Year Chart of the Fed's Balance Sheet
10 Year Chart of the Fed’s Balance Sheet
source: FederalReserve.gov

If the Fed can continue to unwind its balance sheet, confidence in the central bank (and US economy) will soar. And, most importantly, it will be ready for the next financial crisis which inevitably will come. We argue this is the central bank’s primary goal: To manage crises. Understandably, the Fed has a way to go before it is fully prepared.

Fed Funds Rate Reaches Neutral

In a bid to continue reducing its balance sheet, pausing interest rates is the first option. Federal Reserve chairman Jerome Powell explained on December 19th that,

“Where we are right now is the lower end of neutral.”

The Fed funds rate is between 2.25% and 2.5%. We expect it to stay near this range all year, with perhaps a single hike in December if GDP stays between 2-3%.

On January 15th, Esther George, president of the Kansas City Federal Reserve Bank explained the Fed funds rate “may be closing in on” its final destination. According to an article from France24 titled Fed official says interest rates nearing final goal,

“She noted that the increases to date had had an effect on the economy “and the effects will need to be watched carefully” but she said “we must acknowledge that rates are approaching, and may be closing in on, our destination of neutral” — the level that neither stimulates nor restricts the economy.”

In a Friday, January 18th, Bloomberg article, John Williams Says Fed Should Be Patient About Any Further Tightening, the president and CEO of the Federal Reserve Bank of New York, stated,

“…interest rates are closer to normal levels, and inflation is tame. The approach we need is one of prudence, patience and good judgment.”

Do you think the Fed got Trump’s memo (outrageously combative tweets) in December? While members of the bank insinuated they could care less about what Trump thinks, if the stock market and economy flounder, the Fed is less powerful and jeopardizes its global control…

For the US to maintain control and keep chugging along, it needs sovereign wealth funds and foreign governments to gobble up its debt or it has no way to finance its ever-steady deficits.

After two years of steady rate hikes, a pause is long overdue.

Federal Funds Rate – 10 Year Chart
10 Year Fed Funds Rate
10 Year Fed Funds Rate
fred.stlouisfed.org

As is the case in Canada, central banks need to give consumers time to adjust to paying higher interest rates. While 2.25-2.5% is still historically low it represents an impressive feat in a few short years. Remember, the Fed funds rate was at nearly 0% for almost 8 years.

Federal Funds Rate – Historical Chart
Fed Funds Rate
Historical Fed funds rate
source: fred.stlouisfed.org

The days of a Fed fund rate between 4%-5% may be over, at least for the foreseeable future.

Market Volatility Subsides with Recession Fears

Recession fears are fading (at least until 2020), the Fed is on board with pausing rates or reducing them if need be, and volatility is falling. However, don’t expect huge gains from the broad markets in 2019…

2-3% GDP is baked in to the markets, and likewise a trade deal with China.

N.B. According to a special report from Bloomberg:

“China has offered to go on a six-year buying spree to ramp up imports from the U.S., in a move that would reconfigure the relationship between the world’s two largest economies, according to officials familiar with the negotiations.

By increasing annual goods imports from the U.S. by a combined value of more than $1 trillion, China would seek to reduce its trade surplus — which last year stood at $323 billion — to zero by 2024, one of the people said. The officials asked not to be named as the discussions aren’t public.”

Wrapping Up

Guggenheim Partners Global Chief Investment Officer Scott Minerd is also of the mind the Fed is pausing rate hikes for now. While his views of the economy are not rosy, his firm shows no recession until 2020. Reuters quoted him,

“We see a broad-based slowdown in real GDP growth to below 2 percent year-over-year by the fourth quarter of 2019.”

And that,

“Our recession model is signaling relatively low recession risk in the next 12 months. The yield curve has not yet inverted, Fed policy is not yet restrictive, and leading indicators, though slowing, are still positive.”

Far from restrictive, the Fed funds rate is on hold for the foreseeable future. In an environment where economic growth is slowing, we believe investors must seek out yield in niche sectors expected to outperform…

In April of 2018, Grand View Research, Inc. forecast the legal marijuana market would be worth US$146.4 billion by 2025. Included is a CAGR (compound annual growth rate) of 34.6%.

While the broader economy in both Canada and the US will likely grow somewhere between 1-3% annually, the legal marijuana market is anticipated to grow at more than 10 times that rate.

It should be obvious why investors are clamouring for exposure to the marijuana sector. They seek growth in a relatively slow-growth global economy. From medical to recreational, new legislation is making cannabis legally available to hundreds of millions of people for the first time. The sellers/retailers of marijuana are standing on the precipice of a massive, new industry.

Stay tuned…

All the best with your investments,

PINNACLEDIGEST.COM

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